What is Loss Aversion?

Angela Brady

Loss aversion is the term applied to the tendency of investors to try to avoid a loss even harder than they try to achieve a gain. Studies have shown that investors are more likely to sell a good stock to earn profit than they are to sell a bad one to minimize loss. Psychologically, people tend to feel losses more acutely than wins, and a loss often leads to feelings of regret. Regret can make people confuse a bad outcome with a bad decision, and in extreme cases, have widespread effects on their confidence in decision making.

Businessman giving a thumbs-up
Businessman giving a thumbs-up

The economy can be affected by people’s natural tendency toward loss aversion, especially in times of economic hardship. It is one of the reasons people are reluctant to upgrade high-ticket durable goods and take financial risks. Sellers see the merchandise as a loss, and price accordingly. Buyers see the merchandise as a gain, and budget accordingly. Problems occur when the seller and the buyer do not see eye-to-eye on the value of the item.

The real-world result of loss aversion on both sides of the negotiating table can lead to status-quo bias, which is an inherent preference for things to remain as they are. Nothing is gained, but nothing is lost, either. When evaluating risk, especially financial, a certain type of individual or company tends to prefer the security of sameness to the stress of a gamble.

Loss aversion can be avoided if the acquired item has the same benefits as the traded item, even if it has different attributes. For example, purchasing a car is basically just trading a certain amount of money for a car. If the customer feels that the car would serve him just as well as that amount of money, the transaction is completed without reluctance, even though a car and money are two very different things. Studies have shown that focusing on the concrete differences between the two items (driving a car versus spending money) can lead to more loss aversion than focusing on similar benefits (they both allow a level of freedom).

Marketing departments take advantage of loss aversion to get their product into the public conscience. Free-trial programs operate on the idea that once a customer tries a product, he is then evaluating how much he would pay to avoid losing that product, rather than gain it. Delayed-payment programs work the same way. Standing in the store looking at a television, a consumer may balk at the $3,000 price tag. Once the television has been in his home for a few months and he has been enjoying it with his family every night, he is much more likely to decide that it is worth $3,000 to avoid losing it.

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