Loss Aversion: Why Taking Risk Is Hard

There is no reward without risk. Any potential investment, career opportunity, or significant life change carries with it upside reward and downside risk. They are two sides of the same coin.

Yet, we do everything we can to avoid downside risk because we suffer more from a loss than we enjoy from a proportionate gain. We have a natural aversion to loss.

This is a feature of the human mind, not a bug. It’s designed to keep you alive. To keep your genes alive. And it has important consequences when you navigate the world - ones that can work for you if you know what you’re doing and against you if you don’t.

What Is Loss Aversion Bias?

Loss aversion bias is the natural tendency to suffer more from a loss than you enjoy from a proportionate gain.

Psychologists Amos Tversky and Daniel Kahneman explore the concept in their paper, Loss Aversion in Riskless Choice: A Reference-Dependent Model. Here’s their definition:

“Loss Aversion: The basic intuition concerning loss aversion is that losses (outcomes below the reference state) loom larger than corresponding gains (outcomes above the reference state).”

In the simplest terms, the pain of losing a $20 bill is greater than the joy of finding one. It’s an asymmetric reaction to the downside.

Deprival-Superreaction Tendency

Charlie Munger calls this phenomenon Deprival-Superreaction Tendency.

His definition has an important addition, though. Not only do you suffer more from a loss than you enjoy from a proportionate gain, but you also suffer just as much if you almost get what you want and then have it ripped away.

Here’s Munger explaining Deprival-Superreaction Tendency in his speech, The Psychology of Human Misjudgement:

“The quantity of man’s pleasure from a ten-dollar gain does not exactly match the quantity of his displeasure from a ten-dollar loss. That is, the loss seems to hurt much more than the gain seems to help.

Moreover, if a man almost gets something he greatly wants and has it jerked away from him at the last moment, he will react much as if he had long owned the reward and had it jerked away. I include the natural human reactions to both kinds of loss experience—the loss of the possessed reward and the loss of the almost-possessed reward—under one description, Deprival-Superreaction Tendency.”

You don’t even have to “have” the thing to feel the pain of losing it! And this influences how humans behave and react to the world.

Examples Of Loss Aversion

Once you start to notice your loss aversion, you’ll begin to see it everywhere - even in animals!

Have you ever tried to take a piece of food out of a dog’s mouth?

No matter how much this dog loves you - no matter how friendly this dog is or seems to be - it will try and bite your hand off if you attempt to take food out of its mouth. That’s loss aversion in action.

Humans aren’t so different. Charlie Munger writes:

“A man ordinarily reacts with irrational intensity to even a small loss, or threatened loss, of property, love, friendship, dominated territory, opportunity, status, or any other valued thing.”

This “irrational intensity” induces many illogical reactions and decisions like…

Loss Aversion Makes It Hard To Enjoy A Great ROI.

Here’s an example of loss aversion that every single investor has felt in their lifetime. Say you have an investment that goes from $10,000 to $100,000 over three years and then gets cut in half to $50,000 in short order. If I saw you, I’d congratulate you on a great return!

But that’s not what it feels like for you. Loss aversion makes you feel the pain of “losing” $50K, even though you never had that money, to begin with! Despite knowing this is illogical, you can’t help but feel like you lost money.

Contrast bias magnifies this feeling. You don’t compare your $50K to the $10K you started with - you compare it to the $100K you briefly had.

This is you reacting with irrational intensity to “the loss of the almost-possessed reward.”

To counteract this, always compare what you have to what you started with at the very beginning, not with what you had most recently.

Loss Aversion Means You Prefer The Status Quo.

Loss aversion induces a bias to remain on the same path you are on, called status quo bias or commitment and consistency bias (another Munger term).

Amos Tversky and Daniel Kahneman write:

“Loss aversion induces a bias that favors the retention of the status quo over other options.”

Because you fear losing what you have, it’s far easier to remain on the path you’re on, even if the other options look pretty good!

That’s why making big life changes is really hard. When I quit my job, getting over the fear of losing my monthly income was the hardest part. I had a severe aversion to loss.

But once I did it, I started to discover the sheer number of other options available. You are never as trapped as you think you.

Status quo bias is also why, once you choose a path, you tend to stay on it for a relatively long time. The average length of a job in the U.S. is about four years. That’s a big chunk of your working life - around 10%.

To counteract status quo bias, Amos Tversky and Daniel Kahneman recommend weighing other options slightly more than the current path you’re on. If all other things are equal, take the new direction.

Loss Aversion Means You Value What You Own More Than You Should.

Have you ever tried to sell something you own but haven’t been able to find a buyer to meet your price? This could be because loss aversion makes you value what you own more than the market does.

Here are Tversky and Kahneman explaining this tendency:

“Loss aversion is an important component of a phenomenon that has been much discussed in recent years: the large disparity often observed between the minimal amount that people are willing to accept (WTA) to give up a good they own and the maximal amount they would be willing to pay (WTP) to acquire it… Results of several comparisons indicated that the reluctance to sell is much greater than the reluctance to buy.”

This means you would not go out and buy that thing that you own for the high price you are willing to sell it for! You value what you own more than you really should.

To counteract this, try to consider what you would be willing to pay for the good if you didn’t already own it. Then, price accordingly based on market comparables.

If You Remember only One Thing, Remember This.

Now that you know what loss aversion is start to look for it. Notice how you get irrationally irritated at even the prospect of a small loss. And then begin to use logic, not emotion, to counteract this bias.

If you remember only one thing, remember this:

“If I gave you a nice house and a Lamborghini, put a million dollars in your bank account, and provided you with a social network, then, a few months later, took everything away, you would be much worse off than if nothing had happened in the first place.” - Nassim Nicholas Taleb.

That’s the power of loss aversion.