Heads I win, Tails you lose

I’ve mentioned loss aversion theory a few times, so what is it?

Also known as prospect theory, or framing effect, loss aversion theory was developed by two psychologists, Amos Tversky & Daniel Kahneman. (Some of you may know Daniel Kahneman as author of the best seller, Thinking Fast/Thinking Slow.) To my knowledge, these are the only two non-economists to win the Nobel prize for economics, and they did it by telling economists that much of what they thought they knew about the world was wrong.

The basic experiment ran like this. You take a room of experimental subjects and divide it in half.

You ask one side of the room to make a choice between receiving $1k in cash, no questions asked, or taking an opportunity to win twice the amount –$2k– on a coin flip. If they lose the flip, they get nothing.

The question you’re essentially asking: “Are you risk averse, or risk seeking?”

¾ will take the money. Every time.

For the other side of the room, you frame the question slightly differently. “I’ll take $1k from you. I’ll give you a chance to flip a coin, and if it comes up your way, I’ll give back your $1k. But if you lose, you now owe me $2k.”

¾ will take the coin flip. Every time.

This shouldn’t happen! But because it’s framed two different ways, you get two completely different results.

Humans are risk averse when it comes to gains and risk seeking when it comes to losses.

This finding is robust across ages, cultures and even species! We are hard wired for it. The best explanation comes from evolutionary psychology. If you imagine you’re a species at the end of survival and you have the choice between a small gain or a risky larger gain – you’ll almost always take the small, sure win instead of a big win, yet risk a great deal to avoid even small losses.

Why? As a caveman, a sure loss likely means you’re dead, so you might as well take the gamble –since you’re still dead– but even a small chance that you may get out of the loss entirely is very attractive.

This thinking may have worked well for cavemen, but it has serious drawbacks in the modern world of finance.

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