Behavioral finance FAQ / Glossary (Aversion)

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Dates of related message(s) in the Behavioral-Finance group (*):

Year/month, d: developed / discussed, i: incidental

(disappointment, loss, risk, regret, uncertainty...) Averse, Aversion

See "aversion, disposition and prospects", disappointment aversion,

loss aversion, risk aversion, regret aversion, uncertainty aversion...

To invest money gives either the feeling of becoming a nabob

or the aversion of swinging a leg in a crocodile pond.

Aversion-related phenomena in investment, borrowing, business, economics

Aversion is a form of pain (the same as attraction is -usually - a form of pleasure)

when facing some situations or some decisions / actions to take.

Definition: Aversion is a painful feeling in the form of a dislike,

an hostility, a negative attitude (see "attitude") towards

something (or somebody).

It activates a suffering in a particular emotional brain area (see neurosciences).

Some neurons are nagging!

In decision-making and the related behaviors, aversion brings:

Most of the time, a reluctance to act.

Sometimes, a more personalized hostility or even hate that

leads to resist, fight or eliminate whoever is considered the "culprit".

The opposite attitude is liking, based on an impression of pleasure,

an attraction towards something / somebody

In between liking and aversion, there is the neutral or tolerant attitude.

Aversion can cause various kinds of biased behaviors.

Typical ones are found in moves - or lack of moves - related to money matters.

 

Here, when a possible loss is at stake, various phenomena under the "aversion" umbrella can appear:

Risk aversion (see that phrase) is one of the oldest economic concept.

It leads to the expected utility (see that phrase) notion.

It is, when having the choice:

To prefer a situation or a behavior that allows to obtain or to keep a

safe / certain amount of money without risk,

Than to opt for one that gives the possibility to get a bigger amount

but with the risk of getting nothing (or of loosing something).

"Better be safe than sorry", is the feeling behind this.

  Uncertainty aversion (see uncertainty). is an attitude related to risk aversion.

It takes place when probabilities are not statistically known and probability laws

do not fully apply.

This is often the case in markets, whatever is said about "statistical risk", or about "volatility"

that only show the "ordinary" risk, the "historical" one, or even more short-sighted, the "recent" one.

Uncertainty tends to incite:

Either, paradoxically, to stick to a false feeling of certainty...

* by ignoring, neglecting or denying - possible scenarios and new situations that do not fit

already known data (see numeracy bias) and/or clear-cut probability laws (see distribution),

* even by building - or adhering to - beliefs and pseudo certainties to explain unclear

situations and make predictions.

Or on the contrary to create an exaggerated fear of uncertainty.

Loss aversion and regret aversion are other types of aversions.

They are explained in the "aversion, disposition and prospects" article below.

Aversion, disposition and prospects

(Synthesis article on those various concepts)

 

This article compares for clarification, various notions

present in the glossary and partly related to one another:

* Risk aversion, loss aversion, regret aversion,

disappointment aversion,

* Prospect theory, disposition effect, endowment effect...

Hamletian reluctance to do or not to do certain things?

Prospect theory and reference price

To sum it up, people have a much higher hate of losses than a love of gains.

The prospect theory (see that phrase) complement the risk aversion notion. That theory addresses usually:

Assets already owned (there is here a relation with the disposition effect as seen below),

It can sometimes apply to new commitments also, as an aversion to take them.

A reference price for such assets (see reference point),

It is for example the buying price, an historical high market price,

or a price objective including an expected gain, etc.

That theory states that, when calculated

from the same reference price (for example the buying price):

The disutility (= displeasure)

of a prospective loss

Is higher

than

The utility (= pleasure) of a

prospective gain of the same amount

For example, people would usually accept to risk a loss of 100 Euros only if they expect

to gain much more than 100 Euros (typically 200 or 300 Euros) (*)

(*) Expected losses / gains being defined as foreseeable gains / losses multiplied by

their probabilities (see an example in the "expected value" article).

The difference with the plain risk aversion is that the comparison is made

Not only between two investments with fully opposite traits: a risky and a riskless one,

But, for the risky investment itself, between its downside and upside prospects,

And / or between two risky investments.

What is more irrational, is that loss aversion is not based on future risk

or on utility, and that it can lead to risk taking on already losing operations.

Although called the "prospect" theory it applies not only to future gains and losses but also to actual ones,

the eggs already broken.

Moreover, it gives explanations on loss aversion, regret aversion and more generally the disposition effect

(see below those three concepts).

Disposition effect and regret / loss aversion

Sorry, what is mine is not for sale.

1) Disposition effect

The disposition effect (see that phrase) is a widespread asset owner's

aversion to sell unless getting what is considered a "good price",

This wanted price can be called a reference price,

but not necessarily the one triggered by the loss aversion.

This is a bit different from the endowment effect,

which is somebody's reluctance to sell an asset it owns whatever the price.

It differs also from the loss aversion, in which the reference price is

usually the buying price, as seen below.

2) Regret / loss aversion

The disposition effect, which exists by itself, is reinforced by other types of aversions

when the unfavorable price situation entails a regret or loss.

But it can be compensated if the regret or loss diminishes

(for example after a price rise, even if it does not compensate the loss fully).

The regret aversion (see that phrase) is one of the causes of

the general aversion to sell whatever the price...

...whether there is or not a reference point

...and whatever the kind of reference (buying price, previous price

at which the asset could have been sold).

While the loss aversion is usually the aversion to sell when

comparing the present price to the buying price.

Anyway, the regret aversion or loss aversion:

Can be stronger for a specific asset, for which the investor feels guilty to have made a bad choice

when he bought it,

Than for a stock which prices evolved like the whole market; which makes him think that

the evolution is independent from his decision.

In that last case, there is only a disappointment effect / aversion (see that phrase).

The regret aversion (see the detailed article) can also apply to a missed buying opportunity,

while the loss aversion can give an explanation to the aversion to sell old assets to buy new ones

When regret / loss aversion can oppose risk aversion.

When the price is under their reference price people are usually more loss averse than risk adverse:

they prefer the risk to go on betting on a horse than to accept what that horse already lost.

This shows that, perversely, loss aversion can lead to risk seeking.

(*) To find those messages: reach that Behavioral-Finance group and, once you are there, 1) click "messages", 2) enter your query in "search archives".

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