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
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.
[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.