Where Does Loss Aversion Come From?
Reflections from reading Thinking Fast and Slow by Daniel Kahneman
In a video from the Veritasium Youtube Channel video, Derek Muller (the host) asks people in the street the roughly the following: “Here’s $10, and here’s a coin. I’ll toss it up in the air, and you call it. If you’re right, you get this $10, but if you’re wrong, you give me $10.” Ensuing that proposition, you hear an awkward laugh from practically every single one of the participants in that experiment that he was trying to set up.
If you’re human, you understand why. People hate losing a lot more than they hate winning. The prospect of winning $10 and enjoying free money just doesn’t match the fear of losing the same amount—$10. Derek goes even further and proposes the participants that he will give them $20 if they are right while they only have to give him $10, and most participants still do not want to take the bet!
This concept is called loss aversion, and it’s really perplexing because from a purely statistical point of view, with a 50/50 bet where you can win $20 vs. lose $10, you are better off taking the bet.
The Origins of Loss Aversion
To me, loss aversion aversion has always been just a fact of life. I’ve known it in myself and in other people, and it’s practically been intuitive. Recently, however, I think I’ve understood exactly where it comes from, and I thought to share because it’s fascinating.
I’ve just finished reading Thinking Fast & Slow by Daniel Kahneman, and very early on on Chapter 28 titled “Bad Events”, it reads the following:
The brains of humans and other animals contain a mechanism that is designed to give priority to bad news. By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal’s odd of living long enough to reproduce.
This made me realize why we have loss aversion, and it’s basically because of evolution. Here’s how the logic makes sense.
Evolution: The Survival Game Through Natural Selection
Let’s first focus on “bad events”, which I’ll consider to be any event that can have a negative impact on the livelihood of someone.
Now think about the raw and savage animal worlds, and think back to when humans were just as unsafe as other animals. Imagine that that is the beginning of humans, and different types of humans are scattered throughout the world at random. Obviously there are many variables, but one of them is how much these humans are sensitive to “bad events”. Some humans are not sensitive at all, some are a little, and some are very sensitive to bad events.
In this set up, you realize very quickly that those humans who are sensitive to bad events are much more likely to survive. For instance, if a lion is approaching, that can be considered a bad event. Other examples:
- Seeing traces of blood nearby from a hunted prey
- Seeing that the clouds are darkening due to an upcoming rain
Humans that are sensitive to those bad events will quickly think about ways to protect themselves while those who aren’t will not protect themselves, and as a result of that, the humans that are sensitive to bad events will survive and reproduce.
It’s like, no matter what setup you choose (say 90% not sensitive and 10% sensitive), there is a clear reason why the humans that are sensitive to bad events will end up being the ones that will reproduce and survive.
Where Loss Aversion Play Comes In
The next page of the book Thinking Fast and Slow has the following statement:
As [the psychologist Paul Rozin] points out, the negative trumps the positive in many ways, and loss aversion is one of the many manifestations of a broad negativity dominance.
While this doesn’t explain how loss aversion comes to be, it hints at the fact that loss aversion comes from this idea that humans will be particularly sensitive to bad events—i.e., “the negative”. Here’s how I processed it:
Imagine, again, we’re now in a stage where all the humans have some significant level of sensitivity to bad events and others don’t. The next level to a bad event is when a human loses something. To have a clear distinction between “losing” and other types of bad events, think about the above examples that I listed. They don’t really involve losses—rain might just lead to a flood which you may die from, but outside of loss of life it’s not really a loss. However, losing something is still a very bad event.
If, for instance, a human lost the shelter in which they lived in, they will be much less likely to reproduce and survive because they are in less of a capacity to do so when they’ve lost all their resources. Also, there are many ways to lose, and I speculate that it got to a point where the humans that were hyper-sensitive to losses were also more likely to survive and reproduce. That eventually resulted in loss aversion, which is generally accepted to be a feature of every human being today.
So, this shows how loss aversion is a manifestation of this sensitivity to bad events!
The reason I find this fascinating is because the reason we’re loss averse is not because of some crazy logical reason. It’s simply happened by chance. The animal world is a dangerous place, and in order to survive, you have to be hyper-sensitive to bad events otherwise you won’t be able to survive and reproduce. It’s like, this all happened because of the process of natural selection. Then, in today’s world, it has led to the birth of so many industries.
Here’s the next idea that comes from the book.
The Fourfold Pattern
The pattern looks like the following:
Here’s how the book explains it. For each quadrant:
- The first line indicate “an illustrative prospect”
- “The second row characterizes the focal emotion that the prospect evokes”
- “The third row indicate how most people behave when offered a choice between a gamble and a sure gain (or loss) that correspond to its expected value”. For instance, in the top left, it’d be either take a bet where you have a 95% chance to win $10K, OR settle for $9.5K for sure—missing out on possibly $500.
- “The fourth row describes the expected attitudes of a defendant and a plaintiff as they discuss a settlement of a civil suit.”
The Industries and Behaviors Revealed from the Fourfold Pattern
This pattern is already super cool on its own, but what I realized as soon I saw it was how which industries or human behaviors essentially exist solely because this pattern is true.
- TOP LEFT: Basically anytime there is a court settlement where things are favorable, that happens because of this. Plea bargains also happen because of this.
- BOTTOM LEFT: Lottery and people letting themselves be taken advantage of (e.g., simping).
- TOP RIGHT: Wars, gambler’s fallacy which fuels casinos, risky business choices, proposing a court settlement.
- BOTTOM RIGHT: Suing large companies, insurance, futures contract, etc.
Then, it’s also crazy that this pattern emerged from super simple natural selection rules. I’m sure there are many behaviors here as these are just the ones I spend a little bit of time thinking of.
It’s like, remove loss aversion from humans and we may not have lotteries anymore. Remove loss aversion from humans and we may not have futures contract anymore. Remove loss aversion from humans and we may not have as many wars as we have had anymore. That to me sounds insane because this comes simply from natural selection.