The Benefits of Loss Aversion

It's easy to deride our irrational bias against losses. From the perspective of economics, there is no good reason to weight gains and losses so differently. (Losses feel twice as bad as gains feel good. We demand a $40 payoff for a $20 bet.) Opportunity costs should be treated just like "out-of-pocket costs". But they aren't: losses carry a particular emotional sting. Take this imaginary 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 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 asked 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 prefer a sure good thing over a gamble that risks utter failure. They are acting just like the people who choose the certain one week tour of England. 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?

These two different questions examine identical dilemmas. Saving one third of the population is the same as losing two thirds. But when this simple scenario is framed in terms of losses, physicians reversed their previous decision. Only 22 percent voted for option C, while 78 percent of them opted for option D, the risky strategy that might save everyone. Of course, this is a ridiculous shift in preference. Loss aversion makes us look stupid.

But it's also important to note the benefits of loss aversion. Look, for example, at the recent speculative bubble in tech-stocks. When investors bought shares in sketchy internet companies, they had lost their fear of losing money. They saw dot-com stocks as sure things, destined to perpetually increase in value. (A financial bubble is a popular delusion of optimism: everybody is suddenly convinced that they are going to get rich.) While this behavior might seem ridiculous in retrospect, it can also be viewed as perfectly logical. These tech stocks had always appreciated in the past. Why should the future be any different? Alas, the future is always different. This is also why we naturally worry about risky gambles. While most economists think loss aversion is a silly and irrational habit, it also prevents us from sinking our savings into dubious investments. Without a little loss aversion, more of us would lose everything.

In his column today, Krugman worries that the markets have once again lost their irrational fear of losses:

After the bursting of the technology bubble of the 1990s failed to produce a global disaster, investors began to act as if nothing bad would ever happen again. Risk premiums -- the extra return people demand when lending money to less than totally reliable borrowers -- dwindled away.

For example, in the early years of the decade, high-yield corporate bonds (formerly known as junk bonds) were able to attract buyers only by offering interest rates eight to 10 percentage points higher than U.S. government bonds. By early 2007, that margin was down to little more than two percentage points.

For a while, growing complacency became a self-fulfilling prophecy. As the what-me-worry attitude spread, it became easier for questionable borrowers to roll over their debts, so default rates went down. Also, falling interest rates on risky bonds meant higher prices for those bonds, so those who owned such bonds experienced big capital gains, leading even more investors to conclude that risk was a thing of the past.

Sooner or later, however, reality was bound to intrude.

Of course, it's easy to understand why evolution would favor loss aversion. From the perspective of natural selection, it's better to be safely good than dangerously great. We should instinctively avoid unnecessary risks. After all, the dead don't reproduce.