David Myers

When Excessive Fear of Losing Steals Our Chances to Win: Irrational Loss Aversion in Business, Sports, and Everyday Life

Blog Post created by David Myers Expert on Aug 30, 2018

Imagine that you’re about to buy a $5000 used car. To pay for it, you’ll need to sell some of your stocks. Which of the following would you rather sell?

  • $5000 of Stock X shares, which you originally purchased for $2500.
  • $5000 of Stock Y shares, which you originally purchased for $10,000.

 

If you’d rather sell Stock X and reap your $2500 profit now, you’re not alone. One analysis of 10,000 investor accounts revealed that most people strongly prefer to lock in a profit rather than absorb a loss. Investors’ loss aversion is curious: What matters is each stock’s future value, not whether it has made or lost money in the past. (If anything, tax considerations favor selling the loser for a tax loss and avoiding the capital gains tax on the winner.)

 

Loss aversion is ubiquitous, and not just in big financial decisions. Participants in experiments, where rewards are small, will choose a sure gain over flipping a coin for double or nothing—but they will readily flip a coin on a double-or-nothing chance to avert a loss. As Daniel Kahneman and Amos Tversky reported, we feel the pain from a loss twice as keenly as we feel the pleasure from a similar-sized gain. Losing $20 feels worse than finding $20 feels good. No surprise, then, that we so vigorously avoid losing in so many situations.

 

The phenomenon extends to the endowment effect—our attachment to what we own and our aversion to losing it, as when those given a coffee mug demand more money to sell it than those not given the mug are willing to pay for it. Small wonder our homes are cluttered with things we wouldn’t today buy, yet won’t part with.

 

Loss aversion is but one example of a larger bad-is-stronger-than-good phenomenon, note Roy Baumeister and his colleagues. Bad events evoke more misery than good events evoke joy. Cruel words hurt us more than compliments please us. A bad reputation is easier to acquire—with a single lie or heartless act—than is a good reputation. “In everyday life, bad events have stronger and more lasting consequences than comparable good events.” Psychologically, loss is larger than gain. Emotionally, bad is stronger than good.  

           

Coaches and players are aware of the pain of losses, so it’s no surprise that loss aversion plays out in sports. Consider this example from basketball: Say your team is behind by 2 points, with time only for one last shot. Would you prefer a 2-point or a 3-point attempt?

 

Most coaches, wanting to avoid a loss, will seek to put the game into overtime with a 2-point shot. After all, an average 3-point shot will produce a win only one-third of the time. But if the team averages 50 percent of its 2-point attempts, and has about a 50 percent chance of overtime in this toss-up game, the loss-aversion strategy will yield but a 25 percent chance of both (a) sending the game to overtime, followed by (b) an overtime victory. Thus, by averting an immediate loss, these coaches reduce the chance of an ultimate win—rather like investors who place their money in loss-avoiding bonds and thus forego the likelihood, over extended time, of a much greater stock index win.

 

And now comes news (kindly shared by a mathematician friend) of loss aversion in baseball and softball base-running. Statistician Peter MacDonald, mathematician Dan McQuillan, and computer scientist Ian McQuillan invite us to imagine “a tie game in the bottom of the ninth inning, and there is one out—a single run will win the game. You are on first base, hoping the next batter gets a hit.”

 

As the batter hits a fly to shallow right, you hesitate between first and second to see if the sprinting outfielder will make the catch. When the outfielder traps rather than catches the ball, you zoom to second. The next batter hits a fly to center field and, alas, the last batter strikes out.

 

You probably didn’t question this cautious base-running scenario, because it’s what players do and what coaches commend. But consider an alternative strategy, say MacDonald and his colleagues. If you had risked running to third on that first fly ball, you would have scored the winning run on the ensuing fly ball. Using data from 32 years of Major League Baseball, the researchers calculate that any time the fly ball is at least 38 percent likely to fall for a hit, the runner should abandon caution and streak for third. Yet, when in doubt, that rational aggressive running strategy “is never attempted.”

 

You may object that players cannot compute probabilities. But, says the MacDonald team, “players and their third-base coaches make these sorts of calculations all the time. They gamble on sacrifice flies and stolen base attempts using probabilities of success.” Nevertheless, when it comes to running from first, their first goal is to avert loss—and to avoid, even at the cost of a possible run, the risk of looking like a fool. We implicitly think “What if I fail?” before “How can I succeed?”

 

Often in life, it seems, our excessive fear of losing subverts our opportunities to win. Caution thwarts triumph. Little ventured, little gained.

 

My late friend Gerry Haworth understood the risk-reward relationship. A shop teacher at our local high school, he began making wood products in his garage shop. Then, in 1948, he ventured the business equivalent of running to third base—quitting his job and launching a business, supported by his dad’s life savings. Today, family-owned Haworth Inc., America’s third-largest furniture manufacturer, has more than 6000 employees and nearly $2 billion in annual sales. Something ventured, something gained.

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