✍️ Loss aversion is a cognitive bias, or a systematic pattern of thinking, that refers to our natural inclination to focus on setbacks more than progress.
It influences, for example, how we make decisions and take risks regarding our personal finances. Consequently, understanding this bias and how it affects us can help improve one’s financial decision-making skills.
What Is Loss Aversion?
We, people, don’t like to lose our possessions.
What’s more, losing makes us more upset than gaining something of equal value; we feel the pain of, say, losing $100 more strongly than the joy of making $100 — in fact, twice as strongly[1].
This is also known as loss aversion.
Loss aversion was first identified by psychologists Daniel Kahneman and Amos Tversky, who coined the term in their 1979 paper on subjective probability. As they noted, “losses loom larger than gains”.
Effects
In particular, loss aversion has implications in the field of economics and personal finance. For instance, a strong fear of losing can cause both corporations and individuals to avoid financially risky decisions.
This can be seen as a double-edged sword: Although being averse to losses can help us avoid decisions that could lead to negative financial results, it may also prevent us from taking risks with the potential for reasonable returns.
This same effect also applies in other domains: In any type of decision-making situation, people may be inclined to dismiss ideas, theories, and solutions that are highly innovative but carry higher risks.
Besides financial context and risky decisions, it has been shown that loss aversion also creeps its way into relationships: For instance, one study found that, in interactions between married couples, it takes about five positive comments to offset one critical comment[2].
Marketing
Loss aversion is also important to understand for marketing professionals.
According to the concept, showing your potential customers how your product will help them avoid something painful is likely to be a more profitable approach than showing that they would gain something positive.
Furthermore, it explains why people tend to react more strongly to an increase in prices than to a decrease[3].
Individual Effects
In many situations, avoiding things that could potentially lead to losses is undoubtedly beneficial to us.
However, when the fear is too great, it may also prevent us from making rational choices. The reality is that, with most decisions, we have to risk giving up something in return for something else.
As such, being able to combat this tendency could prove to be highly advantageous for individuals. So, next time you are faced with an impactful choice, make sure to weigh both the possible downsides and upsides, as well as consider the likelihood of the different outcomes.
📖 Additional reading:
