Friday, June 9, 2023

Loss aversion: A general bias

Date:

Aanchal Sharma

Loss aversion is a behavioural bias that speaks to people’s propensity to feel the agony of losses more keenly than the joy of gains.

Loss aversion is a behavioural bias that has been extensively studied in both psychology and economics. It speaks to people’s propensity to feel the agony of losses more keenly than the joy of gains. That is to say; losses are twice as painful as gains. This phenomenon can significantly affect economic outcomes and has substantial decision-making ramifications.

The stock market is one of the contexts where loss aversion is most important. According to studies, even when the potential benefits from holding onto the stock are larger than the losses already experienced, investors are more likely to sell a stock that has dropped in value than one that has grown. This behaviour may result in poor investment choices and increase market volatility.

Consumer behaviour can also be affected by loss aversion. Because the potential loss of not having the warranty is viewed as greater than the gain of not paying for it, a consumer may be more willing to pay for an extended warranty on a product, even if the probability of needing the warranty is low.

Negotiations are one more situation where loss aversion can have a big impact. One party may be more likely to reject a fair offer if they believe they will lose in a negotiation since they will feel more pain from losing than joy from winning.

Why do losses hurt more than gains, then? This behavioural bias is well explained in economics by the term ‘endowment effect’. It is called so because it refers to the consumer choice inertia that occurred when products included in their endowment were valued higher than those not. The two main psychological reasons for the endowment effect are ownership and loss aversion. Another explanation of this behavioural bias is status quo bias. Those who favour the status quo by doing nothing or remaining with a previous decision exhibit status quo bias. This could still occur even when there are just minor transition costs and the decision’s relevance is high.

According to some academics, this is an evolutionary adaptation. During the history of human development, our ancestors encountered numerous circumstances in which the capacity to prevent losses was more crucial for survival than the capacity to pursue gains. For instance, avoiding predators and saving resources might have been more important for ensuring survival than looking for new chances to advance. Several researchers contend that loss aversion is a learned behaviour resulting from experience and cultural conditioning rather than an innate trait. This claim is supported by the observation that loss aversion differs across cultural and contextual boundaries. For example, some cultures are less loss-averse than others, and the degree of loss aversion varies depending on the decision being made. However, it is still mysterious as to how loss aversion has evolved, and more study is required to comprehend the causes and characteristics of this phenomenon.

What can be done to decrease loss aversion’s negative effects? There are often two approaches. The first is through framing. How a transaction is presented to a person can significantly impact how they perceive loss aversion. Framing a question as a gain or a loss might have an impact on one’s response or decision. When presented with a decision that can be affected by loss aversion, one can consider rephrasing the question to stress the potential gain from a transaction. Setting losses in perspective is the second strategy for lowering perceived losses. One can consider the worst outcome if the action were taken as a simple strategy to overcome loss aversion. This usually helps people put loss and the deeply felt emotions that come along with it into perspective and helps them determine whether a decision is worthwhile.

To summarize, loss aversion is a well-studied behavioural bias that can significantly impact how people make decisions and economic outcomes. People and organizations can take action to lessen the consequences of loss aversion and make more logical judgments by being aware of its implications.

Also Read: Climate-tech project funding takes a hard punch from SVB collapse

(Aanchal Sharma is a student of the Department of Economics at Bethune College.)

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