How Loss Aversion Affect Our Decisions

DIGITAL CAMERA Loss aversion is not a new theory.  The basic premise of the idea describes our strong preference to avoid losses versus our desire for gains.  In laymen’s term, we are supposed to feel more displeasure from losing 10 bucks, than the pleasure of gaining 10 bucks. As a result, even when logic implies one should take the loss and move on, many do not.

An obvious example would be stock market behaviour, where signs of loss prevention lurk at every turn.  Many investors refuse to sell stocks at a loss even when all signs point to more price drops.  The rationale behind such behaviour is that as long as one owns the stock, the price may recover.

In a book named Sway: The Irresistible Pull of Irrational Behaviour, the authors described two scenarios of irrational behaviour attributed to loss aversion.  Neither were good for the pocketbook.  The first case was an experiment conducted by a business professor on his unsuspecting students: auctioning off a 20 dollar note in class.  The game was simple: everyone was free to bid, and the winner takes the note.  But one wrench was thrown in: the second highest bidder must also pony up his or her last bid once bidding finishes.  The result is unsurprising to adherents of the loss aversion theory: desperate to prevent loss, the two bidders would eventually bid the price up to much higher than its 20 dollar face value.  The highest bid once surpassed 200 dollars.

The second case would make every investor cringe in pain, probably because most have experienced it first-hand, albeit (hopefully) on a lesser scale.  It chronicled the disastrous investing experience of a startup millionaire who had put all his money into a bio-tech stock (first and second mistakes there), then stubbornly refused to sell as price slid.  Eventually, the forty something dollar share became virtually worthless at less than a dollar.  So much for loss prevention.

Similarly, this can be used to partially explain various irrational, yet common behaviours we exhibit in our personal and professional lives.  People have stayed in relationships that do not work for much longer than necessary, simply because the potential loss of their emotional “investment” is too large to handle.

Where I see the most devastating case of loss aversion is our careers.  We spend most of our waking hours working, yet very few of us give it the attention it deserves.  Some of us have stuck around at jobs, or even professions that we are ill-suited for.  Part of our reluctance to entertain alternatives has to do with the sunk cost of our time and money getting the education required to enter the field.  Yet even upon realizing a misfit between the professional path we chose when we were still teenagers, and who we had become in the process, many find it next to impossible to make definitive changes in their career path.

As a postscript note, Shadox over at Money and Such is holding a career clinic to get some conversations on careers started.  He’s written about his times in law school, business school, working with start-ups, back to the corporate world, and insights that only someone who had gone through all of the above possesses.  So given his plethora of experiences, if anyone has the authority and background to dish out advice, and get this much-neglected topic discussed in the personal finance arena, it’s him.  So send him a question if you have one.

picture source: valcom2the

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