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Don't panic. Loss aversion does exist.

A recent paper by David Gal and Derek Rucker in the Journal of Consumer Psychology sets out a strong critique of loss aversion - one of the most 'successful' and basic ideas in behavioural economics. So, do we really need to ditch loss aversion? Well the first thing to point out is that the paper by Gal and Rucker is considerably milder than a blog-post on Scientific American, by David Gal, that has got a lot of publicity. Personally, I would agree with a lot written in the paper but disagree with just about everything in the blog-post.

So, what are the issues? Loss aversion says that losses loom larger than gains. In their paper, Gal and Rucker basically argue that losses do not always loom larger than gains. Fair enough. Indeed, this, of itself, is not particularly new. But, the 'standard' way of dealing with this 'problem' is to move around the reference point so that losses are no longer losses. For instance, Novemsky and Kahneman in a 2005 paper on 'The boundaries of loss aversion' highlighted contexts in which loss aversion may not kick in, and spending money on a planned purchase was one of those. Similarly, in looking at framing effects there is often considerably leeway to (re)define the reference point. This 'solution' of moving the reference point is not particularly convincing because it diminishes the predictive power of loss aversion and indeed could render it untestable. Gal and Rucker essentially argue we should do away with arbitrary movements in the reference point are recognize that losses are not always so bad.

That all seems relatively uncontroversial. Things become a bit more controversial when it is implied, particularly in the blog post, that loss aversion is rarely an important factor. It is true that behaviour which is often attributed to loss aversion, like the endowment effect, may be due to something else, such as status quo bias. But does loss aversion exist? The answer surely has to be yes? For instance, in the blog-post it is said that 'people do not report their favorite sports team losing a game will be more impactful that their favorite sports team winning a game'. Well some very nicely done recent research finds that football losses do indeed lead to an observable, deep and sustained drop in happiness! The evidence from the lab on $100 gain versus $100 loss is also pretty compelling. And in a way the paper does nothing to deny that. It just gives some examples where losses may not be considered worse than gains.  

To be useful, the concept of loss aversion (or prospect theory) does not rely on everyone being loss averse all of the time. It is enough that some people are predictably loss averse in certain contexts. And it is enough that the concept helps us predict and understand economic behaviour better than the alternative models. As a recent paper by Ted O'Donoghue and Jason Somerville point out loss aversion is probably the main reason we observe risk aversion (not diminishing marginal utility). This is a big shift in how we think about a core idea in economics. So, to find instances where loss aversion is not a factor is not to do away with all the instances where abundant evidence has shown loss aversion is a factor. This view would seem consistent with the basic theme in the paper of Gal and Rucker, but is hardly a novel one.

Consider, for instance, the paper by Harrison and Rustrom, published in Experimental Economics, with the colourful title 'Expected utility theory and prospect theory: One wedding and a decent funeral'. Basically, they say that some people might be expected utility maximizers - who are not loss averse - and some people might be prospect theorists - who are loss averse. They find that plenty of people are best described by prospect theory - more likely to be women, black or hispanic, and older students. Moreover, those that are best described by prospect theory have, on average, a huge loss aversion of factor 5. Yes, losses count 5 times as much as gains.

Related results were obtained in a 2012 study by Glockner and Pachur. They found that prospect theory fits better if we take account of individual heterogeneity. And once we take account of that heterogeneity we see that there is big variation in loss aversion. Some people appear to be strongly averse to losses and others not loss averse at all. This all seems consistent with the idea that loss aversion is useful without being some universal effect that always has the effect of doubling losses. (I'm essentially saying that Gal and Rucker, in claiming loss aversion is seen as universal, are setting up a straw man to make their point.)

So, should we ditch loss aversion? Of course not. A lot of people seem loss averse a lot of the time. Taking this into account improves the predictive power of economic models. Yes, we should be carefully to not overplay the importance of loss aversion, but I personally don't think we were doing that anyway. And lets face it, for an idea to survive the barrage of criticism hurled at behavioural economics over the last 30 plus years, it must have a grain of truth in it.

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