The Frontal Cortex

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 deaths⎯this is the “loss frame”⎯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 loss⎯it feels bad⎯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 gamble⎯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.

Comments

  1. #1 royniles
    February 10, 2010

    Clue: The emotional bran is a short term prediction apparatus.

  2. #2 Nate Peterson
    February 10, 2010

    So, you’re saying that Sociopaths are more likely to be successful investors. . .
    Therefore – Sociopaths are more likely to have more control over large amounts of capital. . . wow, this really explains a lot about how our society works.

  3. #3 Stuart Coleman
    February 10, 2010

    I’m curious about the first example given, that students would demand a $40 payoff for a $20 bet on a coin flip. Do you mean that they wanted to *gain* $40, or gain $20? Because if they would only bet on a coin flip if they would at least double their money I don’t think that’s loss aversion, I think that’s just normal probability (50% chance of success demands a 2X reward for an X bet, unless you like negative expectation games).

    But if you’re saying they demanded a 3X payoff, then it makes somewhat more sense (the second example, however, is a great one. Who wouldn’t take that bet every time? I guess someone who doesn’t understand probability).

  4. #4 Ryan
    February 10, 2010

    Is there an evolutionary advantage to being irrationally risk averse than it’s opposite?

  5. #5 Charles
    February 10, 2010

    My first response to Nate’s comment was right on Nate. But the more I thought the more I realized the managers of the big financial insitutions do not have to feel any risk aversion as the system has evolved to reward them regardless of the outcome of the “investment”. Not to say they do not exhibit sociopathic qualities because I suspect they do; along with narcissictic personality disorder characteristics in abundance.

  6. #6 Bryan adams
    February 10, 2010

    It’s quite ironic that this was exactly the part of your book I read last night before bed. I’m enjoying it very much so far, and I love coming here to get even more. If anyone hasn’t read jonah’s book ‘how we decide’ yet I highly recomend it!

  7. #7 royniles
    February 10, 2010

    The long term “rational” brain, without the oversight of the emotional brain, conceives of risk as dangerous but doesn’t feel fear of this danger as an emotional response.

    Not the same as a sociopath being unable to empathize with others’ fears.

  8. #8 Ray in Seattle
    February 10, 2010

    Roy, Good insight.

  9. #9 royniles
    February 10, 2010

    Thanks Ray. I felt I had to write the second comment to clarify what I must have been trying to say when I wrote the first one.

  10. #10 Burton
    February 11, 2010

    Does the doctors’ evidence really demonstrate loss aversion? Every doctor has gone through endless years of test-taking as students and like many of us has learned to look for clues as to the “right” answer to a problem. Isn’t it possible the differences represent this clue-reading, rather than a fundamental human characteristic?

  11. #11 Chuck LeBeau
    February 13, 2010

    There have been several academic studies that show that investors decisions to sell stocks are influenced by something called the “disposition effect”. As I recall, one of the studies showed that investors are 72% more likely to pick a winning stock to sell rather than chosing a losing stock.

  12. #12 Nerissa Belcher
    February 17, 2010

    The experiments are based upon complete honesty. In the Antonio Damasio and Loewenstein experiment tails meant that $2.50 really would be added to the participant’s account and the game really stopped after 20 rounds. In the real world promised gains are rarely what was presented and the “game” generally continues until the weaker person playing it loses out. As in “if you work 20 years for this business you’ll get a pension.” The employee will generally be fired for no cause prior to the 20 years or the business will go bankrupt typically with few people ever seeing many pension checks.

    I suspect people are prone to loss aversion since we need to be in order to best handle dishonesty.

  13. #13 Denise Shull
    February 23, 2010

    If you look at the work of say Brian Knuston and Camelia Kuhnen of Stanford and Northwestern respectively it gets easier to understand that sequentially the emotion present (whether from the last gamble or externally induced) influences the cognition related to the next decision.

    The loss aversion also can be explained simply in terms of directing attention and the emotion created through the focus on the “opposing” parts of the question.

  14. #14 forrest curo
    April 28, 2010

    I imagine human brains are optimized for an environment in which potential losses are (as they historically “were”) likely to be catastrophic, potential gains marginal.

  15. #15 Trader
    June 10, 2010

    Having tried investing with little money and no education 5 years ago, I have experienced clear examples of selling winners and holding on to losers.

    I am glad to say that the early years, call it fait, did not last and I lost interest. I am now building interest again … though this time I believe my approach is sounder.

    I have started with learning – get this right and the rest will follow.

    Thank you for a wonderful article, it serves as a great reminder to all.

  16. #16 jolly fellow
    June 28, 2010

    The right response to an ambush is to break out as soon as you can – there is no percentage in waiting to be picked off. In the natural world though, ambush is rare and the maxim ‘if in doubt, don’t’ wins over ‘if in doubt, dare’. It would be interesting to see what happened if the subjects were told that they were likely to be victims of organised crime or a pack of hunters before the experiment began.

  17. #17 chatroulette
    March 22, 2011

    I have started with learning – get this right and the rest will follow.

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