Imagine that I invite you to play a game right now. The rules are simple. We’ll flip a coin.
If it shows heads, you’ll lose $100. And if it shows tails, you’ll win $100.
Would you take the bet?
If you’re like most people, you wouldn’t.
And since the risk and reward of the bet are precisely the same, that makes sense.
So, let’s change the rules a little.
If it shows heads, you’ll still lose $100. But if it shows tails, you’ll now win $110.
Now Would You Take the Bet?
Interestingly, most people would still not want to play.
The game has a positive expected value of 10%, meaning that, on average, you’ll win $10 every time you play.
But that doesn’t matter.
Psychologically, the risk of losing our hard-earned $100 outweighs the potential reward.
We enjoy winning. But we really, really hate losing. And that leads to poor reasoning and silly decisions.
“Ridiculously Loss Averse”
When researchers offer people to play the coin flip game, they find that most of us demand a chance to win $200 or more to participate.
And that, in the words of psychologist Daniel Kahneman is “ridiculously loss averse.”
A major implication of loss aversion is something called the “endowment effect”; our tendency to perceive things as more valuable just because we own them.
To understand how it works, let’s have a look at another experiment.
Mugs vs. Candy
In this study, the researchers took a big group of students and split them into two groups.
They gave the first group a mug and asked: “For how much would you sell your mug?” and “How much would you pay for a candy bar?”
Then they gave the second group a candy bar and asked: “For how much would you sell your candy bar?” and “How much would you pay for a mug?”
Since they gave out the mugs and candy randomly, you would expect that many people would prefer the other item.
But that’s not at all the case. What you’ll find when you do this experiment is that almost no one switches.
Mine is Better
The people who get mugs suddenly think mugs are amazing.
And the people who get candy bars now think candy is terrific.
So, both groups end up valuing their item higher and sticking to what they already have.
Loss aversion and the endowment effect makes us overprotect and overvalue what we have.
And that often lead to choices, big and small, that are not in our best interest.
It can make you hang on to losing stocks that ruin your portfolio, and it can make you keep needless possessions that clutter your house.
How to Avoid Loss Aversion
Whenever you feel anxious about a potential loss, compare the downside to the upside.
Then dare to make the decision that makes rational sense, even if it feels uncomfortable.
Over the long run, that will lead to much better results.