(The psychology of money series)
The principle of loss aversion is fundamental in the development of Behavioral Economics. This was demonstrated in a landmark study by Daniel Kahneman and Amos Trevsky in March 1979. If you want to unleash the geek in you, look for the study online entitled “Prospect Theory: An Analysis of Decision under Risk.” Kahneman won the Nobel prize in 2002 for this study integrating psychology into economics. Unfortunately, his co-author Trevsky had already died in 1996.
Human beings feel the psychological and emotional impact of a loss more than that of a gain. The estimate is that we feel the impact of the pain twice as much as that of the gain.
Let’s put it in Economics parlance where utility is the unit of measurement of usefulness or satisfaction derived by the consumer when acquiring an object. The loss aversion principle states that the disutility of losing an object is two times greater than the utility of acquiring it.
If we apply money as the object here, the “pain points” of losing P1 million is twice that of the “pleasure points” of gaining P1 million.
Other examples
There have been various experiments done on this subject matter.
1. Employee productivity and bonus/commissions. In studies where they compared which bonus/commission mechanism works best, the two scenarios compared were A) the bonus/commission is given at the end of the period when the agreed-upon goals/measures are met; and B) the bonus/commission is given at the start of the period but can be taken back when agreed-upon goals/measures are not met. Which do you think made the employees meet the agreed-upon goals? It’s option B.
2. Discouraging the use of plastic shopping bags. A store tried to do its part by encouraging its customers to do away with the use of plastic bags. Option A gave five to ten cents rebate to its customers who didn’t ask for plastic bags. Option B charged 5 to 10 cents for the plastic bags. Which do you think discouraged the use of plastic bags more effectively? It’s option B.
3. Trial period. Do you ever wonder why stores allow their customers to have a free trial period? It’s because when you extend free use of your product to a customer for a limited period, something happens. A “sense of ownership” develops during the trial period. I have a friend who showed me her new home with a few pieces of painting hanging on her walls. She said, “The artist just gave me these pieces to hang on my walls for the meantime while I make up my mind.” You guessed it right, she ended up buying them because they “grew on her.” Not buying them would feel like she was losing her art pieces.
We are loss averse because we have bias for the status quo. The bonus/commission given upfront and the paintings hanging on my friend’s walls became the new normal levels such that letting go of those technically temporary arrangements would feel like losing things that have been treated as something owned.
For the second example, the cost of paying 5 to ten cents plastic shopping bags was losing something owned, which felt more significant than gaining the same amount by virtue of the rebate. The rational consumer should be indifferent to both, but of course we’re not.
Applying to saving and investing
When it comes to saving and investing, loss aversion is very much at work in a lot of people’s portfolios. We all know that savings, current accounts and even time deposits hardly give us any yield; and yet a lot of people just keep their hard earned money in these accounts. Because of the possibility of losing money in stock investment, only less than 1 percent of our population invests in this asset class. Even if studies show that stocks provide the highest returns in the long-term and that all of us have to prepare for our retirement (a long-term goal), the loss aversion is so powerful in the decision making that most people are willing to take the more certain risk of eroding the purchasing power of their savings.
It’s a matter of framing
I’ve read various versions of this experiment inspired by the Prospect Theory. In this experiment by Dean Buonomano (see link below), the participants were given $50 at the start. Then these were the two scenarios:
A. The participants were asked to choose between two options:
1. Keep $30 or
2. Gamble with a 50-50 chance of keeping or losing the entire $50.
Results: Participants acted in a risk-averse way (only 43 percent decided to gamble).
B. Participants changed the secure option and were asked to choose between:
1. Lose $20 or
2. Gamble with a 50/50 chance of keeping or losing the entire $50.
Results: Participants acted in a risk-seeking way (61 percent decided to gamble).
The two sets of options are the same but how come the choices made by the participants are not the same? It’s because of the framing. If the situation is framed such that it is about gaining something, we exhibit a risk-averse behavior. We would rather keep what is sure than risk losing something.
On the other hand, if the situation is framed to be about losing something, we exhibit risk-seeking behavior. Because of the stigma of losing something, we take the risk in order to avoid that loss (or so we think because really, the two scenarios above are just the same
No wonder only a miniscule number of people are investing in the stock market for retirement. Investing for retirement is framed as a gain; thus, it elicits the risk-averse behavior. Result: People are so focused on the possibility of losing because of the daily movements of the market that they’d rather not invest in this historically highest-yielding long term asset class.
On the other hand, more people buy investment linked insurance products. You guessed it right, the framing is about losing something; hence, the risk-seeking behavior is switched on. Hold on here, as it may be confusing to understand how buying insurance is risk-seeking. Here’s what I mean. In selling insurance, the framing used is the possible loss. When that is triggered, the human dislike for loss is enough to make him purchase more expensive products, unknowingly, exhibiting risk-seeking behavior because he is now putting his bet on these products.
This can also be seen at work in the brisk sales of insurance products for small ticket items such as cellphones and other gadgets. Since the framing is losing something, the cost of this usually unnecessary expense is somehow overlooked, such that the buyer is willing to bet his cash on a low likelihood of gaining something from it (i.e. his gadget getting lost or conking out).
What now? Knowing what we know now, it may be wise to take stock of the things we buy. Are we overwhelmed by loss aversion in the daily choices we make? It is healthy to know and manage our risks in order to avoid losses. However, after understanding our human brain’s propensity to hate losses twice as much as it loves gains, we have to be conscious of the way we decide so that we do not lose more than we have to. In an episode of Mareng Winnie’s “Bawal ang Pasaway” featuring billionaires, one of them aptly said, “Kung natatakot kang matalo, talagang talo ka na!”
We should not sacrifice long-term gains just because of this myopic loss aversion (This interesting concept of Richard Thaler and Shlomo Benartzi shall be further discussed in a future article).
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The psychology of money series – Feel free to check the author archive for previous installments on this series (The pain of paying, Mental accounting, The price of free, Anchoring, Ego depletion, etc.)
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Rose Fres Fausto is a speaker and author of bestselling books "Raising Pinoy Boys" and "The Retelling of The Richest Man in Babylon" (English and Filipino versions). Click this link to read samples – Books of FQ Mom Rose Fres Fausto. She is a behavioral economist, a certified gallup strengths coach and the grand prize winner of the first Sinag Financial Literacy Digital Journalism Awards. Follow her on Facebook and You Tube as FQ Mom, and Twitter & Instagram as theFQMom.
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