How Loss Aversion in Behavioral Economics Explains Your Irrational Money Choices

by Emily Guy Birken · 3 comments

If you ever kept a gym membership long after it has become clear that you are not now and will never be a gym rat, then you have felt the effects of loss aversion. This particular effect of behavioral economics explains why people are more likely to work to avoid a loss than they are to earn a gain. Loss aversion is the wiring that makes us feel more depressed at the loss of $100 than elated at winning the same amount of money. No, it’s not rational, but it does affect how you handle your money.

The Retail Effect

For example, ever wonder why retail clothing stores have those helpful bags and baskets for gathering all your potential purchases? Retailers know that once you have held an item in your hand, you’re psychologically tied to it and you don’t want to give the item up. The longer you have it in your possession, the stronger that connection, and the more you are unwilling to part with your new stuff.

Loss Aversion in the Stock Market

You will also see this effect very often in the stock market. Investors will hold onto a tanking stock long after it is clear that the investment is dead in the water, because loss aversion makes it difficult to let go in fear that it might recover. This is also the reason why people keep bread machines, treadmills and their college stereos around the house, as they hate to think of selling it at a loss. Even though it’s worth more to you if you sell it for $5 at a yard sale, the perceived loss is a killer.

Avoiding Loss Aversion

Loss aversion is so deeply written into our psyches that it is extremely difficult to avoid, even though it is possible to watch others make irrational decisions based on loss aversion. In order to combat the effect, it’s necessary to do a rational cost/benefit analysis of nearly every financial decision, which is difficult to say the least. However, there are a few things you can do to combat loss aversion in various settings:

When you are out shopping, avoid picking up any items you don’t really want to buy. It’s much easier to leave the cute purse or new gadget behind if you’ve never thought of it as “mine!”

When you’re offered a free trial period of anything, like HBO with your cable package for example, just say no if it’s not something you’re currently willing to pay for. The cable company knows you will be willing to pay more in three months to keep your fix going than you are to just buy it outright. That’s why they offer the trial.

In terms of investments, automation of a sensible strategy will help to combat your loss aversion. If you are not involved in the intimate details of each purchase and sale of a stock, you’re less likely to feel so psychologically tied to a particular decision.

Make Loss Aversion Work For You

Luckily, loss aversion can be a powerful tool for self-improvement, if you recognize how to use it. Just as you don’t want to lose money, you don’t want to break a streak, either. If you post a large calendar in your home and place a gold star or red X on every day that you do something you’re working toward, compose 500 words of the novel you’ve been meaning to write, refrain from smoking, exercise, etc, loss aversion will keep you working on that streak once you have a decent chain of days going. Your disappointment in seeing a day without a gold star is greater than your happiness at any single day’s work. So use that psychological trick to keep you on track.

Next week, we’ll examine why it is so difficult for our brains to understand just how unlikely it is to win the lottery.

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{ 3 comments… read them below or add one }

KM October 21, 2011 at 7:06 am

I don’t think I am affected by loss aversion. It’s actually more difficult for me to justify spending money on something that’s in my basket than it is to let go of it. So many times I will pick something up and carry it around the store, in the end realizing it’s not worth it, putting it back, and walking out empty handed.

But I look forward to your lottery post since my husband will need to read it. I never buy lottery tickets because the chance of winning is so tiny and the money one spends in tickets is definite and adds up, but he insists of buying them and thinks he will win the jackpot just because someone else did.

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Ken Faulkenberry November 4, 2011 at 4:41 am

Thanks for addressing this important concept. One of my pet investment peeves is investors who are willing to take the risk of a large loss in order to not accept a very small loss. This happens more than some might believe. It’s important to overcome this aversion to taking a loss for one to be a success investor.

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Victor April 1, 2013 at 4:56 pm

What can we say about those who sell too early and miss out a huge profit, if he would have hold on?

This is one of the great pain of loss.

That happen to me. Can some good guy or gal say something on or comment this?
Thanks.

Victor

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