(credit: Jim Culp)

When loss aversion is your loss

What are we really giving up when we are being led by extreme loss aversion?

An old friend of mine took up an unusual hobby at a relatively advanced age (well he was younger then than I am now, so maybe I will need to rephrase that). About ten years ago, he bought an old Formula Ford car and started participating in the Historic Formula Ford Car championship.

In his Christmas card (traditionally among the first we receive), he mentioned he had been doing quite well (“for his age”, he always adds) in the races he took part in this season. I had to explain to my wife what Formula Ford racing was: driving around at speeds of up to 130mph in an open top, single seater, open wheel car looking somewhat like cross between a go-cart and a Formula-1 car.

There must be something wrong with his adrenaline, my wife said. Why on earth would a sensible person get into such a flimsy vehicle, to drive it around at breakneck speeds, risking life and limb?

I am not sure what it would mean in practice to ‘have something wrong with one’s adrenaline’. But if my friend has a preference for an adrenaline fix that can be fulfilled by driving an old car round a track, trying to overtake without being overtaken, then that might actually be a pretty rational thing to do. And maybe my better half’s conclusion that it would not be for her could be equally rational. The cost represented by the risk of an accident with dire consequences would not be outweighed by any identifiable benefit to her.

The biggest problem is the extension lead (image: theredrocket)

But when we think of such pastimes, or of even more risky activities like BASE jumping, highlining or (the slightly frivolous) extreme ironing, do we actually make a conscious trade-off when we decide it’s not our bag? Perhaps not. What we do instead is zoom in on the risk, or more precisely on the potential loss (because we don’t even look at the probabilities). We visualize the terrible consequences of a mishap, and we conclude we want to avoid this — effectively at any price. We do not consider the possible upside.

That is, in a way, an extreme version of loss aversion. Typically this refers to our tendency to prefer avoiding a loss over acquiring an equivalent gain — i.e. we think it is worse to lose £5 than to miss the chance of gaining £5. But in this case we make no comparison: we simply choose to avoid the loss, full stop.

Businesses too display extreme loss aversion. Earlier this week, economist and expert on global inequality Branko Milanovic tweeted his dismay with being unable to open his hotel window in Mexico to enjoy the mild temperatures outside. It did not open ‘for security reasons’. Presumably the hotel wanted to avoid guests staying with them only to then promptly commit suicide by jumping out of the window.

Self-defenestration is an uncommon way to commit suicide in most countries. But it is the salience of events like this that might be behind such windows-firmly-shut policies. Here too, the thought of a really bad outcome, irrespective of the probability, inspires decision making.

It is not true that there is no loss, though. It is guests like Branko who pay the price, in inconvenience and frustration. (He was cold because of the permanently on aircon fixed to 18 degrees C, and so he had no choice but to switch on the space heater.)

Let’s not take any risks here. (image: PIRO4D)

It is easy to see (or think we see) irrationality in other people’s actions and decisions. But chances are we, too, are making choices based on fear of a certain outcome rather on a cool evaluation of costs, benefits and actual risk.

When news reports of assaults and muggings on the streets in the evening make us decide not to go out, it is true that we will avoid with certainty being assaulted and mugged out on the street. But the reports don’t give us an accurate view of how likely that is. And by staying in, we lose out on the chance of meeting up with friends, going to the cinema or the theatre. Is that a good trade-off?

When we have an invitation to a function with lots of interesting people, but we are afraid that nobody will pay attention to us and we’ll be a wallflower all evening, not going means we will be spared that deeply awkward experience. But no matter how vividly we can imagine standing on our own in a corner all the time, how likely is this really, and what delightful encounters might we miss?

When look at our savings and we anxiously want to avoid any kind of investment in which we might lose some of our capital, leaving all the money in a savings account with a pitiful interest rate, we definitely avoid losing our capital. But are we, by rejecting any prospect of loss, however improbable, really acting in our interest?

The simplicity of being led by the horror of the worst possible outcome is tempting. But if we really want to do what is best for us, we should try to resist it, and reason in a nuanced way. Only if we consider what we really give up by giving in to extreme loss aversion can we come to the right conclusion.

And who knows, maybe soon you too will be enjoying the thrills of extreme ironing.

Originally published at koenfucius.wordpress.com on December 8, 2017.

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Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius

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