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Tuesday 23 June 2009

Loss Aversion Affects Tiger Woods, Too

Behavioral Biases (3): Loss Aversion

Loss aversion, the tendency for people to be more risk adverse when protecting a gain than when chasing a loss, is a pervasive psychological bias. Indeed, it appears not even Tiger Woods is immune:
“Although the very best golfers are slightly less biased than their peers, even the best golfers—including Tiger Woods—exhibit loss aversion. This is a costly mistake. If any one of the top 20 golfers in 2008 was able to overcome this bias, his expected annual tournament earnings would have increased by $1.2 million dollars (a 22% increase).”
Put simply golfers play better when attempting to avoid dropping a shot than when trying to gain one, when they consistently leave their shots short. Yet this doesn’t make any sense – “bogey”/loss” and “birdie”/“gain” are purely relative concepts – all that should matter is the overall score or portfolio value.

Fantasy Investors and Phantom Profits

Rational economic theories predict that people will treat losses and gains identically but the actual research doesn’t bear this out, largely because rational man is a fantasy dreamed up by repressed economists who can’t get a date. The classic research on this by Tversky and Kahneman in 1979 showed that the reference point of purchase price significantly influences the way we act. In particular we value losses more than equivalent gains – a thousand dollar loss matters more than a thousand dollar gain.

In general we seek risk when it comes to reducing our losses and run from it when it comes to protecting our profits. Most investors run their losers and cut their winners, thus simultaneously ruining their returns and undermining thousands of economists’ careers. So at least some good comes out of it.

Persuasion Through Framing

Clever manipulators of people like politicians, realators and advertisers are adept at using loss aversion to get us to do their bidding. That's why we don't like any of them, but still they succeed - this is powerful stuff. By framing a situation in terms of a potential loss rather than a gain they significantly improve compliance. It’s a simple and effective trick used by people trying to sell us something, whether it be washing powder, real-estate or a political point of view.

Kahneman and Tversky (1981) give a series of examples of how framing can change results. If you were presented with the following choices what would you do?
A&D. 25% chance to win $240, and 75% chance to lose $760
B&C. 25% chance to win $250, and 75% chance to lose $750
Obvious, eh? You'd be right, too, because 100% of people presented with these choices chose B&C. Yet simply by framing the question differently in terms of potential losses and gains to trigger loss aversion effects Kahneman and Tversky were able to reduce the number of people selecting B&C to 3%.

Does Expert Knowledge Mitigate Loss Aversion?

These results on loss aversion are sound across lots of different domains and the evidence for alternative explanations has gradually been eroded as researchers have expanded their range of experiments. Yet while loss aversion is a real problem for investors there’s evidence that its effects can be mitigated or even removed by expert knowledge. The idea is that although the experiments are showing something real about the way humans treat losses and gains and although these behaviours do genuinely impact investor returns it’s still possible, through gaining expertise, to mitigate the effects.

As we’ve seen before John List has carried out a series of real-world based trading experiments which appear to show exactly this effect – while loss aversion may make inexperienced investors unwilling to perform trades that are in their own interests the effect of experience is sufficient to overcome this bias. Such field experiments have the virtue of being far more like the real-world we actually live in and less like the laboratory. Laboratory experiments have a nasty tendency to cause people to start behaving in ways they might not in the nasty, brutish world outside the ivory towers.

Homo economicus Evolves

Indeed Levitt and List have made exactly this point recently in Homo economicus Evolves:
“Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. ... For example, the competitive nature of markets encourages individualistic behavior and selects for participants with those tendencies. Compared to lab behavior, therefore, the combination of market forces and experience might lessen the importance of these qualities in everyday markets.”
This, of course, opens up a vista of hope for experienced stockmarket investors who can hope to overcome the undermining effects of loss aversion. The idea is based on adaptive markets theories - that the long-term survivors are those who are best adapted to deal with behavioral biases. However, do simplified field experiments suggesting that experience can help overcome loss aversion really apply in genuine real-life situations?

Yet The Experts Fail Too

Pope and Schweitzer’s golf study suggests not. The idea behind the study is ingenious – given enough processing power they can compare the results of professional golfers' attempts to knock the ball in the hole in differing situations reflecting classic loss aversion scenarios. (For the non-golfers out there each hole has a “par” score which is the number of strokes you’re expected to take to stick the ball in the hole. If you take an extra shot that’s called a “bogie” and if you take one less that’s called a “birdie”. Think of “bogie” as “loss” and “birdie” as “gain” and “par” as buying price and you’ve got the idea).

Making a par or not at a single hole is pretty irrelevant, because it’s the overall score over the whole course that really counts. Rationally every golfer should try their hardest to get every shot in the hole. However, what the study shows is that this isn’t the case. When a golfer is trying to make a birdie they succeed less often from the same position than when they’re trying to avoid a bogey. This is classic loss aversion – dropping a shot means more than gaining one. However, this is profoundly irrational – either way they should try their hardest to get every shot in the hole.

Loss Aversion Is Real

It’s a clever study because there are no artificial laboratory or experimental concepts getting in the way and none of the golfers is likely to modify their behaviour in the slightest because of the presence of the experimenters. Yet the existence of loss aversion in the hugely competitive world of professional golf throws significant doubt on whether pure expertise is enough to overcome these effects in complex real-world situations. It may be that because everyone suffers from these biases that there's no adaptive pressure for anyone to overcome them.

No doubt there’ll be another study along in a while to dispute this, but in the meantime all investors need to start thinking about making every investment putt count, and not worrying about the artificial anchoring point of a par buying price. At any moment in time a stock is either good value or poor and if you can’t tell the difference then index trackers will guarantee you an above average return compared to the average active fund anyway – so why bother fighting your inner demons and wasting your time to boot?

Previous Article: Behavioural Biases (2): Hindsight Bias

Next Article: Behavioural Biases (4): Regret


  1. You find it irrational that a pro golfer chasing the lead would take the risky shot direct at the flagstick (lined up with hazards), but the one with a lead would play the safe layup shot or to the center of the green. That is just basic course management, not irrational. At the end of the game, the scores are wiped clean and everyone starts all over next week, so it doesnt matter as much if your big risk ended in disaster. I wish it was the same with money, but if you take a disasterous risk there, it sticks with you for a long time. Besides I dont care if I'm #1 on the wealth leaderboard, as long as I have a comfortable number, so why take extra risk.

    'Ingenious' naturalistic study, and love the golf aspect, but wrong conclusion and irrelevant.

  2. I don't find such behaviour irrational and a secondary part of the study confirms your suggestion.

    The point is, of course, leadership only really matters on the final day. For most of the tournement, while everyone's jockeying for position, the standard loss aversion against par applies. However, as the endgame unfolds the effect changes so the behaviour is no longer relative to par, but is relative to the leader's score.

    It's definitely ingenious, its conclusion is interesting and it can't be dismissed on these grounds as irrelevant. It's a well constructed paper as well, worth reading the introduction and conclusion.

  3. Different anonymous here. It's still not clear to me that the effect anonymous mentions reverses earlier on. It seems to me that it would just diminish.