According to prospect theory, the concept of loss aversion states that people generally prefer to avoid losses rather than gaining profits. Psychologically the losses seem to be twice more powerful than the gains.The theory of loss aversion was first developed by Amos Tversky and Daniel Kahneman in the year of 1979 under the prospect theory framework.
The concept of loss aversion invariably leads to the concept of risk aversion. The loss aversion theory can explain many paradoxical phenomena in the traditional choice theory and hence gains the immense popularity. The most famous examples of loss aversion theory are endowment effect, equity premium puzzle and the status quo bias. The loss aversion is also applied in behavioral finance.
The concept of loss aversion can be explained in a better way. For example if a person loses $100, he will lose more satisfaction compared to another person’s satisfaction gain over an unexpected gain of $100.
The loss aversion theory is applied in marketing as the sellers take the advantage of the general tendency of the buyers and offer rebates and trial periods. The concept of loss aversion theory merges both the concepts of Economics and Social Psychology.
People are more affected by the perception of loss rather than the reality of loss. For example, let’s take up an example of one investor who was offered with the same mutual fund by two financial advisors.
Let us assume that the first financial advisor explains the investor that the fund had been giving a return of 8% over last five years. On the other hand, let us assume that the second advisor explains the investor that the fund had been experiencing above-average returns in last 10 years but had been declining in recent past. If we follow the loss aversion theory, the investor is most likely to purchase the fund from the first advisor.
Some economists believe that the loss aversion behavior is irrational. According to the implicit assumptions made in conventional economics, the only relevant metric in expenditure is the volume of absolute change.
Last Updated on : 1st July 2013