Behavioral finance FAQ / Glossary (Loss aversion)

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

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

Loss averse, aversion




00/10i - 01/8i - 02/1i,4i,5i,8i,9i
- 03/3i,4i,10i - 06/4i + see risk
aversion, disposition effect, regret,
commitment,
sunk-cost fallacy,
prospect theory, selling aversion
+ bfdef2

Sadder to lose than happy to gain.

Definition

Loss aversion is an asymmetric / unbalanced emotional attitude
towards gain prospects and loss prospects.

To illustrate it simply, people need

* to hope to gain 20 (or even 30) Euros

 to compensate

* the fear to lose 10 Euros.

Look at that:

1+1+1+1+1+1+1
+1+1+1+1+1+1+1
+1+1+1+1+1+1


Euros you receive

in
one hand

 

are slightly worth

1+1+1+1+1
+1+1+1+1+1


 

Euros you let fall

from the other
hand!

Technical formulation

Filling the vocabulary bag.

Behavioral economists, in the wake of Nobel prize Daniel Kahneman's
"prospect theory" (see that phrase) call this skewed attitude the

" loss aversion" and translated it as:

"The disutility of losing something is greater than
the utility (see that word) associated with acquiring it."

However widespread this mental asymmetry is, it is poorly efficient and

rather irrational when it feeds decisions.

Thus it can be categorized as a cognitive or emotional bias (see bias).

Practical effects on investor behaviors

Losing ...the sense of proportion?

There is a widespread investor preference, in managing
their assets, to sell winners instead of losers.

Loss aversion seems to be the main motive (*).

Many studies have shown that most investors, and among them the less
experienced ones, are loss averse.

Their loss aversion is stronger than their urge to seize gain opportunities.

A specific aspect of loss aversion is that, in contradiction to their
risk aversion, people are willing to take risks on an asset that has
failed them.
They have the (dubious) idea that keeping it gives them a chance to minimize
latent losses on that asset.

Investors resist to sell an asset on which they
   lose money
.

They would prefer to keep it, even if the asset's prospects do
not show favorable traits
(barring some wishful thinking)

either on the fundamental side (not all fallen stocks are "value
    stocks")

and/or the market trend side (who knows when a downwards
    momentum will revert?).

They take therefore the risk that its price fall even more.

They might even invest more money into
   assets on
which they already have losses (see "get-

eventis", "cost averaging"):

They accept a bigger risk on the hope of recouping a loss
(a rather widespread attitude in gambling also).


In parallel, they tend to sell too early an asset that shows a
   gain
,
for fear that it might turn into a loss.



Also, as seen in economics (the taxi driver paradox), they might
   strive
and work longer on days that bring them a loss or
   an insufficient gain, so as to compensate them. ..instead of making 

a surge of efforts on days when the state of affairs is better and
would allow them to optimize their earnings.

(*) Other motives than loss aversion (and regret aversion, see
     
that phrase) are:

their reluctance to admit their "mistake" ( pride / ego),

their attempt to reduce the mental pain (regret)

of having made an initial damaging investment decision),

their intention to keep what for them is a personal

"commitment" (see that word) to a specific investment.

Associated concepts, and search
     for what might cause that aversion

Pain and pleasure are not born equal.

Loss aversion is a key aspect of the "prospect theory".

See more details about that theory in the related glossary article.

Also the general "aversion" article helps to see relations  

between risk aversion, prospect theory, loss aversion, regret
aversion, disposition effect...

Whether the main cause of loss aversion is cognitive or emotional, and whether
there
might be or not some rationality in that behavior, is debatable.


Anyway, when pain and/or pleasure are at stake, something usual when facing
a loss or benefiting from a gain, the   emotional factor often
dominates.

Reference point and prospect theory

An old price tag deeply engraved inside the brain.

According to the prospect theory, people start to measure their gain and losses
from a reference point / price (the zero point of the graph in the prospect
theory article).

Funny how the frontier between pain and pleasure is just a market price
number!

That "mental starting line" and "mental pivot" is often the
price at which the asset was bought - rarely adjusted
(for
inflation or costs).

It can also be another anchor price (see
anchoring), for example the highest market price reached in the past.

To situate the prospect theory in an (overly) simple way:

If we use the prospective approach, people need, as

seen above, to hope for a gain of 2 or 3 to compensate for the
fear
to lose 1.

Another prospective aspect is that when we missed a highly desired
gain we see it as a loss. Here the "reference point" from which
the loss is calculated in the future

If we use the regret approach, they would have:

- More regret (see that word) to have made a decision by which
  they lost 1

- Than delight to have made a decision by which they gained 2 or 3.

Loss aversion and risk aversion

Gain v. loss.
Relative v. absolute.
Backward v. forward...

How do those ingredients mix?

Some academics tend to consider that the loss aversion includes the risk
aversion (see that phrase)
- whether that last one is biased or not.

The difference would just be a matter of degree.

There is some confusion heresome confusion here.

There are real differences, even opposed traits, between the two
phenomena:

Risk aversion and loss aversion sometimes oppose
   each other:

When the market offers for their asset a price under their
reference price,
people get usually more loss adverse than risk
averse.

They prefer the risk to go on betting on the losing horse than to
accept the loss they already made with that lame animal.


Risk aversion could be seen as an absolute concept,

It characterizes the preference for a small gain that is certain
(zero loss
probability against a higher probable gain but that
entails also a probability of loss.


Loss aversion is a relative and asymmetric concept.

It is related to the comparison between several probable gains
(calculated from the same reference point) that entail each one
a probable loss
, but  with different probabilities.

The higher the probability of loss, the larger a
potential gain is needed to compensate it.
But also the size of that needed gain rises faster
than the size and probability of the loss.

A huge gain is needed to offset a rather average-size
     loss

The prospect theory S-shaped curve (see the "prospect theory"
article), which pivot
is the reference price mentioned above,
shows that the perceived positive utility of gains increases more
slowly than the negative utility (disutility) of losses.


Loss aversion is more irrational than risk aversion,

as it can lead to take risks on losing operations.

Beware of semantic confusions

Word salad.

A different kind of loss aversion is the myopic loss aversion.

It is a reluctance to buy equities instead or bonds (or in complement
to them as a diversification move) even for long term investment (see
equity premium).

The myopia means here that overcautious and shortsighted investors might
see
the immediate risks but not the long term prospects.

On the other hand it is true that, if we look at rare events (see that
phrase) there is more chance

* of a big stock exchange collapse that would need decades to be
   corrected

* than of a drastic overall bond market collapse.

But none of those two types of assets are immune by the way
(look at the current sovereign debt turmoil)

Loss aversion differs also from the disposition effect aka endowment
  
effect (see those phrases)

This bias makes people often reluctant to sell any asset they
own.

This fetishist attitude is more a form of status quo bias than of loss aversion.

People tend to consider that their belongings have more value than (about)
any price offered for them, whether that price would allow to realize a loss
or a gain compared to their acquisition price.

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

Members of the BF Group, please

 vote on the glossary quality at BF polls

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This page last update: 20/08/15  

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