New Research On Loss Aversion Is Causing Me To Think Deeper – Worth A Closer Look

I have been a close follower of behavioral economics research. This broad research is insightful and has caused me to think deeper about how to make better decisions. It has certainly reinforced my belief that using algorithms to make decisions is preferable to relying on discretionary judgment. However, I have read a series of recent papers that have prompted me to take a closer look at some of the core behavioral beliefs established in this area. See the work of Dan Gal and Derek Rucker in the Journal of Consumer Psychology and the recent article in the Observation Section of https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3049660

A core concept in behavioral economics regarding risky choices is that loss aversion has a significant influence on behavior. As simply put by the original authors, Dan Kahneman and Amos Tversky, “Losses loom larger than gains”. The relative pain from a loss is greater than the gain from winners, and this asymmetric view is more than just a function of risk aversion.

The disposition effect, driven by loss aversion, suggests that investors tend to hold onto losers and sell winners. It has become a bedrock behavioral view about investors and is a core reason why many managers have stop-losses in models to counteract this bias.

Now, we have research that calls into question loss aversion as the core reason for these effects, both from a theoretical and empirical perspective. There is clear evidence that contradicts loss aversion, but it has either been dismissed or ignored. Loss aversion is a description of behavior, not an explanation of it. This research does not offer an alternative to loss aversion, but instead provides a commentary on its usefulness and explanatory power.

This new research may not completely change minds on the importance of loss aversion, but it does suggest that loss aversion is a nuanced concept and should be employed with greater care. How we evaluate decision outcomes is very sensitive to a reference point that is often the status quo. The setup of the problem influences the results, suggesting that any general conclusions concerning loss aversion may be suspect.

According to Gal and Rucker,

“In general, it can be stated that the name ‘loss aversion’ represents exceptional branding from the perspective of enhancing the idea’s intuitive appeal, as everyone is essentially averse to losses (just as everyone is attracted to gains). This good branding might have led researchers to identify phenomena as being supportive of loss aversion, even though the phenomena, while involving losses, do not involve comparisons of the impact of losses relative to equivalent gains. As discussed in the previous section, examples include the sunk cost effect, the disposition effect, and others.”

This research is subtle and may not change an investor’s decision-making, but it is a testimony to careful thinking about problems. The obvious may not always be correct, and a straightforward narrative is not always applicable to a wide set of problems.

Do I worry about the pain from trading losses? Yes. Should I take extra steps to reduce downside “pain” more than what would be the case given my level of risk aversion (specifically account for loss aversion)? I am less sure. Accepting conceptual uncertainty can facilitate decision-making.