Loss Aversion
If we are offered a coin toss in which we may lose $10, we will on average ask for a potential win of $20. Why is it that we are more sensitive to losses than to equivalent gains? How can we avoid making hasty, irrational decisions when we deal with an immediate loss, or the possibility of a loss?
This phenomenon takes many forms:
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The stock market is going up. You only have twenty percent of your money in stocks. You feel you are losing out, and buy more stocks. Pretty soon, you may have shifted most of your investments to the stock market. This is when the bubble bursts. This has happened many times, to many people, over the course of numerous bubbles.
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You lose a poker hand. You want to recoup your loss. To do so you bet on riskier hands. You lose more.
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A flat tire made you late. You want to make up lost time. You are speeding, and you go through a red light.
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You rent a car. Your car insurance and credit card company will take care of the costs in case of an accident. Yet you let the sales rep convince you to get the loss damage waiver.
Nobody seems to be immune to loss aversion. Since 1926, stocks have outperformed bonds by a factor of 10. Yet economics Nobel Prize winner Harry Markowitz split his own investment portfolio equally between stocks and bonds. Only neurological patients who are unable to feel any emotions seem to be immune to loss aversion.
The neurological basis for our greater sensitivity to losses than to equivalent gain is still unclear. A broad set of brain areas is activated in response to gains. Interestingly, losses do not appear to activate different areas: the activity of the same areas decreases.
How can we do better?
When faced with an immediate loss, the best way to avoid the trap of loss aversion is to take the long view. Is this loss significant over the long run? Are there risks involved with reacting the way I am tempted to? More often than not the answers are no, and yes. Are these risks worth taking?