Loss aversion refers to the tendency of individuals to take a loss more into account than a gain of the same magnitude.
The losses are bigger than the gains. A loss is psychologically estimated to be twice the value of a gain. That is, for us to bet an amount, the prize must be double the bet. That is why for us to make a bet of equal magnitude we must have some psychological component by which we believe more in profit.
The concept of loss aversion is associated with prospect theory, within behavioral finance. It is also one of the fields of study in behavioral economics and marketing. It is studied why people generally show a tendency to choose not to lose rather than win when they have an investment decision or a certain level of risk in their hands.
Studies on loss aversion are closely related to psychological factors and the study of human behavior. Through them, it can be known that in most cases an individual avoids taking some type of risk despite having an option to benefits.
In this sense, loss aversion is a main cause for the appearance of risk aversion. A person may be risk averse, risk neutral or risk prone. When it is risk-averse, it suffers more from a loss than from a gain of the same magnitude, while being risk-neutral it values it the same. In contrast, a risk-prone values a gain more than a loss of the same magnitude.
Loss aversion example
If walking down the street we find a 5 euro bill, we will have a level of satisfaction and we will be happy. However, if we lose that money later, the feeling of loss that would appear would be greater than the initial positive sentiment. At first we did not carry that money and when we lose it we simply remain the same and the absolute value is zero. However, psychologically there is a negative effect as if the loss had been real.
Another example that is often used to explain the financial irrationality of individuals is the choice between two games that have the same expected long-term outcome. Despite having the same expected result, people tend to choose more certainty for gains (due to our aversion to risk), but uncertainty for losses (we become prone to risk). This is because people value profit and loss differently. Therefore, they will base their decisions on perceived gains and not on perceived losses.
Imagine that we can choose between two games. Both consist of tossing a coin into the air:
- In the first game, if heads come up we win € 100, while if tails come up we don’t win anything. (Net profit = € 50)
- In the second game, whether it is tails or heads we win € 50. (Net profit = € 50)
Despite the fact that the long-term net profit is the same (50 euros), people choose certainty, because they see a simple profit of 50 euros to be certain (game 2) more favorable than a possible profit of 100 euros or not winning at all . Choosing the first option is consistent with traditional finance.
But in the case of losses the situation is reversed. Because of people’s fear of loss, they act emotionally and not rationally. If the game was reversed than before and the elections were a net loss, the decision would change. Let’s suppose:
- With the first game we lose 100 euros if heads but if tails we do not lose anything. (Net loss = € 50)
- The second game is the same as before but in reverse, whether tails or heads we lose € 50. (Net loss = € 50)
In this case, given the possibility of not losing anything, people choose uncertainty (game 1), hoping that tails come out and they stay as they were, despite the fact that they can lose more.