What is Loss Aversion?

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.

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.