Loss Aversion

Definition

Loss aversion refers to people's tendency to prefer avoiding losses to acquiring gains of equal magnitude. In other words, the value people place on avoiding a certain loss is higher than the value of acquiring a gain of equal size. Consider, for instance, the subjective value of avoiding a loss of $10 compared with gaining $10. Usually, people say that the former has a higher value to them than the latter. Such a preference seems striking, given that, objectively, $10 is $10, regardless whether it is lost or gained. Nevertheless, the aversion toward incurring losses is a strong and reliable effect, and the value of avoiding a loss is usually twice as high as the value of acquiring an equivalent gain.

Theoretical Explanation

Loss aversion can be explained by the way people view the value of consequences. Specifically, the value of a certain consequence is not seen in terms of its absolute magnitude but in terms of changes compared with a reference point. This reference point is variable and can be, for example, the status quo. Starting from this reference point, every increase in a good is seen as a gain, and the value of this gain rises with its size. Importantly, this rise does not follow a linear trend but grows more slowly with ever-increasing size. Contrarily, starting from the reference point, every decrease is seen as a loss. Now, the value is negative and decreases with the size of the loss. This decrease also slows down with ever-decreasing size, however, not as fast as on the gain side. Therefore, a gain does not increase subjective value at the same rate as a loss of the same size decreases subjective value. Given that individuals are assumed to maximize subjective value, they should express a preference for avoiding the loss. Hence, as suggested in the beginning, people usually prefer avoiding a loss of $10 compared with ensuring a gain of equal size. In general, this may be because bad events have a greater power over people than good events.

Background and History

Daniel Kahneman and Amos Tversky were first to fully recognize the importance of the loss aversion [Page 536]phenomenon for a better understanding of human decision making. They made loss aversion a central part of their prospect theory, which explains human decision making in situations when outcomes are uncertain. Of importance, the idea of different values for equivalent gains and losses strongly contradicted the assumptions held so far in classic theories of decision making; namely, that gains and losses of the same size should have the same value for people. However, as abundant empirical evidence in favor of the loss aversion phenomenon demonstrated, the grief of losing is stronger than the pleasure of gaining.

In subsequent research on the phenomenon of loss aversion, the effect was demonstrated in many domains, including, for example, economic, medical, and social decision making. In addition, it was shown that loss aversion is not limited to decisions under uncertainty but also occurs in situations in which the outcomes of alternatives are certain.

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