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“Loss aversion” isn’t always

This entry by Will Wilkinson reminded me of something that’s bugged me for awhile, which is the use of term “loss aversion” to describe something that I’d rather call “uncertainty aversion,” if that. (Wilkinson doesn’t actually do this thing that irritates me–he actually is talking about loss aversion, referring to actual aversion to loss–but he reminds me of this issue.)

As I wrote before,

If a person is indifferent between [x+$10] and [55% chance of x+$20, 45% chance of x], for any x, then this attitude cannot reasonably be explained by expected utility maximization. The required utility function for money would curve so sharply as to be nonsensical (for example, U($2000)-U($1000) would have to be less than U($1000)-U($950)). This result is shown in a specific case as a classroom demonstration in Section 5 of a paper of mine in the American Statistician in 1998 and, more generally, as a mathematical theorem in a paper by my old economics classmate Matthew Rabin in Econometrica in 2000. . . .

Matt attributes the risk-averse attitude at small scales to “loss aversion.” As Deb points out, this can’t be the explanation, since if the attitude is set up as “being indifferent between [x+$10] and [55% chance of x+$20, 45% chance of x]”, then no losses are involved. I attributed the attitude to “uncertainty aversion,” which has the virtue of being logically possible in this example, but which, thinking about it now, I don’t really believe.

Right now, I’m inclined to attribute small-stakes risk aversion to some sort of rule-following. For example, it makes sense to be risk averse for large stakes, and a natural generalization is to continue that risk aversion for payoffs in the $10, $20, $30 range. Basically, a “heuristic” or a simple rule giving us the ability to answer this sort of preference question.

There was some discussion of this on the blog last year. To recap briefly, no, I don’t think this example is loss aversion, since no losses are involved. Yes, you could shift the problem by subtracting, to get losses, but that’s not how it’s framed. Getting back to the $40,$50,$60 example: if you want, you can say that the very mention of the $50 makes anything less seems like a loss, but I don’t see it. I think the evidence is that people react to actual losses much more strongly than to a non-gain.

Risk aversion. No, it’s loss aversion. No, it’s uncertainty aversion. No, it’s rule-following.

Anyway, my problem here is with “loss aversion” used in an automatic way to summarize various aspects of irrationality (such as avoidance of expected monetary value for small dollar amounts). My take on it (which is probably historically inaccurate) was that decision scientists first simply assumed that people used expected monetary value. Then they coined the term “risk aversion” and associated it with concave utility functions. Simple calculations (such as mine and Matt’s, mentioned above) made it clear to many people (eventually everyone, I hope) that the typical non-EMV attitudes cannot be sensibly fit into an expected-utility framework. This led to ideas such as prospect theory which had aspects of expected utility but with biases caused by framing, confusions about probability, loss aversion, and so forth.

Now loss aversion is the catchphrase–and I agree, it’s an improvement on the now-meaningless “risk aversion”–but I think it’s silly to apply “loss aversion” to settings with no losses. Really, in some of these settings, I don’t see “aversion” at all but rather a preference for certainty (perhaps “uncertaintly aversion”) or even just the following of a rule.

The big issue

The big issue pointed out implicitly by Wilkinson (and others) is that people often seem to respond to the trend rather than the absolute level of the economy. I’m certainly not meaning to imply that, in battling over terminology, I’m resolving these deeper issues. My goal here is simply to point out that some commonly-used terms can have misleading implications.

Regarding Wilkinson’s actual entry, his discussion is interesting, but I’m confused by his main point, which seems to be:
(a) Middle-class Americans shouldn’t be so scared about losses–they’d still be able to get by OK on half their incomes.
(b) By being less afraid of losses, a middle-class American could take more risks which could result in a doubling of his or her income.
But, if point (a) is true, and you could easily live on half, then what’s the motivation to double your income? Shouldn’t we all just be taking more vacations?

I’m not trying to disagree with Wilkinson’s point that many people’s economic lives might not be so precarious as they think–as he puts it, middle-class Americans get a lot of things for free. I just don’t see why this implies that people should be taking more risks.

4 Comments

  1. Hi Andrew,

    Thanks for the interesting discussion. About your last comment… what I had in mind for (b) is more like this:

    (b') By being less afraid of losses, a middle-class American could take more risks which could result in greater job satisfaction and/or a larger income.

    Other things equal, bigger incomes are better. But, past a threshold of economic sufficiency, high job satisfaction is even more important to a sense of well-being than additional income. People aiming at happiness ought to be willing to take a hit in income to reap higher job satisfaction, but loss aversion locks them into suboptimal sitatuations. Once you've got money, you need meaning more than money, but meaning doesn't just fall in your lap, and it's hard to buy. Often finding it requires defying our anxiety and risking economic loss.

  2. peter says:

    The preference for $10 over ($20, .55) (taking x to be the current reference point) could perhaps be made a little more sense of keeping in mind the less prominent (than the value function) component of prospect theory, viz. the probability weighting function. If p>.3 or so tend to get underweighted, then you'd of course expect 50/50 bets for twice the money to be rejected.

  3. Andrew says:

    Dinesh,

    Yes; see here.

    Peter,

    Yes, but I think you'd see the same phenomenon with 50/50 probabilities: for example, people would be indifferent between $x and (.5 chance of $x-10 and .5 chance of $x+15, or something like that.