What is... | October 5, 2016

What is loss aversion?

People enjoy profiting on investments and dislike losing money. Yet we can feel the pain of losing €100 more than we enjoy an equivalent gain.

Some studies suggest the pain associated with a financial loss is two to three times the pleasure associated with an equivalent gain. We are motivated to minimise feelings of loss, based on a previous reference point – even when it doesn’t make financial sense to do so. This is known as loss aversion.

For example, Basil has invested €20,000 in the share market, and loses €5,000. This means Basil now has €15,000 (let’s imagine there are no fees, taxes or interest to be paid). His friend Carol, on the other hand, invested only €10,000, on which she gets a return of €5,000.

Basil and Carol both now have the same amount of money – but their initial reference points were different. Basil feels bad about his €15,000 because he now has less money than he started with.

Loss aversion, as a seminal paper by Daniel Kahneman and Amos Tversky explains, means people will feel a loss more than an equivalent gain, comparing it with an initial reference point.

“Losses and disadvantages have greater impact on preferences than gains and advantages,” Kahneman and Tversky write. “Standard models of decision-making assume that preferences do not depend on current assets.”In short, people’s money choices depend on what they already have."

Crystallising losses
It follows that when people are averse to what they perceive as a loss, it can affect how they make money decisions. They can become unwilling to sell an investment that has fallen in value, as that would mean actually realising the loss.

But this can make things even worse, as the price of the investment might keep falling, ultimately increasing the amount lost. Loss aversion can play a role in a whole range of asset classes, including shares and property.

Heads in the sand
The ING International Survey – Savings 2015 found that people in Europe are more likely to know the interest rate they receive on savings than how much interest they pay on debts.

Overall, 19% in the survey of almost 13,000 people in Europe did not know the interest rate they earned on savings. This compared to 27% who do not know the interest rate they paid on debts, excluding mortgages but including bank overdrafts and other loans.

The finding may surprise some, given that interest on debt is typically higher than on savings and needs to be paid regularly, according to the terms of the loan. Psychologists use the term “ostrich effect” to describe this tendency to avoid information we expect to be painful to hear. Because we dislike losses, some borrowers may bury their heads in the sand to avoid acknowledging the costs of debt.

Home loss
Loss aversion has a noticeable effect in the housing market – a sector often steeped in emotion. Research here and here suggests people are often unwilling to sell their home for less than they paid for it. Yet housing often accounts for a large share of individual wealth and so falls in house prices can have important financial consequences.

One tip that might help investors put losses into perspective is to take a longer term view of finances and of prices in general. The flow of everyday news can tempt us to look at asset prices too often. Prices go up and down, day to day and month to month, in a seemingly random pattern.

At any time, there may be news suggesting share prices have not fallen as much as previously thought or may soon rise. Such stories can appear to support our beliefs and can dominate our thinking – effects known as the confirmation bias and availability bias.

Taking a step back and taking the time to look at longer term trends in asset prices might help. Investigate what’s happening in a market – are conditions likely to get worse? If so, weigh up whether to take a financial hit sooner, to avoid a bigger loss later on. Doing so might require overcoming loss aversion but it could pay off long term.

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eZonomics team
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