Loss Aversion

Posted in Principles

I hate to lose more than I love to win.” –Jimmy Connors

This sentiment – common both among elite competitors and the rest of us – captures the main insight behind the psychology of “loss aversion.” More scientifically, we can illustrate loss aversion with a simple wager: Let’s say we flip a fair coin and tails means you lose $10. How much would you have to win from heads for you to be willing to take this bet? Economic theory would dictate that a tiny bit over $10 should be sufficient because your expected value from the bet would be slightly positive. However, most people demand $20 for heads in order to accept this gamble. In other words, they view a loss as roughly twice as bad as an equivalent gain is good.

Loss aversion can cause us to make less than optimal choices in many different domains. For example, we might wait too long to sell a poorly performing investment because it gives us great displeasure to realize a loss. On the flip side, our intrinsic disdain for losses can be employed constructively by using “loss framing.” One recent study gave teachers the opportunity to earn a bonus at the end of the school year based on whether their students reached achievement targets (a gain frame). Meanwhile, another treatment gave teachers a bonus at the beginning of the school year, but told them they would lose some or all of it if their students did not meet their achievement targets (a loss frame). The loss frame condition performed significantly better – the equivalent of a one standard deviation increase in teacher quality – showing just how much our aversion to losing can motivate us to perform better.

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