A Challenge to the Biggest Idea in Behavioral Finance
Two professors make an interesting argument, but the theory of loss aversion isn’t dead yet.
Bloomberg, August 9, 2018
Yesterday, I referenced a fascinating discussion at Scientific American about Loss Aversion. [i]
Today, my column on this is out at Bloomberg. As I noted, I have a dog in this fight: I have been deeply involved in behavioral finance for a long time; I found the psychology behind behavioral economics so profound that RWM uses the discipline as a key aspect of its principles.[ii]
A quick definition may be in order: “prospect theory” describes the way people behave when the probabilities of future gains or losses are uncertain. Even when potential value of upside or downside outcomes are similar, people exhibit a greater tendency to avoid losses versus seeking gains. I look at the claim that a key aspect of prospect theory, Loss Aversion, is a “fallacy.”
Put that in terms of monetary gains or losses for the dominant primates on the planet. Losing money typically reflects a prior exchange of time for value (better known as employment). That time is gone, never to be recovered. It is a permanent loss. But a small, corresponding gain in money from any sort of risk-taking tends not to be life-changing — it is only a modest, temporary improvement in one’s circumstances.
It is noteworthy that near Las Vegas casinos one often finds expensive jewelry and watch stores; people tend to do things with their winnings they might not otherwise do. They purchase expensive baubles with their winnings because “they are playing with the house’s money.”[iii]
The column is posted here.
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[i] The Loss of Loss Aversion: Will It Loom Larger Than Its Gain?, Journal of Consumer Psychology, 9 Oct 2017 Last revised: 26 Apr 2018, by David Gal, University of Illinois at Chicago and Derek D. Rucker Northwestern University (Mirror). See also their response to critics, Loss Aversion, Intellectual Inertia, and a Call for a More Contrarian Science: A Reply to Simonson & Kivetz and Higgins & Liberman, Journal of Consumer Psychology 2 Mar 2018, by David Gal, University of Illinois at Chicago and Derek D. Rucker Northwestern University. (Mirror)
[ii] At some future date, I will detail the ways we have utilized behavioral economics and known cognitive errors to protect investors from their own worst enemies – themselves.
[iii] The unfortunate flip side of this is that gambling junkies often pawn their valuables to keep on playing. This reflects not loss aversion but a debilitating addiction.
[iv] Econometrica Vol. 47, No. 2 (Mar., 1979), pp. 263-292 (mirror)
