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Is Loss Aversion A Bias?

Is Loss Aversion A Bias?

Hi There,

This week we are talking about burgers but we are not comparing Burger King and Burger Singh, this is not a food review. Instead, we are discussing whether people get more upset about losing one compared to being happy about getting a free one. No, I am not joking. This is a real issue, and it is called loss aversion. It turns out there is more to loss aversion than it seems, the findings provided by early research do not account for other potential determining factors.

Let me explain ... Suppose you buy a single Burger for $1, and you are given two options:

Option 1: You can keep the Burger.

Option 2: You can return the Burger and receive $1.50.

Which option would you choose?

Most people are likely to choose Option 1, because choosing Option 2 may not seem like a significant gain if they have to lose their existing option. This is because the psychological pain of losing what they already have, in this case, the Burger, is often more intense than the pleasure of gaining a small reward.

Recently, Starbucks got a lot of criticism for increasing their rewards points for free coffee, even though they've reduced the rewards for iced coffee, one of the most requested drinks. This shows a loss aversion in people, where they strongly dislike losing something they have and prefer to keep it instead of gaining something.

This concept was introduced in 1979 by two psychologists who we keep mentioning over and over again, Amos Tversky and Daniel Kahneman, who conducted a study in which participants were presented with two gambles to choose from. Both gambles had different levels of risk and reward, with one gamble being relatively safer but with a lower reward, and the other being riskier but with a higher reward. The results showed that most participants were more likely to choose the safer option, even when the reward was lower because the fear of losing money was stronger than the desire to earn more money. The study has been the most widely cited and has influenced research in several fields, including psychology, economics, and finance.

It has helped to establish the concept of loss aversion and showed that people tend to experience stronger negative emotions when faced with potential losses compared to potential gains. It also provided evidence for the idea that people are more risk-averse when it comes to losses and more risk-seeking when it comes to gains.

This theory can be used to explain numerous phenomena, such as to why people do not quit their jobs even when they're miserable, why people are less likely to save for their retirement, or why investors are hesitant to take risks.

However, recent research has found some limitations to this theory. This suggests that the impact of losses and gains on individuals may be more nuanced and context-dependent than previously assumed.

Loss Aversion in Context:

Previously, research has shown that when faced with the prospect of losing or gaining a large sum of money, it makes sense that individuals would be more psychologically impacted by the possibility of losing that money. However, when small amounts of money are involved, the impact on one's objective well-being is expected to be negligible. In this case, it is concluded irrational for individuals to exhibit a greater sensitivity to losses as compared to gains. This perspective is supported by the work of Rabin and Thaler.

In the article "The Loss of Loss Aversion," David Gal and Derek Rucker's critique focuses on two types of decision-making: riskless and risky. In riskless decision-making, the options and outcomes are known with certainty, such as deciding whether to keep a Burger or exchange it for $1.50. On the other hand, deciding whether to invest in a start-up with a 50% chance of either doubling your money or losing it all would be a risky decision.

The authors also examine the phenomena of status quo bias and the endowment effect in the concept of riskless choice, where the options and payoffs are known with certainty. They argue that the reluctance to exchange a good, often referred to as status quo bias or endowment effect, is due to a preference for inaction rather than loss aversion. The authors argue that current evidence does not support this theory and propose a more nuanced understanding of the relative impact of losses and gains, suggesting that their impact can vary depending on the context in which they occur.

In the case of risky choice, where the outcome is only known after the decision is made, Gal and Rucker argue that loss aversion is not a good explanation for many observed empirical results. They suggest that other factors, such as probability weighting, ambiguity aversion, and reference dependence, drive decision-making in risky situations. Another recent study suggests that moderators such as education, experience and financial risk-taking may also be important considerations when analysing the impact of losses and gains on individual behaviour.

Gal and Rucker challenge the notion of loss aversion as the primary explanation for observed results in both riskless and risky choices. The authors believe that to understand decision-making better, it's important to take into account not just the impact of losses and gains, but also other factors like the tendency to stick to habits, unclear or uncertain preferences, and the way people perceive the probability of different outcomes.

Instead, loss aversion may reflect differences in information processing, including attentional and emotional regulation. Additionally, it is important to consider the context and individual differences that may influence the expression of loss aversion. For instance, loss aversion may be stronger in some individuals or in certain decision-making situations. Thus, the findings should not be interpreted in a way that disregards loss aversion entirely when analysing decisions involving money. Rather, these findings suggest that loss aversion is likely not the only factor to consider when evaluating the outcomes of financial decisions.

Written by Farheen

Edited by Aurko


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