Loss Aversion
Decision-making can be categorized in many ways. One simple way to understand the decision-making process is determining whether the person is a risk-taker or a risk- avoider. Whether it is due to factors of financial instability, or simply the fear of the unknown, the majority of us tend to avoid taking risks.
This explains the well-known concept of risk-aversion. However, when one’s past experiences and the expectations of the outcome are valued higher than the tangible cost and benefit itself, we begin dabbling into the concept of loss aversion.
Loss aversion defines peoples’ tendencies to prefer avoiding losses over acquiring gains. It explains the behavior that people will choose to stay where they are and not expand their financial gains if there is a risk of losing the initial amount. “It is better to not lose my $1 than to find a $1.”
Yes, even if there is a clear opportunity to make another dollar or even $50, the rationale is to not get involved because the decisions in this concept rely heavily on satisfaction gained from the outcomes than the outcome itself. The findings of loss aversion conclude that the satisfaction gained from avoiding losses is twice the pleasure received from acquiring gains.
Loss Aversion vs Risk Aversion
Loss aversion differs from risk-aversion in that it completely disregards one’s risk-taking ability, financial-instability or need for gains. It focuses on not wasting resources and retaining one’s money. This concept in its simplest form is decision-making explained by our emotions and how much emotional toll we wish to bare.
It also focuses on saving one from the emotional toll of losses. For example, if you were given the following choice of gaining $80 straight away or playing a card game that led you to gain $100, with the loss of $20, the theory of loss aversion concludes one would immediately accept the $80 even though the gain is higher in the latter scenario because the pain of the loss is higher than the satisfaction received from the gain.
This concept similarly explains the irrational behavior among investors who become loss- averse and focus solely on avoiding losses instead of making gains (play this game to test your loss-aversion).
While being loss-averse may lead to irrational behavior, this aversion makes absolute sense on a human level. It is understandable that humans fear the loss of things they have already earned and own over things that they could potentially own but do not yet. Regardless of how rational we might wish to be, our emotions, our past experiences and present circumstances all play a key role in the decisions we make in our daily life.
Read about other behavioral finance biases like anchoring or gambler’s fallacy.