Gal and Rucker (2018) on the Loss of Loss Aversion

David Gal and Derek D. Rucker, “The Loss of Loss Aversion: Will It Loom Larger Than Its Gain?” Journal of Consumer Psychology 28(3): 497-516, July 2018.

• Social scientists seem to all but universally believe in loss aversion, the notion that losses “loom larger” psychologically than do similarly-sized gains.

• Gal and Rucker claim that the actual evidence does not support any general tendency for losses to loom larger than gains: everything depends upon the context.

• There’s a bit of circularity in the promotion of loss aversion: some phenomenon (like the equity premium puzzle or the endowment effect) is “explained” by loss aversion, and then the existence of the phenomenon (the equity premium, the endowment effect) is taken to be evidence that loss aversion is pervasive. 

• The status quo bias might reflect a preference towards inaction – and such a preference can exist in the absence of loss aversion, due to the lack of a motive for action, or economizing on processing costs, or the tendency to regret errors of commission more than errors of omission. 

• When asked to trade their original good for an essentially identical one, loss aversion is not implicated – but people still show a large status quo bias. Action v. inaction confounds the loss-gain story. 

• Is the endowment effect just a case of a status quo bias, and therefore does not require loss aversion? 

• The “retention paradigm” recasts endowment effect experiments as willingness-to-pay (WTP) to obtain an item v. WTP to retain an item – so now the “inaction” choice is not to have the good in both cases. (That is, the confounding of loss aversion with inaction is sidestepped.) 

• If loss aversion is active, then in the retention paradigm, the WTP to retain will be higher than the WTP to obtain. But in the experiments, there was no premium to retain a good or service. For “mundane” goods – mugs, notebooks – obtaining tended to have a higher WTP than retaining. 

• One has to be creative to come up with reasonable “retain” scenarios! Fixing a broken phone, perhaps? 

• Analogous experiments ask if you would like to receive $0 for a good you own, or exchange it for another good. The second condition swaps the owned and alternative good. Mug v. $5 shows no endowment effect – even though the standard exchange paradigm (that is, not the "retention" paradigm) with these goods shows a significant endowment effect. 

• For the standard “loss aversion ratio” test, not accepting the bet is the status quo. This test, too, can be recast: Would you rather receive $0 with a probability of 1 or take a 50-50 bet with the possibility of winning or losing $15? People seem to have a slight preference for the risky alternative. 

• When stakes are higher, preferences shift toward the sure thing – but this could reflect risk aversion, not loss aversion. (And, loss aversion is generally taken to be independent of the stakes.) 

• When you ask people directly about the psychological impact of winning or losing something – you ask them how they feel about these events – losing doesn't dominate in terms of the magnitude of feelings. How do you feel about losing a mug versus winning a mug? 

• How do you feel about losing $3 versus winning $3? What about $100? At the low stakes, people seem to care more about the gain. 

• Loss “frames” are not generally more motivating than “gain” frames (despite some evidence to the contrary in certain domains). 

• Why is loss aversion so popular given its questionable evidentiary base? Perhaps in part due to a status-quo bias among researchers(!), or confirmation bias within Kuhnian “normal science.” 

• Loss aversion holds intuitive appeal: we all feel some losses acutely. And the name “loss aversion” itself is persuasive.

Chen and Schonger (2016) on Ambiguity Aversion

Daniel L. Chen and Martin Schonger, “Is Ambiguity Aversion a Preference?” TSE Working Paper No. 16-703, December 2016.

• Ambiguity aversion has been implicated in many real world phenomena, including the equity premium puzzle: the stock market operates under Knightian uncertainty (ambiguity), not risk, and so ambiguity-averse investors need compensation to buy stocks. Overly punitive plea bargains are acceptable to ambiguity-averse defendants…

• But perhaps the sort of behavior exhibited by the Ellsberg paradox is not really indicative of underlying preferences – perhaps it is mistake, the use of a decision heuristic in inappropriate circumstances. Perhaps people are not actually ambiguity averse.

• Maybe people (rightly) shy away from unfamiliar offers, especially when the person making the offer possesses superior information – and this is the situation when experimental participants are presented with the Ellsberg game. Subjects suspect that the experimenter actually knows how many red and blue balls are in the urn.

• Chen and Schonger set up an Ellsberg experiment where the experimenter is not the party responsible for the contents of the ambiguous urn; rather, the choices of other subjects determine the contents. 

• Every subject decides which of two symbols to send to the others. In experiment 1, the symbol that gets the most “votes” is the symbol that will appear in the “ambiguous” urn for other participants (which need not be the same for all participants, incidentally). 

• All experiments involve a toss of a fair coin, where the subjects can choose to bet on either heads or tails, along with the two ambiguous options. A correct outcome yields 4€. The choice of the bet is determined by taking the maximum of the valuations provided by each participant for each of the four bets. 

• People turn out to prefer the ambiguous bets! “For each of the 16 sessions, individuals were more likely to bet on a symbol with subjective uncertainty, and in all but 2 of the 16 sessions, both bets with subjective uncertainty were more popular than the bets with objective uncertainty [p. 15].” This remains true in design 2, where there is a full-on urn and not just a specific symbol chosen by others.

Larson, List, and Metcalfe (2016) on Myopic Loss Aversion and the Equity Premium Puzzle

Francis Larson, John A. List, and Robert D. Metcalfe, “Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders.” August 31, 2016; available here.

• The puzzle: the real return on US equities is about 8% per annum, versus about 1% for riskless assets. This spread cannot easily be explained as a risk premium. 

• One hypothesis: traders display myopic loss aversion (MLA), and hence the frequent downticks (short-term declines in asset value) are psychologically costly – people will only put up with these costs if there is an offsetting premium in the monetary return. If MLA can explain the equity premium puzzle, then it must be present in the “marginal” trader. 

• Laboratory experiments have found that myopic loss aversion is common. The standard design involves varying the rate at which price information is delivered to traders. Those who receive information at high frequency are exposed to more revelations of downticks, and hence, if they display MLA, they will underinvest in the risky asset, the one that is subject to lots of downticks. 

• The Larson, List, and Metcalfe paper employs a (natural?) field experiment, where traders do not know they are taking part in an experiment; they think they are beta-testing a new online trading platform. 

• The traders' recompense is to be paid eventually in-kind based on the profits that they accrue during their two weeks of testing. They can “buy” a risky asset whose return is tied (in a not-fully-obvious way) to the US dollar exchange rate. The tying is such as to bias the return to the asset to be positive. 

• The experiment reveals MLA – traders who are given infrequent (once per 4 hours) price updates keep more of their stake in the risky asset, and earn considerably more, than those traders who receive second-by-second updates. 

• Traders tend to desire more frequent price updates, but perhaps that information degrades their performance. 

• Since both the Frequent (n=73) and Infrequent (n=78) groups of traders can trade at any time, this experiment avoids a confounding feature of past laboratory experiments, that both information and trade opportunities are altered among conditions.

Barberis (2013) on Tail Events

Nicholas Barberis, “The Psychology of Tail Events: Progress and Challenges.” American Economic Review 103(3): 611-16, 2013.

• “Tail events” are low probability, but high impact outcomes, like a huge stock market crash. 

• Analysis of human reactions to tail events focuses on the perceived probability of the event, and, with that probability given, how the outcome itself is judged. 

• People tend to overestimate the probability of rare, but monumental events, whether the outcomes are superb (like winning the lottery) or disastrous (like being victimized by terrorists). 

• Even when people assess probabilities objectively, however, they tend to put “excessive” weight on the outcomes tied to tail events. Hence they might be willing to pay to avoid a very unlikely but large loss, at the same time they are willing to pay to buy a very unlikely chance at a windfall: the rare outcome of the big loss is overweighted, as is the rare outcome of the big win. This overweighting is a feature of preferences and (probably?) cannot be said to be a mistake. 

• The excessive weight on low-probability outcomes indicates that positive skewness (a lottery-like low probability of a big win) is valuable to people, so that shares of stocks of individual companies that offer such skewness do not have to have as high of an expected return to attract buyers. 

• But the excessive weight placed on low probability events also implies that negative skewness (a small probability of a large loss) is aversive, so that assets that are negatively skewed (such as the overall stock market, which might crash) require a premium in terms of expected returns to attract buyers; this approach offers an explanation for the equity premium puzzle.

Rabin and Thaler (2001) on Risk Aversion and the Failures of Expected Utility

Matthew Rabin and Richard H. Thaler, “Risk Aversion,” Journal of Economic Perspectives 15(1): 219-232, Winter 2001.

·  In the expected utility (EU) model, risk aversion is equivalent to diminishing marginal utility of income.

·  Any meaningful risk aversion over small stakes is inconsistent with EU maximization, as it requires a crazy unwillingness to take on risk at larger stakes. In other words, EU maximizers must be effectively risk neutral for small stakes, such as those in laboratory experiments. Nonetheless, people display risk aversion at small stakes.

·  Extended warranties and rental car insurance are purchased by many people, though the small stakes (relative to lifetime wealth) and high prices involved imply that they should be unattractive to expected utility maximizers.

·  Small-scale risk averse behavior is consistent with loss aversion, where the status quo is the reference point, and with mental accounting (narrow bracketing), a failure to look at the situation in the bigger picture.

·  Even the money pump argument offers more support for loss aversion and narrow bracketing than for expected utility maximization, as people are not reliably turned into money pumps. They are more likely to purchase those ill-advised warranties, for instance, when the warranties are tied to the purchase of the good itself, thereby promoting an isolated view of the transaction; for most decisions, consumers will not be so misled. An expected utility maximizer who bought such a warranty, however, would then necessarily agree to all sorts of ridiculous purchases.

·  The rate-of-return on stocks (as opposed to bonds, say) seems to be excessive, even though there should be some premium for holding stocks because stocks are riskier than bonds. This “equity premium puzzle” might be due to loss aversion and narrow bracketing. The day-to-day fluctuations in stock prices cause many short-term losses for shareholders. The equity premium comes from the fact that loss-averse investors require compensation to put up with all of the short term (mental accounting) losses.