Loss aversion refers to the concept that people tend to prefer avoiding losses rather than acquiring gains. It is a phenomenon in which a loss has a more significant emotional impact on an individual than an equivalent amount of gain.
The anguish of loss is thought to be psychologically twice as powerful as the pleasure of gain. For instance, losing $100 typically feels more acutely painful than the pleasure derived from gaining $100.
Amos Tversky and Daniel Kahneman first proposed loss aversion as an important framework for prospect theory, which examines risk-taking decisions. When defined in terms of the utility function shape, as in the cumulative prospect theory (CPT), losses have a steeper utility than gains, thus being more “painful” than satisfaction from a comparable gain.
In the realm of behavioral economics, loss aversion is a pivotal concept that challenges traditional economic theories assuming rational decision-making. It illustrates how cognitive biases can influence economic behavior.
Concept Development
Following the initial 1979 thoughts in the prospect theory framework study, Tversky and Kahneman incorporated loss aversion in a 1991 paper on a consumer choice theory that includes reference reliance, loss aversion, and declining sensitivity. Unlike the original work above, which analyzes loss aversion in dangerous choices, Tversky and Kahneman (1991) discuss loss aversion in riskless options, such as refusing to trade or even sell something we already own.
Here, “losses loom larger than gains” indicates how outcomes below the reference level (e.g., what we do not own) loom larger than those above the reference level (e.g., what we own), demonstrating people’s proclivity to value losses more than gains relative to a benchmark. The paper also supported loss aversion using the endowment effect and status quo bias theories.
Several studies have challenged the existence of loss aversion. Research on the impact of losses on decision-making found no loss aversion in the presence of risk and uncertainty.
There are numerous interpretations for these findings. One is that loss aversion does not exist in tiny payout magnitudes (referred to as magnitude dependent loss aversion by Mukherjee et al.(2017); this appears to be true for time as well. The other is that the loss aversion pattern is not as ubiquitous as previously supposed.
Economic Implications
Investors commonly exhibit loss aversion when making financial decisions, preferring to avoid losses over acquiring gains of the same magnitude. This bias affects the way individuals engage with financial markets, often leading them to reject advantageous prospects due to the potential for loss.
According to a 2017 study on behavioral economics by David Collins, loss aversion can dictate compensation in investor-state dispute settlements, revealing its deep penetration into investment strategies.
In the insurance sector, loss aversion plays a crucial role. Consumers may overvalue insurance as a protection mechanism against potential losses, even when the probability of such events is low. This behavior underpins a high demand for insurance products, as theorized in an analysis of psychological underpinnings within economics from Colin Camerer.
Loss aversion extends to consumer behavior, where it induces heightened price sensitivity. Shoppers are often more sensitive to price increases than to decreases. They perceive the pain of paying more as greater than the pleasure of paying less, illustrating a classic example of loss aversion at play.
Marketing Strategies
In marketing, the use of trial periods and rebates attempts to capitalize on the buyer’s tendency to value the good higher after incorporating it into the status quo. In previous behavioral economics experiments, users participated until the risk of loss equaled any gains. Botond Kőszegi and Matthew Rabin’s experimental economics methods show that an individual’s expectation of an outcome can lead to loss aversion, even if no physical change has occurred.
Marketers tap into the loss aversion bias by framing products or services in a way that emphasizes what consumers stand to lose if they do not engage. For instance, advertising often suggests that not purchasing a service could lead to missing out on potential savings or benefits, making the idea of a missed opportunity seem like an actual loss. This technique leverages the fear of regret which compels consumers to act to avoid that negative feeling.
It is also important whether a transaction is framed as a gain or a loss. The identical price change, but phrased differently, such as a $5 savings or a $5 surcharge avoided, has a major impact on consumer behavior.
Marketers offer free trial periods to reduce the risk associated with trying a new product or service. They frame the end of the trial as a loss of access, which can be avoided by continuing the service with a purchase. This utilizes the customers’ tendency to value what they already have and their reluctance to lose it.
Fear of Loss in Relationships and Ideology
Individuals often exhibit a preference for maintaining the current state of affairs. This status quo bias suggests that people tend to choose options that sustain their existing relationships, as the prospect of loss typically outweighs potential gains.
Social norms further reinforce status quo bias, as they dictate acceptable behavior within relationships. Individuals often conform to these norms to avoid social losses, creating a cycle that perpetuates existing relationship dynamics.
Ownership and Ideological Beliefs
Ownership extends beyond mere possession of items — it envelops ideas and ideologies as well. People demonstrate a strong tendency to cling to their beliefs due to an inherent loss aversion.
When one’s ownership of a belief is challenged, the visceral reaction to protect it can be observed. In the political arena, as noted in a study on loss aversion in politics by Alberto Alesina and Francesco Passarelli, the fear of losing can cause candidates to adhere closely to their ideological party lines, fearing that deviation might result in the loss of voter support.
Ideological beliefs, once established, become part of an individual’s identity, making the notion of losing these beliefs akin to losing a part of oneself. Consequently, individuals are inclined to reject new ideas that conflict with their existing ideologies, prioritizing the preservation of their ideological ownership over the potential benefits of changing their views.
Loss Aversion Neural Basis
Reward anticipation is associated with activation of the the ventral striatum, whereas negative outcome anticipation engages the amygdala. However, only some research have demonstrated amygdala activation during negative outcome anticipation, while others have not, resulting in some contradictions.
It has later been demonstrated that inconsistencies may only have been due to methodological issues, including the utilisation of different tasks and stimuli, coupled with ranges of potential gains or losses sampled from either payoff matrices rather than parametric designs, and most of the data are reported in groups, therefore ignoring the variability amongst individuals. Therefore, later studies, rather than focusing on subjects in groups, focus more on individual differences in the neural bases by jointly looking at behavioural analyses and neuroimaging.
Neuroimaging studies on loss aversion involve measuring brain activity with functional magnetic resonance imaging (fMRI) to investigate whether individual variability in loss aversion was reflected in differences in brain activity through bidirectional or gain or loss specific responses. In addition, multivariate source-based morphometry (SBM) to investigate a structural network of loss aversion and univariate voxel-based morphometry (VBM) to identify specific functional regions within this network.
Brain activity in a right ventral striatum cluster increases, especially when gains are anticipated. This includes the ventral caudate nucleus, pallidum, putamen, bilateral orbitofrontal cortex, superior frontal and middle gyri, posterior cingulate cortex, dorsal anterior cingulate cortex, and portions of the dorsomedial thalamus that connect to the temporal and prefrontal cortex.
The degree of loss aversion correlates significantly with the strength of activity in both the frontomedial cortex and the ventral striatum. This is demonstrated by the fact that the slope of brain activity deactivation for rising losses is much greater than the slope of activation for growing gains in the appetitive system, which includes the ventral striatum in the reward-based behavioral learning network.
On the other hand, when anticipating loss, the central and basal nuclei of amygdala, right posterior insula extending into the supramarginal gyrus mediate the output to other structures involved in the expression of fear and anxiety, such as the right parietal operculum and supramarginal gyrus. Consistent with gain anticipation, the slope of the activation for increasing losses was significantly greater than the slope of the deactivation for increasing gains.
Decision Networks
Multiple brain systems are activated while making decisions, demonstrating functional and structural individual variability. Biased prediction of negative outcomes, which leads to loss aversion, requires unique somatosensory and limbic components.
fMRI test measuring neural responses in striatal, limbic and somatosensory brain regions help track individual differences in loss aversion. Its limbic component involved the amygdala (associated with negative emotion and plays a role in the expression of fear) and putamen in the right hemisphere.
The somatosensory component includes the middle cingulate cortex, posterior insula, and rolandic operculum on both sides. The latter cluster largely overlaps with the right hemispheric one, which exhibits the previously documented loss-oriented bidirectional response, but unlike that region, it primarily involves the posterior insula bilaterally.
All of these regions play an important role in recognizing threats and preparing the organism for proper behavior, with connections between amygdala nuclei and the striatum mediating avoidance of aversive events. There are functional variations between the right and left amygdala. Overall, the significance of the amygdala in loss anticipation suggests that loss aversion could be a Pavlovian-conditioned approach-avoidance response.
Preference Functions
The neural activity involved in processing aversive experiences and stimuli is not just a temporary fearful overreaction prompted by choice-related information, but rather a stable component of one’s own preference function, reflecting a specific pattern of neural activity encoded in the functional and structural construction of a limbic-somatosensory neural system anticipating the brain’s heightened aversive state. Even when no decision is required, individual differences in the intrinsic responsiveness of this interoceptive system reflect the impact of expected negative effects on evaluative processes, resulting in a preference for avoiding losses over collecting larger but riskier rewards.
Individual differences in loss aversion are linked to age, gender, genetic factors influencing thalamic norepinephrine transmission, as well as brain anatomy and activity. Outcome anticipation and loss aversion engage various brain networks, demonstrating functional and structural individual heterogeneity that is directly connected to choice outcomes.
References:
- Alesina, A. and Passarelli, F. (2019), Loss Aversion in Politics. American Journal of Political Science, 63: 936-947.
- Barkley-Levenson, EE; Van Leijenhorst, L; Galván, A (2013). Behavioral and neural correlates of loss aversion and risk avoidance in adolescents and adults. Dev Cogn Neurosci. 3: 72–83. doi: 10.1016/j.dcn.2012.09.007
- Camerer, C. (2005). Three Cheers — Psychological, Theoretical, Empirical — for Loss Aversion. Journal of Marketing Research, 42(2), 129-133
- Canessa, Nicole (19 November 2016). Neural markers of loss aversion in resting-state brain activity. NeuroImage. 146: 257–265. doi: 10.1016/j.neuroimage.2016.11.050
- Collins, David. Loss Aversion Bias or Fear of Missing Out: A Behavioural Economics Analysis of Compensation in Investor–State Dispute Settlement, Journal of International Dispute Settlement, Volume 8, Issue 3, September 2017, Pages 460–482,
- Ert, E.; Erev, I. (2008). The rejection of attractive gambles, loss aversion, and the lemon avoidance heuristic. Journal of Economic Psychology. 29 (5): 715–723
- Kahneman, D. & Tversky, A. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty. 5 (4): 297–323
- Kőszegi, Botond; Rabin, Matthew (September 2007). Reference-Dependent Risk Attitudes. American Economic Review. 97 (4): 1047–1073. doi: 10.1257/aer.97.4.1047
- Mukherjee, S., Sahay, A., Pammi, V.S.C., & Srinivasan, N. (2017). Is loss-aversion magnitude-dependent? Measuring prospective affective judgments regarding gains and losses. Judgment and Decision Making, 12(1), 81–89
- Seymour, B; Daw, N; Dayan, P; Singer, T; Dolan, R (2007-05-02). Differential Encoding of Losses and Gains in the Human Striatum. J Neurosci. 27 (18): 4826–31
- Tversky, Amos; Kahneman, Daniel (1991). Loss Aversion in Riskless Choice: A Reference-Dependent Model. The Quarterly Journal of Economics. 106 (4): 1039–1061. doi: 10.2307/2937956
- Xu, L.; Pearlson, G.; Calhoun, V. D. (2008). Joint source based morphometry identifies linked gray and white matter group differences. NeuroImage. 44 (3): 777–789. doi:10.1016/j.neuroimage.2008.09.051