In 1979 two guys called Daniel Kahneman and Amos Tversky published a paper that described why people tend to overweight losses compared to gains when making decisions. They called this theory “Prospect Theory.” This particular piece of work earned Daniel Kahneman a Nobel Prize in economics in 2002. Daniel Kahneman has also authored a very influential book called Thinking Fast and Slow which I would highly recommend to anyone.
The central premise of prospect theory is that the pain of losing something outweighs the joy of getting the same thing. When faced with a decision of either losing or gaining something human beings tend to avoid loss and prefer gain. This theory has become central in an emerging field in finance called “behavioral finance.” Behavioral finance views people not just as rational beings but rather as emotional beings who have several biases.
One such bias is “loss aversion” which is essentially what prospect theory is all about. We don’t like losing things, especially money. That’s why we feel bad when we lose money in a deal. The pain of losing 10k is much worse than the joy of gaining 10k. This loss aversion bias can be a good thing and prevent us from taking extreme risks, however, in many cases, it can hinder our progress. The loss aversion bias can prevent us from making good investments for fear of losing our money. It can also make us stay in bad investments for far too long for fear of losing the money we have already sunk in.
Loss aversion is closely linked to another bias called “buyer’s remorse.” Buyer’s remorse is a feeling of regret experienced after making a purchase, typically one regarded as unnecessary or extravagant. This feeling is made worse if we use cash instead of electronic money. This is why people prefer using credit cards which eases the pain. Unfortunately using credit cards to reduce buyer’s remorse can land you in a lot of debt.
Loss aversion is also similar to the “endowment effect” bias which is basically our tendency to overvalue the things we own. People tend to overvalue things they own. For example, the furniture in your house is of much less value than you think. Your husband or wife is not as perfect as you claim! People also tend to believe they are smarter, more beautiful, and more charming than they really are. This overconfidence can get us in trouble especially when we take on too much risk.
Another common bias closely linked to loss aversion is the “herding effect.” People tend to associate in herds or groups. This is probably because they fear losing out on something which the crowd might get. That is how pyramid schemes attract so many people. People fear missing out on all the free cash the other group is getting. Unfortunately blindly following a crowd can lead you into a lot of trouble.
Astute marketers have figured out how to use loss aversion to trick people into making unnecessary purchases. For example, enticing the fear of death in a potential customer may make it easier to sell life insurance. Some politicians also use fear of impending chaos to get elected into office. Some scrupulous pastors use the fear of hell and punishments to induce their congregations to pay tithes, offerings, and special “gifts.”
Loss aversion is a very strong bias that everyone possesses. You can learn to use it to your advantage by becoming aware of its effects. You should carefully weigh the risks before investing in anything. However, don’t let the fear of losing money stop you from making prudent investments. Be careful also not to overstay in losing positions for fear of losing the money you have already spent. Watch out for overconfidence in your abilities. You are not as smart as you believe to be. Be really careful of crowds! Finally don’t allow other people to use the fear of losing something to entice you into doing things you would rather not.