What is Loss Aversion?

What is Loss Aversion?

In most walks of life loss aversion refers to one’s desire to reduce uncertainties. Some people revel in chaos while most prefer to reduce worries and anxieties where they can. The concept is loved by psychologists, who term it the naive diversification heuristic.

Humans have a habit of spreading the load or hedging their bets. A good example is our behaviour at the food buffet – we tend to have a little of everything – just in case we miss out on a real gem! But in reality some 75% of what we choose isn’t exactly to our taste; whereas we really like the other 25%. The eat-as-much-as-you-like buffet drives our desire for diversity.

How might you react in the following scenario? You have to choose a favourite snack to have with your lunch but you must do so in advance. In the first scenario, you choose on Monday morning what you’re going to have that week. In the second scenario you choose what you’re going to have for the rest of the month. If you’re similar to the college students who were examined in a recent academic study you will diversify much, much more in the second scenario.

When we are presented with a breadth of decisions with multiple choices we tend to diversify more – in some cases it is a genuine fear of making the wrong choice but more often it is our natural response to loss aversion. We simply hate losing out.

There is forever a raucous debate around how consumers should allocate their investments. Diversification is espoused but it requires closer examination. It has been shown that when presented with a list of investment options, consumers will choose to diversify assets in direct proportion to the number of alternatives on the list. For example, if the investment proposal contains 100 choices; 50 of which are equities; 30 bonds and 20 commodities – consumers will adopt that ratio. If the food buffet experiment was tweaked consumers would surely follow the same line of reasoning.

Marketing material has not been slow to recognise these human traits and to present consumers with choices that aggravate this bias. The glossy presentations deliberately paint a rosy image of pro-rata diversification as a one-size-fits-all solution to loss aversion. This appeals to the masses but it may not be the best result for any one individual. So called “default strategies” may be the worst offenders. These are investment options that capitalise on the consumer’s fear of missing out – herding the throngs into corrals with irresistible names like “Doctors’ Retirement Fund” or “Teachers’ Default Plan.”

Armed with this knowledge, financial advisers play a hugely important role in trying to ensure that consumers invest in products that are suitable to them individually; and not necessarily to consumers in general. Broad-spectrum approaches are potentially dangerous. Diversification may be a natural defence mechanism for most humans but the naive diversification heuristic (or loss aversion) needs due attention. MMPI insists on personalised solutions; financial regulation demands it!