Loss aversion - Definition and Overview

In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful than gains.

This leads to risk aversion when people evaluate a possible gain; since people prefer avoiding losses to making gains. This explains the curvilinear shape of the prospect theory utility graph in the positive domain. Conversely people strongly prefer risks that might possibly mitigate a loss (called risk seeking behavior).

Loss aversion may also explain sunk cost effects.

Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a 5% discount, or avoid a 5% surcharge? The same change in price framed differently has a significant effect on consumer behavior. Though traditional economists consider this "endowment effect" and all other effects of loss aversion to be completely irrational, that is why it is so important to the fields of marketing and behavioral finance.

Loss aversion was first theorized by Amos Tversky and Daniel Kahneman.

See also

• status quo bias
• list of cognitive biases

References

• Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica 47, 263-291.
• Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. Quarterly Journal of Economics 106, 1039-1061.