Loss Aversion

The amygdala is an almond shaped chunk of flesh in the center of your brain. It's long been associated with a wide variety of mostly negative emotions and behaviors, from the generation of fear to the memory of painful associations. (There's some suggestive evidence that sociopaths have a broken amygdala. Because they can't learn from their moral mistakes, they don't comprehend morality.)

And now there's solid evidence that the amygdala also underlies one of the most potent human biases: loss aversion. To understand this bias, it helps to take a little quiz, which was pioneered by the great Tversky and Kahneman:

The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program A is adopted, 200 people will be saved. If program B is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved. Which of the two programs would you favor?

When this question was put to a large sample of physicians, 72 percent chose option A, the safe-and-sure strategy, and only 28 percent chose program B, the risky strategy. In other words, physicians would rather save a certain number of people for sure than risk the possibility that everyone might die. But what about this scenario:

The U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If program C is adopted, 400 people will die. If program D is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die. Which of the two programs would you favor?

When the scenario was described in terms of deaths instead of survivors, physicians reversed their previous decision. Only 22 percent voted for option C, while 78 percent of them opted for option D, the risky strategy. Most doctors were now rejecting a guaranteed gain in order to partake in a questionable gamble.

Of course, this is a ridiculous shift in preference. The two different questions examine identical dilemmas; saving one third of the population is the same as losing two thirds. And yet, doctors reacted very differently depending on how the question was framed. When the possible outcomes were stated in terms of deathsâ¯this is the "loss frame"â¯physicians were suddenly eager to take chances. They were so determined to avoid any alternative associated with a loss that they were willing to risk losing everything.

Kahneman and Tversky stumbled upon loss aversion after giving their students a simple survey, which asked whether or not they would accept a variety of different bets. The psychologists noticed that, when people were offered a gamble on the toss of a coin in which they might lose $20, they demanded an average payoff of at least $40 if they won. The pain of a loss was approximately twice as potent as the pleasure generated by a gain. Furthermore, our decisions seemed to be determined by these feelings. As Kahneman and Tversky put it, "In human decision making, losses loom larger than gains."

Loss aversion also explains one of the most common investing mistakes: investors evaluating their stock portfolio are most likely to sell stocks that have increased in value. Unfortunately, this means that they end up holding on to their depreciating stocks. Over the long term, this strategy is exceedingly foolish, since it ultimately leads to a portfolio composed entirely of shares that are losing money. (A study by Terrance Odean, an economist at UC-Berkeley, found that the stocks investors sold outperformed the stocks they didn't sell by 3.4 percent). Even professional money managers are vulnerable to this bias, and tend to hold losing stocks twice as long as winning stocks. Why do investors do this? Because they are afraid to take a lossâ¯it feels badâ¯and selling shares that have decreased in value makes the loss tangible. We try to postpone the pain for as long as possible. The end result is more losses.

[Note: much of the above was cut and pasted from my book.]

And now comes a paper, by neuroscientists at UCL and Caltech, which looks at a rare pair of neurological patients with bilateral lesions to the amygdala. (The rest of their brains are perfectly intact, so that both women have normal language skills and IQs.) But as the scientists show the patients don't demonstrate the effects of loss aversion, and routinely went for risky gambles that normal subjects avoided.

Both amygdala-lesioned participants showed a dramatic absence of loss aversion yet they retained a normal response to reward magnitude. This pattern of behavior is consistent with evidence that monkeys with amygdala lesions maintain a stable pattern of preference among sets of food items even though they will approach foods that are paired with potentially threatening stimuli more quickly than control monkeys.

It's worth noting that this isn't the first time a set of neurological patients has failed to demonstrate loss aversion. While these scientists argue that the amygdala is the fleshy source of the negative feeling, it's also possible to suffer brain damage which blocks the experience of that feeling. The amygdala might be pumping out fear, but they don't notice it.

Consider this experiment, led by Antonio Damasio and George Loewenstein. The scientists invented a simple investing game, which they played with three different groups of subjects. The first group had suffered damage to some part of their emotional brain, either the orbitofrontal cortex, insula or amygdala. The second group had suffered brain damage in non-emotional parts of the brain. And the third group was a control sample of undergrads.

In each round, experimental subjects had to decide between two options: invest $1 or invest nothing. If the participant decided not to invest, he would keep the dollar, and the game would advance to the next round. If the participant decided to invest, he would hand a dollar bill to the experimenter. The experimenter would then toss a coin in plain view. Heads meant that the participant would lose the $1 that was invested; tails meant that $2.50 would be added to the participant's account. The game stopped after 20 rounds.

The rational thing to do is to always choose to invest, since the expected value on each round is higher if one invests ($1.25, or $2.50 x 50 percent) than if one does not ($1). In fact, if people invest on each and every round, there is only a 13 percent chance of making less money than if they never invest and simply pocket the $20.

So what did the subjects in this study do? Those with an intact emotional brain chose to invest less than 60 percent of the time. Because we are wired to dislike potential losses, most people were perfectly content to sacrifice profit for security, just like investors choosing a low-yield bond. Furthermore, the willingness of people to gamble plummeted immediately after they lost a gambleâ¯the pain of losing was too fresh.

These results are entirely predictable: loss aversion makes us naturally irrational when it comes to evaluating risky gambles. But Damasio and Loewenstein didn't stop there. They also played the investing game with neurological patients who could no longer experience emotion. If it was the feeling of loss aversion that was causing these bad investing decisions, then these patients should perform better than their healthy peers.

And that's exactly what happened. The emotion-less patients chose to invest 83.7 percent of the time, and gained significantly more money than normal subjects. They also proved much more resistant to the misleading effects of loss aversion, and gambled 85.2 percent of the time after losing a coin toss. In other words, losing money made them more likely to invest, as they realized that investing was the best way to recoup their losses. In this investing situation, being numb to their emotions was a crucial advantage.