Risk Aversion

Andrew McAffe's Blog has his thoughts on how people value and avoid loss. His explanation was fascinating, and very insightful. He said that we need to stop thinking about consumers as highly rational evaluators of the old vs. the new products, lining up pros and cons of each in mental tables and then selecting the winner. Instead, we need to keep in mind three well-documented features of our cognitive 'equipment' for making evaluations.

• We make relative evaluations, not absolute ones. When I'm at a poker table deciding whether to call a bet, I don't think of what my total net worth will be if I win the hand vs. if I lose it. Instead, I think in relative terms -- whether I'll be 'up' or 'down.'

• Our reference point is the status quo. My poker table comparisons are made with respect to where I am at that point in time. "If I win this hand I'll be up $40; if I lose it I'll be down $10 compared to my current bankroll." It's only at the end of the night that my horizon broadens enough to see if I'm up or down for the whole game.

• We are loss averse. A $50 loss looms larger than a $50 gain. Loss aversion is virtually universal across people and contexts, and is not much affected by how much wealth one already has. Ample research has demonstrated that people find that a prospective loss of $x is about two to three times as painful as a prospective gain of $x is pleasurable.