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A Challenge to the Biggest Idea in Behavioral Finance

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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.

When Richard Thaler, Nobel laureate in 2017, was asked about the $1.1 million award that came along with the Prize in Economic Sciences, he cheekily said “I will try to spend it as irrationally as possible.” Thaler’s bon mots are a subtle admission of how humans behave in the real world. That’s what he was awarded the prize for in the first place.

No matter, the paper drew a good deal of attention from those like Drew Dickson, chief investment officer and managing partner at Albert Bridge Capital. In a pointed tweetstorm, he succinctly summed up their position, challenged their thesis, while noting that they perhaps have identified “other motivations for well-known biases.” But he too reaches the conclusion that loss aversion is alive and well.

Where I suspect the authors went astray was in the conflation of various cognitive failures, biases and heuristics with loss aversion. Consider for a moment a Las Vegas casino. If people were truly loss averse, the counterargument might suggest that casinos shouldn’t exist. But they not only survive, but thrive. This is due to other powerful cognitive errors: 1) people tend not to understand how the odds are stacked against them and in the house’s favor; 2) others understand the probabilities, but irrationally believe they are an above-average gambler; 3) others simply gamble for its entertainment value and are willing to accept the inevitable losses.

The mere fact that gain-seeking behavior exists hardly eliminates loss aversion as a phenomena.

What is most fascinating to me about the premise that Gal and co-author Derek Rucker of Northwestern University’s Kellogg School of Management have pushed forward is around the meta-concept that challenging the status quo is an uphill battle. They are on to something here, though surely they recognize that Daniel Kahneman and Amos Tversky’s famous theory was itself not accepted for a long time. Kahneman and Tversky’s ground-breaking 1979 paper was an assault on the status quo at the time, and it took decades before their thesis was assimilated into psychology and economics.

But this does bring up an intriguing concept: As any counterintuitive idea slowly becomes mainstream, it too is eventually challenged as the status quo. Perhaps this is what physicist Max Planck meant what he stated that “science advances one funeral at a time.”

For many good reasons, loss aversion has become accepted wisdom on how people make decisions under conditions of uncertainty. I suspect it will be a long time before that explanation is overthrown.

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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.”


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