Loss Aversion: A Crucial Theory in Economics

Explained Details about Loss Aversion

Loss aversion is a concept related with the prospect theory and encapsulates the expression ‘losses loom larger than gains’. Loss aversion is a crucial part of behavioural economics and explains why the individuals are capable of feeling the pain of loss with more intensity than the equivalent pleasure associated with gain. In behavioural economics, presents the preferences of people to avoid losses, in comparison to gaining an equivalent amount of pleasure or satisfaction. It is the tendency of behavioural finance where businessmen are too fearful of losses to enjoy or invest in any kind of gainful implements. The more experience of losses that an investor or businessman experience, the more prone he becomes prone to loss aversion. Investors also show an increased pain of loss compares to enjoyment of making any profit. The behavioural criteria where a behavioural tendency of averting losses with the fear of its emotional and financial impact even if there remains a chance of gain.

Why Is It Important to Understand Loss Aversion?

It is necessary to understand the loss aversion since it enables the businessmen or investors make responsible decisions regarding their investments. The term of loss aversion was first coined by psychologists Ames Tversky and Daniel Kahneman, in their paper published in 1979. The loss aversion behaviour is important to understand the human behaviour which makes the decisions basis the investments. The loss aversion basis develops as a part of the emotional sector which has developed as an evolutionary tool. The loss aversion basis enables the evaluation of consumer behaviour as it determines the reactions to the free trails, increase in prices and limited period offers. The loss aversion principle is a common behaviour among these, and hence while crafting a marketing strategy, the loss aversion bias might affect the buying habit of the consumers. The understanding of loss aversion also ensures that the investors are able to avoid the sunk cost fallacy. The sunk cost fallacy indicates the behaviour of some people who are unwilling to concede in the loss of bad investment and hence continue to invest into the bad investment. The unwillingness in conceding to the loss can hence motivate the irrational behaviour.

What are the Examples of Loss Aversion?

There are various examples of loss aversion which includes investor economic behaviours which determine the aversion of loss behaviour. One such example if the investment in low return and guaranteed investments which promise investments which carry a higher risk. Another such example of loss aversion includes the behaviour of not selling a stock which an investor holds when the current rational analysis of the stock has been indicating that the stock investment should be abandoned as an investment. This is a typical example of the behavioural economics of loss aversion. The investor is so averted to loss that he or she does not sell the stock even after the analysis ensures that the stock should not be kept as an investment for a hope of greater return of investment. Another example of loss aversion is telling oneself that unless an investment is sold, it cannot be a loss, since the worth of the loss is not felt until it is selling at a loss. One example of loss aversion also includes the selling of a stock which has increased in price and then realising that the gain of the amount is presented and when the analysis indicates that stock hence should be held for a longer period to gain a larger profit.

How does prospect theory explain loss aversion?

The prospect theory states that the investors who value gain as well as their losses differently, do so by placing more importance on the perceived gains versus the perceived losses. The prospect theory explains the behavioural economic subgroup which describes how individuals present loss aversion as they make risky choices between the probabilistic alternatives and where the probability of the different outcomes are unknown. The prospect theory was developed by Daniel Kahneman and Amos Tversky, and hence explains that the individual’s behavioural choices are singular and independent and the Probability of any loss or gain is determined as 1 out of 2 instead of the probability actually presented. The probability of the gain is always perceived to be greater than the probability of loss. The theory explains loss aversion as the loss causing a bigger emotional impact on the particular individual rather than an equivalent amount of the gain. As a result, the given choices are presented in two different ways which offer similar results and individuals generally opt for the option which offers the perceived gains. Thus loss aversion is explained by the prospect theory as a potential economical behaviour.

What are the Criticisms of loss aversion?

The loss aversion presents a cognitive bias where the comparison of potential losses to the equivalent gains presents a dilemma and longer decision making process. Under the risk and uncertainty, there exists a dearth of evidence regarding the applicability of the loss aversion. The loss aversion has not been found to exist in the small magnitude payoffs, and in time too. The low generalizability of the loss aversion is also a potential criticism of its existence and hence presents an area for further research. There are some critics which suggest that some of the phenomenon attributed to loss aversion such as endowment effect, status quo bias, and the preference over risky to safe choices, are explained better by the psychological inertia. The asymmetry in the loss-gain concept hence presents questionable doubt regarding the loss aversion concept. The magnitude of the loss aversion theory varies in numerous situations and hence, the predictable ways are not explained properly. The loss aversion theory also presents a generalised behaviour concept, and individual behaviour varies. It is thus necessary to identify the specific causes and risk factors for such variation to be implemented in the generalised context. Loss aversion might also have minimal effect on the weighing of the outcomes.