What is the loss aversion bias? How does loss aversion theory explain some irrational behaviors?
The loss aversion bias is the theory that people are unwilling to lose something they have even if it’s in their best interest. You may not want to swap for something better or take any risks because you fear losing what you have.
Read more about the loss aversion bias and how it affects decisions.
What Is the Loss Aversion Bias?
Loss aversion theory says that human beings are naturally predisposed to be unhappier with losses than they are happy with gains. Consequently, our behavior consistently reveals a hesitancy to risk loss, even when the gains of a particular choice or course of action might be significant.
Numerous studies reflect humans’ loss aversion bias. In one experiment, half of the students in a class was given coffee mugs, the other half large chocolate bars. Even though the dollar value of the two objects was about the same, only 10% of the students traded. Simply put, we’re more afraid of suffering a loss than realizing a gain.
A close relative of cognitive biases from loss aversion theory and the status quo bias, “mindlessness” signifies our tendency to go on autopilot when performing routine tasks.
Some of our most mindless behavior occurs when we’re eating. Two studies illustrate the fact. In one, a behavioral economist gave moviegoers stale popcorn in either a medium bucket or a large one. No one liked the popcorn—it was five days old!—but the economist found that the people given the larger bucket ate 53% more popcorn on average. This might be your brain on autopilot or the loss aversion bias and not wanting to throw away popcorn.
In the second study, the same economist presented subjects with a large bowl of Campbell’s soup and told them they could eat as much as they wanted. Unbeknownst to the subjects, the bowl featured a mechanism beneath it that refilled the bowl automatically. The economist found that subjects ate a tremendous amount of soup without realizing how much they were consuming.
Nudges to Improve Investing
Not very long ago, the most common retirement plan offered by employers was a “defined-benefit” plan—that is, one that made fixed payments to the beneficiary based on tenure and salary. Now, the most common type of retirement benefit is a “defined-contribution” plan, which consists of contributions made to a tax-sheltered investment account.
With this shift has come a greater decision-making burden on workers. What level of risk am I willing to take, and how do I allocate my savings accordingly? Should I be investing in stocks or bonds or both? How often should I revisit my allocation of assets, and what real-world information should I be looking for to know when to change it?
If we were Econs, we would have no trouble (1) recognizing that stocks outperform bonds historically and (2) calculating our tolerance for risk based on the probability distribution of stock-market returns. But, because we’re Humans, the complexities and variability of defined-contribution plans tend to bring out harmful cognitive biases that end up—quite literally—costing us.
One cognitive bias that is especially common when it comes to investing is the loss aversion bias (see Chapter 1), which results in overreactions to short-term market fluctuations. For example, Humans will fixate on the monthly, weekly, or even daily movements of the market and potentially change their asset allocations on those bases—when, in fact, these fluctuations belie the long-term upward trend of the market. Case in point: A study of retirement plans administered by Vanguard showed new enrollees allotting 58% of their account to stocks in 1992, 74% by 2000 (when tech stocks were booming), and 54% by 2002 (after the tech bubble burst). In other words, these employees bought high and sold low—the exact opposite of what they should have done.
Humans also tend to resort to rules of thumb when it comes to investment decisions. One such rule is “When in doubt, diversify.” But “naive diversification”—e.g., splitting your asset allocation 50/50 between stocks and bonds; or, when faced with more than two options, dividing your money up evenly between the several choices—can be just as detrimental to your retirement account as the loss aversion bias. For example, if you divide your assets equally among three bond-heavy funds and one that’s split 50/50 between stocks and bonds, your investments actually aren’t diverse—you’re overallocated to bonds.
(It’s important to note that, overall, diversification is a good thing. Take, for example, investing in your own company’s stock: Economist Lisa Meulbroek found that a dollar invested in company stock is worth less than 50% of a dollar invested in a mutual fund! Enron and WorldCom employees who poured their retirement savings back into company stock learned this lesson the hard way.)