A recent paper summarized in Scientific American raises an intriguing question: Is one of the founding theories of behavioral finance known as loss aversion — the idea that people place more weight on avoiding losses than gains — correct?
In the magazine, one of the study's authors, David Gal of the University of Illinois – Chicago, writes:
Why has such profound importance been attributed to loss aversion? Largely, it is because it is thought to reflect a fundamental truth about human beings—that we are more motivated by our fears than by our aspirations. This conclusion has implications for almost every aspect of how we live our lives, especially for finance and economics.
But Gal doesn't see it that way. He writes that "loss aversion is essentially a fallacy." He suggests that cognitive bias via loss avoidance doesn't exist, and messages framed in terms of losses are no more persuasive than those framed in terms of gains.
Since this is an extraordinary claim, it requires extraordinary evidence. I don't believe that standard has been met and that the authors failed to make a case that convincingly rebuts the accumulated research.
Let's look at some of the hypotheticals Gal cites: "People do not rate the pain of losing $10 to be more intense than the pleasure of gaining $10." That is not what most of the studies on the subject have found to be case; nor does it square with my personal experiences in dealing with any investor who has suffered losses.
He further writes: "People do not report their favorite sports team losing a game will be more impactful than their favorite sports team winning a game." Again, numerous studies have found that despite the pleasures associated with being a sports fan, the opposite is true.
And one more: "And people are not particularly likely to sell a stock they believe has even odds of going up or down in price (in fact, in one study I performed, over 80 percent of participants said they would hold on to it)." Even if that is true (and I do not believe it is), the endowment effect easily explains why we place greater financial value on that which we already possess.
My pop psychology thesis on this is based on the asymmetrical impact of losses and gains. From an evolutionary perspective, the biological penalties for losses are existential threats to an individual's or a specie's survival; the upside of gains are modest — you live to hunt (or avoid being hunted) another day.
In the modern human world, a loss can feel permanent. You exchanged your finite time for some money (this is otherwise known as employment). Or you risked capital and lost it. That money is gone forever. But get lucky in the markets or a casino and it is ephemeral "house money," easy to spend thoughtlessly.
Barry Ritholtz is a Bloomberg Opinion columnist. He founded Ritholtz Wealth Management and was chief executive and director of equity research at FusionIQ, a quantitative research firm. He blogs at the Big Picture and is the author of "Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy."
