Academics dispute challenge to loss-aversion theory

Tahn Sharpe

By

February 6, 2018

Academics have welcomed a paper challenging the accuracy of loss-aversion theory, despite being broadly sceptical of its conclusions.

In discussing the new work’s challenge to the long-held theory about risk aversion, financial planning experts noted that advisers should watch clients closely to understand their real risk tolerance. As one prominent economics professor explains, knowing your client and what’s important to them should override any academic hypothesis, regardless of how accepted or revered it is.

Loss (or risk) aversion theory is a widely taught tenet of behavioural economics, centring on the notion that people are more biased towards avoiding losses than making gains. The theory is based on the findings of Daniel Kahneman and Amos Tversky in the late 1970s. It has historically been cited to validate investment allocation that prioritises loss mitigation.

The theory was challenged, however, in late 2017, in a pre-publication paper by David Gal and Derek D. Rucker on the Social Science Research Network. The two assert that “current evidence does not support that losses, on balance, tend to be more impactful than gains”, and cite a lack of context as undermining the original research.

As Dr Tracey West, economics lecturer at Griffith University, explains, Gal and Rucker “use their own experiments and previous research to argue that people may not always want to avoid the pain of a loss. Sometimes, in fact, the potential joy of a gain may outweigh the pain of a loss.”

Critics are doubtful. One prominent academic, who did not wish to be named, says the new report “…reflects little knowledge of recent developments in the economics of uncertainty”.

“This isn’t just about Kahneman and Tversky’s work,” the academic continues. “There is a huge amount of literature supporting risk-aversion theory and its applications.”

Economics professor Jeffrey Bennett, of the Australian National University, is similarly inclined to defend the long-held theory.

“For many years, I’ve been engaged in surveying members of the public regarding their willingness to pay for investments in assets,” he says. “This work has consistently demonstrated that people’s willingness to pay to avoid a reduction in their asset holdings (a ‘loss’) is greater than their willingness to pay to achieve an improvement of the same absolute magnitude in their asset holding (a ‘gain’).”

Whether the review is accurate or not, most academics have welcomed Gal and Rucker’s paper in the spirit of ongoing academic rigour, and encourage further review.

As West says, “Theories are and should be subject to scrutiny.”

“These criticisms are valid and important contributions to the field and development of behavioural finance,” she says. “I’m sure Kahneman, Tversky and other well-known behaviourists welcome the additional lines of questioning and thought regarding people’s behaviour in financial spheres.”

Bennett also recognises “the importance of challenging conventional wisdom”.

“Questioning orthodoxy is vital,” he says. “Always looking for evidence that can falsify the hypothesis is a crucial part of the evolutionary process of knowledge.”

West says the lesson for advisers is that clients may readily change attitudes to investing, depending on the context. That is, the ongoing experiences of clients and what the people around them are saying can change the frame of reference for their beliefs.

“In addition, attitudes and willingness to engage may change over time,” she says. “Advisers need to continue to ask diagnostic questions, understand non-verbal cues and err on the safe side; most people will likely, but not always, prefer to avoid or minimise losses. Knowing your client and investing as they expect is still key to good adviser-client relationships.”


TOPICS:   Loss aversion theory

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