Key takeaways
- Even though risk aversion and loss aversion could be interconnected with one another in some situations, they are not the same.
- Loss aversion describes how much people dislike losing something they already have. Risk aversion, on the other hand, describes how much people prefer certainty over uncertainty.
- It’s important to learn how to overcome such behavioral biases and make rational decisions in our day-to-day lives.
What are behavioral biases?
How much should you worry about earthquakes, hurricanes, wars going on around the world, dengue flu, or inflation? And how much of a risk are you willing to take to avoid that associated with each of these? As you can imagine, life is complex. So the risks and potential losses associated with different sorts of dangers can be quite cumbersome to comprehend. When money is involved, it is obvious that one uncalculated loss could lead to dire consequences1Nudge by Richard Thaler.
This is why it’s extremely important to make calculated decisions in our daily lives.
The first step to such a balanced life is to understand our own behavior when we face an intense situation. Studies show that no matter how rational a person is, we always tend to make biased decisions in intense situations2Kahneman & Tversky, 1979. Understanding these biases is important because they affect everything from what we buy to how we save money or invest. By being aware of these mental traps, we can make better decisions and avoid common mistakes.
Risk aversion and loss aversion are behavioral biases that influence our choices every day. But it’s really easy to misunderstand the difference between these two terms. Although they are somewhat intertwined with each other, loss aversion and risk aversion are completely different terms.
Here’s a simple example that highlights both loss aversion and risk aversion:
Imagine you’re shopping for a new smartphone. You have two choices:
1. Option A: Buy the phone outright for $1,000.
2. Option B: Wait for a Black Friday sale, where there’s a 50% chance the price will drop to $800 but also a 50% chance it might increase to $1,200.
A risk aversive person would choose Option A, preferring the certainty of paying $1,000 rather than risking a price increase, even though waiting could save them $200. They dislike the uncertainty and would rather stick to a known cost.
A loss aversive person would also go for the same option (Option A) but for a different reason. If they choose to wait until the Black Friday offer and the price is increased to $1200, the regret of missing out on the guaranteed price of $1000 feels stronger than the joy of saving $200. This fear is what drives a loss aversive person to go with option A.
This example shows how loss aversion amplifies risk aversion—people aren’t just avoiding risk; they’re avoiding the emotional sting of a potential loss.
However, risk aversion and loss aversion do not always align with each other. We will revisit this point later in this blog post.
Risk aversion vs Loss aversion
Now that we understand these two concepts from the example, let’s define them in a more precise way.
- Loss Aversion: Explain the principle of why losses loom larger than gains.
- Risk Aversion: Clarify how individuals typically prefer certainty over risky outcomes.
In other words, loss aversion describes how much people dislike losing something they already have. Risk aversion, on the other hand, describes how much people prefer certainty over uncertainty3Kahneman & Tversky, 1979.
The reference point in decision-making
Let’s take a deep dive into these concepts.
Risk aversion and loss aversion are well studied by Tversky & Kahneman under prospect theory4Kahneman & Tversky, 1979.
Prospect Theory explains how people make decisions when they face uncertainty. According to basic economic theory, people make rational decisions5Vriend, Nicolaas J., 1996. But, statistics show us otherwise, that ‘decisions that people are not always grounded in rationality’
Prospect Theory shows that emotions and context play a big role in decision-making. A key concept in this theory is the “reference point,” which is the baseline people use to judge whether outcomes feel like gains or losses.
How Does the Reference Point Affect Decisions?
People don’t think about absolute outcomes; they think about changes from their reference point.
Here are some real-world examples of reference points in decision-making
An investment said to have an 80% chance of success sounds far more attractive than one with a 20% chance of failure. The mind can’t easily recognize that the two are the same.
Daniel Kahneman
- Stock Market Decision Making: Imagine you buy a stock at $100. If it drops to $90, you might hold onto it, hoping to “recover the loss,” even if better investment options are available. Here, your $100 purchase price is your reference point6Wilaiporn, 2021.
- Retail Discounts: A jacket originally priced at $200 but on sale for $100 feels like a huge gain because your reference point is the original price. However, if the jacket’s usual price was $100, you might not see it as a bargain. The reference point here changes your perception of the value7Wilaiporn, 2021.
These examples show how our decisions aren’t just about logic—they’re shaped by our feelings about gains and losses relative to a reference point.
Let’s look at how the ‘reference point’ influences a risk averse person and a loss averse person to make different decisions even though the options given to them are exactly the same.
Risk aversion and loss aversion do not always align with each other.
Now coming back to the discussion of risk aversion vs loss aversion, this idea of a reference point raises a valid question in our mind. Are risk aversion and loss aversion always aligned with each other?
Not necessarily.
Here’s an example similar to what we already discussed above.
Imagine that you are playing a game and you have to choose between two options. You start with $0
Option A: You get $50, no strings attached.
Option B: You flip a coin—if it’s heads, you get $100; if it’s tails, you get nothing at all.
The reference point: $0
What would a risk aversion person do? They would most probably go with option A because they are ‘certain’ that they will get $50 for sure(Because they prefer certainly over uncertainty). The possibility of walking away with $0 feels uncomfortable, so they avoid the risk.
On the other hand, what would a loss aversive person do?
They would also go with option A. If they choose the coin toss and lose, the regret of missing out on the guaranteed $50 feels stronger than the joy of winning $100. This fear of loss drives people to play it safe and go with option A.
Now, let’s add a twist:
Say, you start with $100 and then you face a choice:
Option C: Lose $50.
Option D: Flip a coin—if it’s heads, you lose nothing; if it’s tails, you lose $100.
The reference point: $100
Let’s run it back with a risk averse person in mind. A risk averse person would go with option C because they know for certain that they will ‘only lose’ $50 no matter what.
But, A loss averse person would not go with option C, if they start with $100. Even though it’s riskier to go with option D, a loss averse person would choose D because they do not want to lose what they have.
In other words, losing something makes a loss aversive person twice as miserable as gaining the same thing makes them happy8Nudge by Richard Thaler.
Key Difference in Action:
- A risk aversive person avoids uncertainty, preferring safe outcomes (Option A and Option C).
- A loss aversive person focuses on avoiding losses, even if it means taking a gamble (Option D).
This example shows how loss aversion and risk aversion can lead to opposite decisions. Risk aversion pushes for certainty, while loss aversion can drive risk-taking if it helps avoid losses.
Real-world implications of risk aversion vs loss aversion
Let’s take a look at a real-world example where both risk aversion and loss aversion affect our decision-making.
In the stock market, the most famous mantra is Cut your losses and let your profits run!9Kaustia, Markku., 2010
Unfortunately, research shows the opposite behavior.
Instead of selling their losing stocks, investors tend to quickly sell stocks that are going up in price since purchase and hold on to the losing ones10Kaustia, Markku., 2010.
Behavioral economists use the term disposition effect to explain this phenomenon. The disposition effect was first studied by Shefrin and Statman (1985), offering insights into how psychological biases impact financial markets11Shefrin, Hersh, and Meir Statman., 1985.
Let’s take a simple example to understand the disposition effect:
Say, an investor buys two stocks(Stock A and B):
- Stock A rises 20% in a few months.
- Stock B falls 20% in the same period.
The rational decision to take is to sell stock B to avoid future losses. But, statistics show that, most of the time, an average investor would sell stock A!12Shefrin, Hersh, and Meir Statman., 1985
But why?
They want to ‘lock in’ on the gains while holding stock B, hoping that it will recover. With this example, blended with prospect theory, the disposition effect makes sense:
- We are risk-averse with our gains because we want to cash out on our winners. This is why most people would sell stock A. This is the exit while-winning mentality.
- We are also loss averse in that we resist acknowledging our losses. This is why people would stick with stock B, hoping the loss will recover in the future.
What this really means is that we are risk seeking when it comes to losses: We hang on to our losing bets, risking even more money just to try and turn them into a win.
To avoid the disposition effect, investors can:
- Set predefined rules for buying and selling based on analysis, not emotions.
- Use stop-loss orders to automatically sell underperforming assets.
- Reassess portfolios regularly to focus on future potential rather than past performance.
Practical steps to mitigate the behavioral biases
It is clear from the above examples that behavioral biases play a major role in our everyday financial decisions.
This is why it is really important to learn ways to overcome loss and risk aversion in order to have a well-balanced financially viable lifestyle. Here are actionable steps to help counteract these biases in daily life:
Strategies for Counteracting Loss Aversion
1. Turn your Losses into Opportunities
Try to focus more on the gains than the losses. For instance, in case if you want to start a new business, think about the skills and insights that you will gain13A. Peter, et al., 2010. Then re-evaluate the potential losses. If the potential skills and experiences you might gain from such a venture overshadow the potential losses, do not back away from starting the business.
2. Set Predefined sets of Rules
Try to remove the emotions from the get-go. For instance, if you want to buy some stocks, set a rule upfront where you will ‘stop the loss’ and sell if the prices of the stocks are going down.
3. Use the “10/10/10 Rule”
Before starting a venture, ask yourself, would I have taken the same decision in 10 minutes, 10 months, and 10 years. As simple as it seems, this rule would help you immensely to gauge yourself in both the short term and long term.
4. Dare to lose in the short term for long-term gains
Embrace the bigger picture. If you lose something today does not mean that you are going to lose forever. Do your research and figure out the long-term statistics. As an example, in the stock market, the prices go up and down all the time. What you should really be looking at is long-term gains because temporary losses can be a part of long-term gains.
Strategies for Counteracting Risk Aversion
1. Start Small
You miss all the chances you don’t take. As simple as it sounds, you will be surprised if you think back to realize how many opportunities you’ve missed over the years because you did not even try.
But, on the other hand, not taking a chance might be the best option at the time considering potential losses14Kahneman, Daniel, and Amos Tversky., 1984.
The best way to combat this is to start small. A good example would be starting your own brand website. People are always thinking about the best hosting and best premium templates. But at the end of the day, what really matters is how good your product is. Therefore, the best action to take is to start with safer, but cheaper hosting and choose a free website template. You can always upgrade when your product starts selling.
2. Gather Information
Before jumping into any venture, it’s important to understand the ins and outs. The more informed you are, the less intimidating uncertainty will feel. Do a proper research. Talk to people. Go to a conference if available. Being proactive never disappoints.
3. Be thankful for the risks you’ve taken
Look back at some of your decision to understand ‘the importance of risk taking’. You will find many instances where taking risks paid off. Assess such situations and bring them forward to make better decisions in the future.
4. Consider the cost of inaction
To the above point, if you are at a point where you have to decide to take a risk or take a pass, think about the possible outcomes ‘if you do not take the risk’. There are always two sides to a coin. Sometimes, what you lose by not taking a risk is not worth taking the risk anyway15Andersen, Steffen, et al., 2020.
Universal Strategies for Both Biases
1. Adopt a Probabilistic Mindset
Having a rational mindset is hard. Because we are naturally predisposed to make decisions out of our feelings, especially when we find ourselves in intense situations where we have to take a risk16Kahneman, Daniel, and Amos Tversky., 1984.
But like all the other things, with practice, you can avoid the possible losses by carefully assessing the situations without relying purely on emotions.
Before making a decision, take a step back and think about all possible outcomes. What is the probability for each one of them to occur? If you have come this far in the thought process, you are entitled to make a more accurate decision.
2. Seek external feedback
One of the very important life skills, that is often overlooked is the ability to ‘seek for help‘. Sometimes our pride holds us back from seeking advice and end up making a bad decision. It’s important to break this barrier and reach out to the people who are willing to help you.
3. Automate decisions
Whenever you can, set things up to automate your saving, investing, or bill payments. This helps you avoid letting emotions get in the way. For example, having a fixed monthly investment plan keeps you on track with your strategy, no matter how the market bounces around.
4. Focus on growth, not fear
Treat every loss or risk as a stepping stone for growth. Shifting to a growth mindset makes it easier to embrace calculated risks and let go of losses.
Frequently asked questions:
Are risk aversion and loss aversion essentially the same concept?
No, they are not the same concept. But they are closely related to each other. Risk aversive individuals avoid uncertain outcomes whereas loss aversive individuals avoid losses, even if such decisions often involve risk.
Which theory of decision-making explains the concepts of risk aversion and loss aversion?
Prospect theory. Tversky & Kahneman are the founders of prospect theory. It explains how people make decisions when they face uncertainty, such as when they face a risk or when they see a potential loss.
What is the difference between risk aversion and loss aversion?
Loss aversion describes how much people dislike losing something they already have. Risk aversion, on the other hand, describes how much people prefer certainty over uncertainty.
What is the psychology behind loss aversion vs risk aversion?
The psychology behind loss aversion and risk aversion is a byproduct of how we perceive potential outcomes of an action. It is often influenced by our emotions, biases, and our evolutionary instincts.
Loss Aversion: Emotionally driven by the pain of losing what we already have.
Risk Aversion: Anxiety-driven by the fear of uncertainty.
The bottom line
In conclusion, it’s extremely important to understand the differences between risk aversion and loss aversion when making decisions in tricky situations. Both of these ideas shape how we deal with uncertainty and the fear of losing something, but they come from different psychological angles. By figuring out whether we’re avoiding uncertainty or trying to avoid the pain of losing something, we can get out of these mental traps and make smarter, more balanced choices in our everyday lives.
Further readings
- Thaler, Richard H., and Cass R. Sunstein. Nudge: The final edition. Yale University Press, 2021.
- Daniel, Kahneman. Thinking, fast and slow. 2017.
