What is Loss Aversion bias?

Explanation

Have you ever heard this expression – “the losses loom larger than gains?” If yes, you would already know what we’re talking about here. However, in this article, we will peep into a concept called “loss aversion.” This concept is an integral part of behavioral financeBehavioral FinanceBehavioral finance refers to the study focusing on explaining the influence of psychology in the decision-making process of investors. It explains the occurrence of irrational decision-making in the financial market when it is expected to be a manifestation of rational decisions and an efficient market.read more. And if you are involved in investing, trading, marketing, or any business, you must know this concept in detail.

Loss aversion bias expresses the one-liner – “the pain of losses is twice as much as the pleasure of gains.” For example, we can talk about a phenomenon we see among investors. If you ask new investors to invest in the equity marketEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE).read more, the first response they will give is this – “No, I do not want to fall prey to the losses of the equity market.” The hilarious part is that they do not know anything about the equity market but still want to avoid losses/risks at all costs.

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Loss Aversion Bias

Why Is Understanding “Loss Aversion” Important?

We often think we make logical judgments when trying to buy/sell anything. But after understanding “loss aversion” bias, there’s a question mark in how logical/rational our thinking is.

Think about this. Let us say a brand would suddenly increase its price. Previously, when someone used to buy their shirts, they offered a 10% discount on the costs. Now, they are offering the same shirt at 10% more prices. What would happen to the demand for the shirts? You guessed it right. It will drastically reduce. Now, let us change the scenario. Let us say that the brand suddenly decreases its price. Previously, when someone used to buy their shirts, they offered the shirts at $15. Now, they are offering the same shirt at $12. What do you think will happen to the demand? It will certainly increase, but not as much as one would have reduced it in the previous scenario.

If you understand this scenario, you can price your products in a way that would generate more revenue, increase demands, and help you stand out. At the same time, as a buyer, you would be more aware of these biases and would not fall prey to them while purchasing/choosing anything.

Before avoiding loss aversion bias, let us look at another related concept, which is equally important.

Myopic Loss Aversion

Myopic loss aversion bias is a temporary situation where one loses sight of the big picture due to a certain event. Myopic loss aversion happens to people, mostly in investment fields. But unfortunately, even the most professional and informed investor falls into the trap of myopic loss aversion bias.

If you are an investor and have been investing for a long time, you would know that you panicked during a sudden crash in the stock marketCrash In The Stock MarketA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more and tried to sell out all your stocks because you did not want to lose out on everything. So even if you call yourself a logical, rational, and experienced investor, you still did make a fool of yourself, and you could not see the big picture at the moment.

One could not blame you because it happens with all investors (professional and new)! To avoid myopic loss aversion bias, you need to know that you cannot make a buying/selling decision based on your emotion/how you feel during a panic-stricken moment. Whenever experiencing myopic loss aversion, you must let the moment go without making any hasty decisions. Once you calm down and become normal again, you can think and decide.

How to Avoid Loss Aversion?

Avoiding loss aversion bias is tougher than avoiding myopic loss aversion bias because myopic loss aversion is momentary. Still, loss aversion is much more ingrained in our subconscious mind, and even when trying to become sane, we still fall into the trap of loss aversion bias.

So how would one avoid loss aversion bias?

Loss aversion is not a thing of behavioral finance or behavioral economics Behavioral EconomicsBehavioural economics refers to a stream of mainstream economics that studies the impact of human psychology, ideology or behaviour on the individual or institutional economic decision-making process.read more only. It is a philosophy that society encourages us to follow (remember status-quo bias). For example, Team A is playing a football match with Team B. Now; Team A is defending Team B with all its might. Team B is attacking all the time. Of course, Team B will win the match, but both of these teams tried to avoid loss by: –

  • Playing not to losePlaying to win so they do not need to go through the pain of loss.

The idea of loss is ingrained in the human mind, and no matter what decision humans try to make (even when they think they are making the most logical decision), they try to become loss averse all the time.

Asking you to avoid loss aversion bias is like saying that you must eliminate society. Of course, it is possible, but somehow, we can benefit from loss aversion bias too.

Here is how.

Winning has importance too. As we have seen earlier in the football match example, loss aversion can help a team win (if they can strategize rightly). Loss aversion bias can also help a new investor avoid loss by becoming less greedy about earning more money.

Society only values the top performer. You will not stand a chance if you fail to become a top performer. In the bestselling book “The Dip,” marketing guru Seth Godin argues that quitting has different forms. You will win if you can leave the right thing at the right time. For example, you have invested a hefty sum of money. You have noticed that the stock price has declined for a few consecutive months. Suppose you do not want to lose a lot of money. In that case, you will immediately call your stockbrokerStockbrokerA stockbroker is an individual or company qualified enough to trade securities in the financial markets on behalf of financial institutions, individual and institutional investors, and organizations. They can work either independently as a professional trader or broker-dealer or associate with a brokerage firm.read more

and sell the declining stocks. We will not call it bias; rather, it is prudence to quit at the right time.

However, quitting does not always turn out to be useful. If you left because you are loss averse without having sufficient proof to validate your decision, your chances of winning would be dim. For example, if you do not start a business just because you do not want to lose money and stay at a dead-end job, you will lose in the real sense (even if you think you are avoiding loss).

One cannot generally speak about avoiding loss aversion bias. It is very subjective, and it differs from person to person and situation to situation. If you want to prevent the loss but, at the same time, do not want to miss out on new opportunities, try to take a balanced approach. It is a given that you will not be able to win always and in every situation. But if you do not take any risk because you’re trying to avoid loss, know that the greatest danger lies in riskless living.

Conclusion

Loss aversion bias is connected with the certainty effect, isolation effect, status-quo bias, endowment effectEndowment EffectThe endowment effect refers to a cognitive bias that explains how individuals develop an affinity for an object and overvalue it when they own it compared to how they would have valued it if they did not own it.read more, sunk costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision’s outcome.read more fallacy, etc. So, to look at loss aversion bias rightly, you need to know the context of your decision and the content.

And no one can tell you whether you are right or wrong without knowing why you did what you did. Loss aversion is not only a habit; it is psychology too. Knowing the psychology behind your particular behavior will allow you to pare down most biases and decide from the facts presented before you.

This article is a guide to Loss Aversion bias and its meaning. Here, we discuss loss aversion bias examples, how it works, and avoid this trap. You may learn more about financing from the following articles: –

  • Calculate Win/Loss RatioCalculate Win/Loss RatioThe win/loss ratio is the success proportion that determines the number of trade opportunities won over the number of trade opportunities lost. However, it is not concerned with the amount won or lost by the trader.read moreTypes of Equity in EconomicsTypes Of Equity In EconomicsEquity in economics is the total value of the shareholding that the stockholders are eligible to get after paying all the debts and liabilities in case the company dissolves. It determines the residual ownership of the shareholders in the organization’s remaining assets.read moreGift of Equity ExampleGift Of Equity ExampleA gift of equity refers to a sale transaction of a residential property to a family member at a price less than the property’s market value.read moreExamples of Deadweight Loss formulaExamples Of Deadweight Loss formulaWhen the two fundamental forces of Economy Supply and Demand are not balanced it leads to Deadweight loss. Deadweight loss could be calculated by drawing a graph of demand and supply. read morePrice-Weighted IndexPrice-Weighted IndexPrice-Weighted Index is the stock index where the member companies are allocated based on the proportion of the price per share of the respective member companies and help keep track of the economy’s overall health with its current condition. PWI Formula = Sum of Members Stock Price/Number of members.read more