Glossary

Loss Aversion

Being more concerned to avoid losses of a certain amount than to make gains of the same amount.

Context: See behavioural finance. This may look like something that would seem quite a common description of human preferences, but it wasn’t until the late 1970s that Kahneman and Tversky developed in academic terms the ideas that economists and then, in the early 2000s, behavioural finance researchers, used to explain aspects of human behaviour. It is particularly relevant in financial theory because so much discussion of investment risk assumes that investors regard losses and gains as equal. However it seems they don’t, and therefore don’t always invest as predicted. What’s more, typically, we become more asymmetric in our views of losses and gains as the potential amount of the loss gets larger.

The academics have now also noted that there may be rational reasons for such behaviour: clearly for most people, losing £1000 may well have a greater impact than gaining it, in terms of the practical impact on their lives. In financial markets there may be equally rational motivations: a trader may lose his job if he loses £1m on a foreign exchange deal, whereas he might only add to his year end bonus by a small amount if he makes £1m.

The idea of loss aversion can be used to explain various market anomalies: for example, the inefficient pricing of risky stocks compared with apparently safe stocks. If an investor is concerned that a stock could go bust, they will be unlikely to buy it, even if the upside is substantially greater than that downside. This, to some more hard-nosed fund managers, may provide a mis-priced investment opportunity if they see a sufficient likelihood of a return.