Risk aversion and loss aversion are two somewhat related concepts that have a powerful effect on how people’s decision making, both rationally and irrationally.
Loss aversion is the simpler of the two: it is when someone weighs losses more heavily than they weigh gains. Weighing losses more heavily than gains, means that the person losing a given amount would hurt them more than them gaining that same amount would help them. If that still feels too abstract, here’s a more precise definition: suppose someone is offered a bet on a flip of a coin, where with half chance they lose $1 and with half chance they gain $X. The smallest value of X that they are willing to accept this bet, is how much more they weigh losses over gains. For example, if they will only take the bet if X is at least 2, it’s because they weigh losses twice as heavily as gains.
Loss aversion is a common cognitive bias, because (usually) it is not rational for people to be weighing losses significantly more heavily than gains (at least when the size of the losses or gains is relatively small). As with other cognitive biases it can affect the way that people make decisions in games, and so needs to be taken into account for practical mechanism design, as I talk about in my cognitive bias article. But more specifically, it often causes a knee-jerk resistance to change in general, which is called change aversion. When a government or other institution makes a change in policy, or something else in the world happens to change, this usually causes some positive changes and some negative. But if people are weighing the negative changes more heavily, then they can perceive the change as having a net negative effect when really it had a net positive effect. Change aversion can be a powerful friction slowing down the adoption of positive changes, but keep in mind that not all opposition to a change is irrational. Obviously many changes are a bad idea. But most people have a systematic bias towards negatively perceiving changes.
Now if you’ll allow me to go into more speculative territory for a moment, I believe that loss/change aversion can be a particularly insidious cognitive bias, leading to people having a general feeling that their situation and the world at large is usually getting worse. This is because in the natural course of life, there is a constant stream of random ‘shocks’ that make a person’s future look more or less positive. Maybe you get an unexpected raise, and so your future looks richer. That’s a positive shock. Maybe you accidentally broke your phone, and so your future looks a bit poorer. That’s a negative shock. Now suppose you made a graph with time on the x-axis and on the y-axes something like how ‘good’ the future looks for you, or the amount of money you expect to make of your lifetime. This graph will probably have a very random and jagged pattern, like the picture below:
(This kind of extreme random motion is called Brownian motion, and is commonly studied in physics and finance.)
See that in the above picture, even though the curve constantly changes between going up and going down, it ends up a bit higher than it started. That means that on average, it’s going up. But what happens if you add a healthy dose of loss aversion to the mix? Then each time the curve goes down those parts are weighed more heavily, and so are stretched further down. And so even though the curve would normally be on average staying flat or increasing, the loss aversion could cause it to be decreasing on average.
If we could all be a bit more mindful of our tendency to over focus on losses and reflexively dislike change, maybe we’d could be a bit more positive and make smarter decisions!
Risk is a commonly used term, but what precisely does it mean in this context? Suppose I offered you an opportunity to bet all of your savings on a coin toss: on heads you double your money, on tails you lose it all. Would you take it? Probably not, because you instantly had the feeling that this bet was too risky. Even if I offered you a free dollar for taking the bet, you probably wouldn’t take it despite the bet earning you on average a positive amount of money (one dollar).
For most people, not taking the bet is the rational decision. The explanation for how some risk aversion is rational, is that the utility (value) to you of money decreases with the amount you have. If you are very poor, each dollar you have is very valuable because you need it to be buy essentials like food and basic shelter. But once these basic needs are met, each additional dollar will be spent on more and more frivolous things. A technical term for this kind of phenomenon is decreasing marginal returns: the return (benefit) you get for each marginal (additional) dollar is decreasing with how many dollars you have. Here’s an example of a utility curve that has this decreasing marginal returns shape: