What better day than Christmas, that day of gift-giving, to discuss “loss aversion,” the purported asymmetry in utility, whereby losses are systematically more painful than gains are pleasant?
Loss aversion is a core principle of the heuristics and biases paradigm of psychology and behavioral economics.
But it’s been controversial for a long time.
For example, back in 2005 I wrote about the well-known incoherence that people express when offered small-scale bets. (“If a person is indifferent between [x+$10] and [55% chance of x+$20, 45% chance of x], for any x, then this attitude cannot reasonably be explained by expected utility maximization. The required utility function for money would curve so sharply as to be nonsensical (for example, U($2000)-U($1000) would have to be less than U($1000)-U($950)).”)
When Matthew Rabin and I had (separately) published papers about this in 1998 and 2000, we’d attributed the incoherent risk-averse attitude at small scales to “loss aversion” and “uncertainty aversion.” But, as pointed out by psychologist Deb Frisch, it can’t be loss aversion, as the way the problem is set up above, no losses are involved. I followed up that “uncertainty aversion” could be logically possible but I didn’t find that labeling so convincing either; instead:
I’m inclined to attribute small-stakes risk aversion to some sort of rule-following. For example, it makes sense to be risk averse for large stakes, and a natural generalization is to continue that risk aversion for payoffs in the $10, $20, $30 range. Basically, a “heuristic” or a simple rule giving us the ability to answer this sort of preference question.
By the way, I’ve used the term “attitude” above, rather than “preference.” I think “preference” is too much of a loaded word. For example, suppose I ask someone, “Do you prefer $20 or [55% chance of $30, 45% chance of $10]?” If he or she says, “I prefer the $20,” I don’t actually consider this any sort of underlying preference. It’s a response to a question. Even if it’s set up as a real choice, where they really get to pick, it’s just a preference in a particular setting. But for most of these studies, we’re really talking about attitudes.
The topic came up again the next year, in the context of the (also) well-known phenomenon that, when it comes to political attitudes about the government, people seem to respond to the trend rather than the absolute level of the economy. Again, I felt that terms such as “risk aversion” and “loss aversion” were being employed as all-purpose explanations for phenomena that didn’t really fit these stories.
And then, in the midst of all that, David Gal published an article, “A psychological law of inertia and the illusion of loss aversion,” in the inaugural issue of the Journal of Judgment and Decision Making, saying:
The principle of loss aversion is thought to explain a wide range of anomalous phenomena involving tradeoffs between losses and gains. In this article, I [Gal] show that the anomalies loss aversion was introduced to explain — the risky bet premium, the endowment effect, and the status-quo bias — are characterized not only by a loss/gain tradeoff, but by a tradeoff between the status-quo and change; and, that a propensity towards the status-quo in the latter tradeoff is sufficient to explain these phenomena. Moreover, I show that two basic psychological principles — (1) that motives drive behavior; and (2) that preferences tend to be fuzzy and ill-defined — imply the existence of a robust and fundamental propensity of this sort. Thus, a loss aversion principle is rendered superfluous to an account of the phenomena it was introduced to explain.
I’d completely forgotten about this article until learning recently of a new review article by Gal and Derek Rucker, “The Loss of Loss Aversion: Will It Loom Larger Than Its Gain?”, making this point more thoroughly:
Loss aversion, the principle that losses loom larger than gains, is among the most widely accepted ideas in the social sciences. . . . The upshot of this review is that current evidence does not support that losses, on balance, tend to be any more impactful than gains.
But if loss aversion is unnecessary, why do psychologists and economists keep talking about it? Gal and Rucker write:
The third part of this article aims to address the question of why acceptance of loss aversion as a general principle remains pervasive and persistent among social scientists, including consumer psychologists, despite evidence to the contrary. This analysis aims to connect the persistence of a belief in loss aversion to more general ideas about belief acceptance and persistence in science.
In Table 1 of their paper, Gal and Rucker consider several phenomena, all of which are taken to provide evidence of loss aversion, can be easily explained in other ways. Here are the phenomena they talk about:
– Status quo bias
– Endowment effect
– Risky bet premium
– Hedonic impact ratings
– Sunk cost effect
– Price elasticity
– Equity risk premium
– Disposition effect
– Loss/gain framing.
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