Losses versus gains (part 1)

"A bird in the hand is better than two in the bush"

Thank you for joining me for my tenth (yes 10 weeks in a row!) blog in the series, highlighting decision-making and the brain. This is my public exploration of what drives decision-making and how we can use that information to make better decisions, resulting in better outcomes.

Think through the following experiment. Let's say you are offered a deal, where literally everything you own is put at risk on a coin toss. If you choose heads and it came out heads, your total wealth is doubled, but if you chose tails you lose everything. If you are like most people, you would not accept that deal, because the loss of everything is much more painful than having two times what you have today.

This is true for losses in general and we will go through examples of loss aversion in real life and how it can leading to surprising outcomes. We call this idea of losses looming larger than gains as loss aversion and it is a key pillar of behavioural economics.

Examples of Loss aversion

In the animal world, an animal that is defending its territory has an overwhelming (some say 6 to 1) advantage over the attacker. Another example is a golfer is more likely to successfully sink a putt to save par then to get a birdie. Both of these point to the idea we see across decision-making: we are more motivated to avoid loss than we are to achieve gain.

Thank you Stephen Read for the image ((3) 15 Examples of Loss Aversion | LinkedIn)

Loss aversion ratios

The idea of losses looming larger than gains permeates throughout decision-making and culture. When psychologists have tried to tempt people into a coin toss, people needed to be given a £150-250 gain against a £100 loss to accept the risk. i.e. they need to be compensated 1.5-2.5x the amount they could lose. This is referred to as the loss aversion ratio, and whilst it varies between people, it does seem that it averages around 2x for a population as a whole. The phrase 'a bird in the hand is better than two in the bush' is therefore on the button with the 2x ratio.

The negative subjective feeling of a gain is about twice that of the positive subjective feeling of a gain

Thank you to Peter Sokol-Hessner & Robb B. Rutledge for this image.

Evolutionary and biological origin of loss aversion

Loss aversion can be understood from an evolutionary and biological perspective. If you do not defend your food, territory or mate, it will decrease your chances of survival and reproduction. When faced with the prospect of loss, your brain stimulates the production of a hormone much like adrenaline. This causes the body to be more alert and your heart rate to quicken which causes a feeling of discomfort and need to act (i.e. motivation).

So Loss aversion is Risk aversion? - Wrong!

Whilst some people see loss aversion the same way as risk aversion, that is not correct. To avoid losses some people also take extra risk. One example is that investors often increase their investment in a share that has lost money ("doubling down"). This helps them (in their opinion) avoid crystallising a loss and gives them a chance to 'win it back'. The merits of that are debatable, but to avoid settling for a loss, they are now taking even more risk (risk-seeking).

How can we use this finding?

The reason you should know about this, is that we are built to avoid loss and it can lead to two types of avoidable bad decisions:

1) If we always accept one in the hand over two in the bush, we will miss out on good propositions in life or in investing and be too conservative

2) If we do not accept that a previous bad decision has been made (e.g. an investment was a bad choice) it might lead us to take unjustified risk to make it back, potentially causing even more problems down the line

The key takeaways from today are:

1) We are hard wired to avoid loss, and feel losses roughly twice as keenly as we do gains

2) This loss aversion has resulted from a survival advantage and results in a physical change which makes you want to act

3) Loss aversion can in different circumstances make you too conservative or too keen to take risks and it's worth knowing when you might be in one of those situations

Thank you for joining. Next week's topic will be how we apply this finding of losses versus gains to the investing world.