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 of Loss Aversion
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.
Loss Aversion Background and History
Daniel Kahneman and Amos Tversky were first to fully recognize the importance of the loss aversion 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.
Loss Aversion Implications
A prominent implication of loss aversion in decisions with uncertain outcomes is a shift from risk-averse to risk-seeking behavior depending on whether a situation is framed as a gain or as a loss. Given that reference points are not fixed but depend on the specific situation, two alternatives that are equivalent from the standpoint of rational decision making (receiving $10 versus not losing $10) can result in different choices if one of the decisions is seen in the context of gains and the other in the context of losses. Consider the so-called Asian Disease Problem with which Kahneman and Tversky confronted participants in an experiment. In this problem, participants were told about a hypothetical outbreak of an unusual Asian disease threatening to kill 600 people in the United States. Participants had to choose between two alternatives to counteract this disease. One alternative was risky, saving all 600 people with a probability of one-third but otherwise all 600 people would be killed. In the other alternative, 200 people were saved and 400 were killed. If this problem was presented in a gain frame by mentioning how many lives in each alternative could be saved, most participants avoided risk and opted for the certain option. But if the problem was presented in a loss frame by mentioning how many people could die in each alternative, participants opted for the risky alternative. This puzzling result can be explained by loss aversion. The higher value of avoiding losses compared with gains makes the one-third probability of nobody getting killed much more attractive in the loss frame than it is in the gain frame (framed as saving 600 lives). Consistent with the assumptions of the prospect theory, people seem to avoid risk in gain frames while seeking risk in loss frames.
Other implications of loss aversion occur for decisions with certain outcomes. One of these implications is the status quo bias. This is the tendency to remain at the status quo because the disadvantages of changing something loom larger than the advantages of doing so. The mere ownership effect (also called endowment effect) is a related phenomenon also explained by the differences in the value of losses and gains. Here, the mere possession of an object makes it more valuable to a person relative to objects the person does not own and to the value the person would have assigned to the object before possessing it. This is because giving the object away means a loss to the person, and following the loss aversion phenomenon, losses weigh more heavily than gains. The compensation for giving up a good, therefore, is usually higher than the price the person would pay for it to possess it (which would mean to gain it). Both the status quo bias and the endowment effect have strong implications for economic and social situations.
- Baumeister, R. F., Bratslavsky, E., Finkenauer, C., & Vohs, K. D. (2001). Bad is stronger than good. Review of General Psychology, 5, 323-370.
- Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 77,263-291.
- Tversky, A., & Kahneman, D. (1991). Loss aversion in riskless choice: A reference dependent model. Quarterly Journal of Economics, 106, 1039-1061.