My Precious! (Loss Aversion)

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Do you ever find yourself unwilling to give something up, despite being sure that this is the best decision? You might be suffering from loss aversion. Read on to learn more, or if you prefer to listen to the episode, you can find it here on our website or on your favourite podcast player.

Ken: Hi there. This is How to Choose, the show that helps you make better decisions and improve your judgment. Thanks for joining us. I’m Ken.

Tessa: And I’m Tessa. Welcome to season three. In this, our third season of How to Choose we’re exploring the topic of thinking problems or biases.

Ken: That is correct – we’re focusing on a number of common thinking flaws that undermine our ability to judge well and make good decisions. Eight, to be precise. We’ll tell you some ways to identify if you’re succumbing to these errors and suggest how you can reduce the impact of these biases.

Tessa: What’s our topic today, Ken?

Ken: Well, today we’re looking at loss aversion. Loss aversion? What’s that I hear you ask? Well, here’s a question for you, even though we can’t actually hear your answers. Imagine we have offered you a gamble on the toss of a coin. If the coin toss comes up tails, you give us $100. If the coin toss comes up heads, we’ll give you $150. Would you accept this gamble?

Tessa: Look, I’m not much of a gambler, Ken, so that doesn’t sound like a good deal to me. But this question is actually posed by Daniel Kahneman in his book Thinking Fast and Slow, a book everyone should have on their shelves at home. Was that a bell, Ken?

Ken: Yes, that’s just the ‘you mentioned Daniel Kahneman again’ bell. But, yes, you’re correct. Interestingly, many people prefer not to accept this offer, even though the odds are in your favor. And that’s the topic we’re covering in today’s episode. So the concept of loss aversion challenges the concept of the rational human, particularly as defined in rational economic theory. Well, what’s loss aversion? Well, it was in fact Daniel Kahneman and Amos Tversky who were the first to write about loss aversion in 1979. Loss aversion describes the fact that humans see or feel losses as more significant than gains of the same size. And to quote the website The Decision Lab, it’s better to not lose $20 than it is to find $20. Some estimates suggest that a loss can weigh twice as much as a gain of equal value in terms of our emotional experience of the loss. Well, here’s another example. Imagine if a guest came for dinner and presented you with a $100 bottle of wine. Well, that’s very nice. You’d be very thankful you’d have a positive emotional response. But now just imagine you went to a shop and you bought a $100 bottle of wine as a gift for someone and accidentally dropped and broke it. And I’m just going to pause to let you experience the pain of that loss. Then loss aversion will suggest that you’ll likely have a stronger negative emotional response than the positive emotional response you’d had when you were given an equal value bottle of wine.

Tessa: Yes, even thinking of that bottle slipping from my hand, Ken, makes me cringe a little bit. Loss aversion pushes us in the opposite direction to optimism bias, which we learned about in the previous episode. It’s related to something known as the endowment effect, the way humans assign greater value to specific goods that they own than to identical goods that they do not own. You definitely see this at garage sales when people try to sell their junk for way more than anyone else thinks it’s worth. And it’s absolutely seen in hoarders who accumulate actual junk but see it as something really valuable.

Ken: Yes. So interestingly, Tess, examinations of subjects’ physical responses have also demonstrated that humans are generally more sensitive to losses than to gains. Studies have shown that the skin conductance response, which is the prickling feeling you feel in your skin when you’re excited or emotionally aroused, your skin conductance response to losses is significantly greater than the skin conductance response to equivalent gains. Pupil dilation and heart rate in gain and loss conditions also exhibited similar differences. So it suggests that humans really are more physically sensitive to loss than we are to gain.

Tessa: And loss aversion can make us more risk averse as well. We’re scared to lose, so we avoid risky decisions. But we do need to understand that deciding not to act or not to make a change is also a decision, and all decisions carry an element of risk. So, bottom line, we can’t avoid risk. So it’s better to make an informed and unemotional assessment of risk and to mitigate it where we can.

Ken: Yeah, exactly. And look, an interesting aside here, loss aversion varies somewhat between cultures. So people in more individualistic cultures display a higher degree of loss aversion than those in more collectivist cultures. Some research also seems to indicate that adolescents experience less loss aversion, experiencing reward more positively and punishment less negatively than adults. But nevertheless, loss aversion impacts all of us in some way, and it can certainly impede our decision making.

Tessa: But being risk averse isn’t always bad, is it, Ken? I mean, being wary and cautious can be a good thing. And if you’re overly optimistic and we talked about optimism bias in our last episode, then you could probably learn to be a bit more aware and alert to potential losses.

Ken: Yeah, good point. You’re right. It’s an issue of ensuring that our optimism or our skepticism are grounded in facts. And in that way, we need to focus on the facts as much as possible and remain aware that our emotions can be misleading.

Tessa: Ken, do you want to talk about how we see this manifested in our personal life?

Ken: Yes. So, look, when it comes to financial decisions, and this is often where loss aversion is observed, we need to consider whether a sense of loss aversion is making us behave inconsistently. Now, loss aversion will impact how we view risk when it comes to deciding on things like health insurance or travel insurance. And insurance companies absolutely understand this. For example, there’s a AAMI insurance commercial that seems to always be playing on the TV at the moment. There’s a guy driving along the road, and as he’s driving, bits of his car are falling off. It’s funny. Well, at least for the first time, not for the 700th time. But as always, the focus of insurance commercials is on the worst case scenarios and their impact, rather than on the likelihood of something going wrong. They never present you with the base rate statistics on how likely it is that such an incident would happen. The goal is to show you what could go wrong, to let you experience the emotion of that as you watch the story play out in the commercial and then suggest why it might be better to get the best insurance just for your peace of mind. What I think we need to ask ourselves is why is my mind not peaceful with my current level of insurance? Am I being reckless? And as a result, am I underinsured? Or is my sense of loss aversion overactivated by this advertising and by an irrational fear? And have I spent perhaps too much on insurance?

Tessa: Yeah, I think this irrationality is on display a lot. When it comes to rental cars, most of us actually have free car insurance with our credit cards, but then when we actually go to that point of sale and hire the car, how often do you get upsold just in case? And I think this plays into relationships too. We might have considered carefully and decided it was in our best interest to, say, end an unhealthy relationship, but then found ourselves unable to do so because the cost of breaking up the relationship just felt greater than the benefits that would be gained by ending it.

Ken: Yeah, marketing specialists exploit this when they offer us a free trial of something such as an online streaming service. And we might never have noticed this before, but we try out this free offer, and then what happens? We become accustomed to it. And at the end of the 30 day trial, loss aversion kicks in and we suddenly think, ‘Well, I can’t give that up!’ And so we decide to pay money for it, even though we might not have been willing to pay for the thing before we tried it out. Have you ever known someone who’s miserable at work but unwilling to leave their job Tessa?

Tessa: Yes. More than one, in fact. Ken there can be a lot of reasons, including fear of the unknown, but sometimes there is a sense of unwillingness to give up what they have and a skepticism that the alternative would actually be better. Caution is commendable, but when you’re deeply unhappy at work or at home and you’re still unwilling to make a change, then I think it’s definitely worth stopping and considering if loss aversion is the cause of your decision paralysis. And for more on this, please go and check out our Stay or Go episode in season one.

Ken: Now, at the start of the episode, I asked a question that involved a coin toss. If it comes up tails, you are going to pay me $100. And if it came up heads, I would pay you $150. Now, neither Tess and I are gamblers, but let’s play this out anyway. We did observe that although this is logically a good gamble, many people would find this quite unappealing because we dislike losses more than we like the gains, even when the gains outweigh the losses. But a simple test that might give you more insight into how strongly you experience loss aversion is to tweak the numbers in that imaginary gamble. So let’s just say the loss for a tail stays at $100, but we increase the winning amount for heads to $175. Does that make a difference? What about $200 or $300? I think for all of us, there’s a tipping point at which we’d say, yeah, that’s worth a risk. And what that indicates, though, is that we all experience loss aversion differently. And it’s just a simple test, but it might be useful to help you think about how strongly loss aversion might impact you when you’re trying to make clear, rational decisions.

Tessa: So, any main tips for dealing with loss aversion?

Ken: Ken well, look, here’s a couple of simple ones. If you are deeply unhappy at work or at home, and maybe that’s in a relationship, or maybe it’s some extracurricular activity that you’re involved in, then consider what is it that’s holding you back from getting out of that situation? Are you more worried about what you could lose than what you might gain from moving? Loss aversion might just be playing a part. So take a clear eyed look at what you stand to lose. Maybe the risk isn’t as great as it feels. Here’s a second one. Realize that some businesses, such as insurance companies, and anyone who offers you a free trial on their product, are very effective at exploiting our natural loss aversion. Please, and I will say this very strongly, don’t interpret this as saying that insurance is bad. But pausing before you spend money on anything can potentially help you make a more rational decision. So, Tess, what’s your main takeaway from this episode?

Tessa: Maybe that I need to price things cheaper at future garage sales.

Ken: Yes!

Tessa: But for me, it’s pausing to consider what I’m afraid of losing when I decide to stay in a situation that’s not great and to take the time to dissect my motives. Do I really want to stay in the job/friendship/Netflix subscription? Or does it just feel too painful to let go?

Ken: Yeah, look, for me, I’d say it’s putting together the lessons of the last two episodes and considering whether I have an unrealistic expectation that things are going to work out well, or an unnecessary fear and pessimism that things are going to work out badly, I should make time for caution. And I should make time for optimism when I’m working through a big decision. But I should also do my research around base rates and probability where I can to understand whether my hopes or concerns are well founded.

Tessa: Now, we haven’t asked this for a long time, listeners, but if you’re enjoying the show, we’d be most grateful if you’d give us a plug. Either leave us a review if your podcast player lets you, or maybe even jump on your socials and share our season three post. That two minutes of your time might just bring a new listener to this show and help them to improve their decision making. And it would make us extremely grateful.

Ken: Yes, indeed. Look, thanks so much for joining us for season three of how to choose. Make sure you jump in and listen to our next episode, where we talk about group think. Bye for now.

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