Most of us are gonna have to make a myriad of financial decisions in our life times. We often presume that people are rational, and that people would make choices using their rationality. But, there seem to be some patterns in our behavior that are quite far from rational. A very interesting theory looks at how we perceive losses and gains, this is called the prospect theory.
We often take risks when deciding to spend or to not. We can choose to get a loan, buy a lottery ticket, or buy a very expensive TV (instead of paying our monthly bills). But, all in all, people seem to be loss averse. This means we will try anything to avoid losing money. Though, losses hurt us more than gains bring us joy. So losing 100 euros is more painful than getting 100 euros were to make us happy. This finding is part of the prospect theory that was formulated by Kahneman and Tversky (Barberis, 2012).
The part were it gets especially interesting is when we start framing different scenarios. Framing is a psychological effect, people will make a decisions based on how a certain message is presented. This is an example from Kahneman and Tversky’s (2000) book:
- Decision 1: Choose between
- A. sure gain of $240
- B. 25% chance to gain $1,000 and 75% chance to gain nothing
- Decision 2: Choose between
- C. sure loss of $750
- D. 75% chance to lose $1,000 and 25% chance to lose nothing
In the first decision scenario, the majority of people seem to choose option ‘A’. But in the second decision scenario, people are more likely to go for option ‘D’. In the second scenario, there is a chance to avoid a big loss, so people are willing to gamble to possibly lose nothing.
With the existence of the internet, it has become so much easier to buy and sell goods. Even for us, consumers, it’s possible to sell our own things, on websites like Ebay. Loss aversion has implications for buying and selling situations. Often when we try to sell stuff that we’ve owned, we demand a higher prices than buyers would be willing to pay. This is called the endowment effect. And loss aversion can explain why there is a gap between the price people are willing to pay for a product, and the price people are willing to accept for their product (Morewedge & Giblin, 2015).
People who are selling are at risk of losing something, and they might want to compensate for this. They are the ones that go from owning something to possible losing something. Whereas a buyer doesn’t lose anything.
In sum, according to the prospect theory, losing money or products hurts us. So think twice before betting / gambling your money away!
Barberis, N. C. (2012). Thirty years of prospect theory in economics: A review and assessment (No. w18621). National Bureau of Economic Research.
Kahneman, D., & Tversky, A. (2000). Choices, values, and frames. Cambridge University Press.
Morewedge, C. K., & Giblin, C. E. (2015). Explanations of the endowment effect: an integrative review. Trends in cognitive sciences, 19(6), 339-348.
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