Loss aversion

Loss aversion is a concept in psychology. It is to prefer avoiding losses to acquiring equivalent gains. The principle is prominent in economics.

The principle of loss aversion was first proposed by Daniel Kahneman and Amos Tversky in 1979. Loss aversion happens when people face the same amount of gains and losses and find the loss is more unbearable. In other words, the pain of loss is greater than the pleasure of equal gain. In some experiments, it shows females have a higher level of loss aversion than males.

Affective Science and Neural basis

The cause of loss aversion lies in people's asymmetric emotional response to gain and loss. Studies show that this asymmetry is particularly strong during the anticipation processing and the immediate experience after presenting the outcome. One study of income and well-being indicates that when people make loss-averse choices, it is not directly due to the loss itself but because the impact brings a series of negative consequences that follow the loss.A classic example presented in the book "Thinking, Fast and Slow" of a flipping coin implies that people will first compare the satisfaction of gaining with the pain of losing before making a decision. Thus, most people would not choose to participate in coin gambling with 50% to get $150 and 50% to lose $100; and according to the "loss aversion ratio," the minimum amount to fulfil the pain of losing $100 will be $200 (assume the coefficient is 2).

In 2001, J. O' Doherty and his colleagues had found that humans process losses and gains in qualitatively different ways by using brain imaging technology and suggests the correlation between the magnitude of brain activation and the extent of reward and losses received.When we are evaluating potential gains, the areas of the brain that process value and reward become more active than it does when assessing the potential losses. The different loss aversion levels differ from individuals by the degrees of sensitivity to losses and gains, in which people are more loss-averse with stronger sensitivity.

Equity premium puzzle

Equity premium puzzle(EPP) refers to the problem of why there is a big difference between returns in stocks and risk-free investments historically. Since stocks are much riskier than government bonds, the underinvestment in stocks relative to bonds supports the idea of loss aversion theory. Specifically, it's the myopic loss aversion introduced by Shlomo Benartzi and Richard Thaler, which indicates the behavioural characteristics of "loss aversion" and "frequent evaluations" of investors. Benartzi and Thaler argue that loss-averse investors are more willing to take risks if they do not evaluate the performance of their investments frequently. In their model, investors are unwilling to accept return variability and tend to take a short-term view of their wealth.

Demand elasticity

Demand is more elastic for price increases than price decreases, based on the assumption that the price increase is a loss while the price decrease is a gain for consumers.

Prospect theory

Based on the principle of loss aversion, Daniel Kahneman and Amos Twersky developed prospect theory to explain how consumers make decisions in uncertain situations. Unlike the hypothesis of rational man use in economics, prospect theory reveals the irrational psychological factors that affect the choice behaviour. Most people are unwilling to take risks when facing gains but become risk-seeking in losses.

Endowment effect

Loss aversion theory explains the endowment effect. The endowment effect refers to the finding that once an individual owns a good, he/she tends to naturally place more value than he did before he didn't own it. Due to the asymmetric responses to losses and gains in the decision-making process, the consideration of "loss avoidance" is far greater than that of "gain seeking," so people value more on a good they own.

Real world applications: Marketing Strategy

By using the loss aversion theory as a marketing strategy, firms are able to gain higher profits by changing consumers' behaviours. For example:

• Free trials. It leads users to subscribe to avert the loss once people establish ownership.

• Cart abandonment notifications. The language uses here of "you left in your cart" makes consumers have a kind of "this item already belongs to me" illusion. Loss aversion might happen.

• Return systems

• Reward systems

• Above a certain amount of money, to get a free shipping fee,etc.

Loss Aversion Media

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  Figure 1: A graph of perceived value of gain and loss vs. strict numerical value of gain and loss: A loss of $0.05 is perceived with a much greater utility loss than the utility increase of a comparable gain.

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  Figure 2: The effect of losses on the allocation of attention according to the loss attention account.

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  Tufted capuchin monkey display human-like behavioral biases, including loss aversion.