The Psychology of Loss Aversion
The Psychology of Loss Aversion
Why do people suffer from loss aversion?
- As anyone who has bought stocks during a bull market will know, making a quick profit is great. But making a loss is difficult to stomach! Behavioural scientists call this loss aversion. People are intrinsically afraid of losses. When compared against each other people hate losing more than they enjoy winning. Thus losses loom larger than gains even though the value in monetary terms may be identical.
- Research by Daniel Kahneman and Amos Tversky into the psychological value of losses and gains indicated that people may have a loss aversion ratio of between 1.5 and 2.5. This means a loss that is identical in money terms, a gain may be up to 2.5 times more than the gain. This is an average as some people are more or less loss averse than others.
- For example professional gamblers are more tolerant of losses. This seems to be because they are less emotionally involved in individual bets than the amateur gambler. The key for any risk taking behaviour appears to be to think like a professional trader or gambler. Don’t get emotional about a purchase or a bet. Think of it as purely a transaction.
Implications of Loss Aversion
Loss aversion is one of the most important drivers of human decision making. It is a powerful technique often used in conversion rate optimisation. This is because it inevitably leads to risk aversion and a number of predictable behaviours in certain situations:
Threat to lifestyle:
- Where a loss could be ruinous or would threaten their lifestyle, people will normally dismiss the option completely. This is one reason why spread betting companies force customers to set automatic stop losses on most of their accounts. This protects customers from their bad bets by limiting potential losses. If there was no such stop loss in place most people would never consider this type of betting.
Winners and losers:
- When people are given a situation where both a gain and a loss is possible there is a tendency to make extreme risk averse choices. For instance the choice between a small but certain gain and a chance for a large gain that also has a low chance of a large loss. People have a tendency to focus on the potential for a large loss. They will often select the former, more certain option. Even a small probability of a large loss is enough to make people shy away from certain types of investments.
Bad choices and loss aversion:
- Where the choice is between a certain loss and a larger loss that is just a probability (i.e. there is a chance of no loss), diminishing sensitivity can result in excessive risk taking. This helps explain why people will sometimes throw more money at a loss making venture. Hoping that they can turn the business around. Gamblers are also prone to putting more money at risk after making substantial losses. They focus on the potential for their next gamble to win the jackpot and wipe out their losses. People become so emotionally involved in trying to avoid a loss. They fail to see they are just making the situation worse.
Power of ownership:
- Where a person buys something with the intention of consuming or using it. The minimum price that they sell the item for is often higher than the maximum price they want to pay themselves. This is called the endowment effect. The ownership of goods appears to increase the value of an item, particularly for goods that are not frequently trading.
- This is the result of our reluctance to give up an item that we already own. Such behaviour can be seen in the housing market where sellers often have to lower their initial asking price. This because buyers do not want to pay the price sellers value their homes at. The endowment effect is most prominent for new goods, such as cars. Owners value their goods much closer to the original purchase price than potential buyers do.
Status quo bias:
- Loss aversion is also powerful force in preventing change. People have a general preference towards the current state of affairs (e.g. their existing supplier) over changing to a better alternative. This is often a combination of loss aversion and the endowment effect. However, fear of regret in making a wrong decision can also play a part in status quo bias.
- This is why it is important to understand the effect of loss aversion and emotional factors when researching how to encourage switching. Money back guarantees and free trials are often used by companies. This reduces the risk of loss and regret that stops people switching away from what they know. However, the fear of loss and feeling regret are such powerful emotions that these activities often fall on deaf ears. Loss aversion is probably the most effective loyalty program most companies have on their side.
“Loss aversion is a powerful conservative force that favors minimal changes from the status quo in the lives of both institutions and individuals”. Daniel Kahneman, Thinking, fast and slow.
How People React to Risk or Probabilities:
- Loss aversion and risk are intrinsically linked. Research into the psychological value (i.e the weight) that people give to different probabilities has identified two key biases that influence human decision making in the face of uncertainty.
- The possibility effect results in highly unlikely (low probability) events being given more weight than they justify. People naturally overestimate the probability that these events occur. They are more willing than they should be to respond to offers that tap into these perceptions.
- This helps to explain the attractiveness of betting on unlikely outcomes (e.g. a horse with odds of 100 to 1) and insurance policies that cover uncommon events (e.g. extended warranties). If people assessed odds rationally they wouldn’t gamble on such unlikely events. They would over time be better off keeping their money in their pocket.
- In market research this means that people tend to express more concern about low probability events such as crime or freak accidents than we might expect them to. This may also explain certain risk averse behaviours that give the impression that the chance of an event is higher than it is in reality.
More About How People React to Risk or Probabilities:
- The certainty effect leads to events that are almost certain being given less weight than their probability justifies. Due to loss aversion it is human nature to want to eliminate risk rather then reduce it. In horse racing this means people place fewer bets on the favourite than we would expect if they were totally rational. Instead the possibility effect encourages people to bet on rank outsiders when the odds don’t justify it.
- In retail, rather than offering 4 for the price of 3, people respond better to 1 free with every 3 purchased. The latter is more compelling because the zero price has more certainty. For websites it also means that if visitors are slightly unsure about how genuine or secure a website is they will have a tendency to magnify the risk. This may lead to visitors abandoning a transaction. It also explains why we are so responsive to guarantees. A guarantee eliminates any uncertainty about the situation, whether it’s about an application being accepted or getting the advertised offer/rate. People are often unsure if they will qualify for offers so a guarantee removes this concern.
- A study carried out by Kahneman and Tversky for their Prospect theory indicated that unlikely events (1% to 2% probability) are over weighted by a factor of 4. However, for an almost certain event the difference is even larger. In experiments a 2% chance of not winning was given a weighting of 13% (or an 87.1% chance of winning).
The Risk of Rare Events:
- Where the odds of an event are very small (e.g. around 0.001% or less) people become almost completely indifferent to variations in levels of risk. Rather emotional factors and how a risk is framed are the key drivers of how people react to these levels of risk. This helps to explain why people are often too willing to bet on extreme events happening or why they buy multiple lottery tickets when there is a large jackpot.
“When the top prize is very large, ticket buyers appear indifferent to the fact that their chance of winning is minuscule.” Daniel Khaneman, Thinking, fast and slow
- Research has also found evidence that rich and vivid descriptions of an outcome (e.g. fantasies about your lifestyle as a lottery winner) help to reduce the impact of probabilities. In particular people are more heavily influenced (in terms of weighting of probabilities) if an event is using frequencies (e.g. the number of people) than by using standard indicators of probability or risk.
- This is why gaming sites tend to promote the number of winners rather than the chance of winning. From a marketing perspective it suggests using rich media to bring events to life and avoid using abstract concepts of probability that people struggle to understand.
So, loss aversion and related biases are a key driver of human decision making in many situations. It explains how uncertainty skews surveys that ask respondents direct questions about risk and uncertainty. If there is any uncertainty about an outcome people are likely to exaggerate the potential risk and respond accordingly. For this reason more value is likely to be gained from observing consumer behaviour and analysing the choices they make (e.g. through conjoint analysis or online experiments).