The Wall Street Point of View

The Psychology of Loss Aversion

The Psychology of Loss Aversion

Posted July 2, 2013By Janet Tavakoli

Daniel Kahneman and Amos Tversky, pioneers in the study of the psychology of judgment and decision making, discovered that people feel worse about the pain that comes with loss than they do about the pleasure that comes with an equal gain. Most people’s feelings are twice as strong about the pain of loss.

Most people are willing to take much more risk to avoid a loss than they will to earn a gain, even when the economic results are the same. If you don’t believe it, try the following game.

Imagine I just gave you $100,000 with the following two choices: I will either guarantee you an additional $50,000, or I will allow you to flip a coin. If you choose to take the coin flip, if the coin comes up heads, you can win another $100,000. But if the coin lands on tails, you get nothing more.

In other words, if you choose to take my guarantee, you are certain to walk away with $150,000. If you choose to flip the coin, you will walk away with either $100,000 or $200,000.

Which option would you choose: the $50,000 guaranteed additional amount or the possibility of either an additional $100,000 or nothing more? Most people choose to take the certainty and walk away with $150,000.

But suppose instead I gave you $200,000, with the following two choices: I will either guarantee you lose $50,000 of the $200,000, or you can flip a coin. If the coin comes up heads, you will lose $100,000; if the coin comes up tails, you lose nothing.

Now which option do you choose? Most people choose to flip the coin.

In both situations, you wind up with $150,000 if you choose the guarantee. In both cases if you choose the coin flip, you have a 50/50 chance of ending up with either $200,000 or $100,000.

Most people choose the sure $150,000 when they stand to gain. But it is a very different story when they stand to lose. Most people will choose to flip the coin. They take more risk to avoid losing money, even if that means they will potentially be worse off.

It’s as if people believe they should try to avoid the certain loss. They can’t seem to do nothing, and just let it happen to them, even when the best action may be no action.

This is true of most people, but it isn’t true of everyone. For more read “Dead Man’s Curve.“

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