Loss Aversion in the Consumer Mind

Avoiding sunk costs is considered a rational decision, isn't it? Despite being a well-known concept in behavioral economics and psychology, why do humans struggle to accept it? When was the last time you walked into a terrible movie, realizing you misjudged it? Did you leave as soon as you started hating it? Most likely, you didn't. I imagine that many of us endure through such movies, feeling frustrated at misleading ratings and our own questionable judgment. This endurance stems from the heavy weight of loss on the human psyche. In our mixed economy, normative economics dictates that every decision we make carries economic weight, either costing us money directly or consuming our valuable time. This economic balancing act often leads humans to prioritize avoiding losses over pursuing gains (Kahneman & Tversky, 1979).

Kahneman & Tversky's famous thought experiment illustrates this phenomenon. People are presented with a choice between two concurrent options:

Option A: A guaranteed gain of $24,000.?

Option B: A 25% chance to gain $100,000 and a 75% chance to gain nothing.?

Option C: A guaranteed loss of $75,000.?

Option D: A 75% chance to lose $100,000 and a 25% chance to lose nothing.

Kahneman & Tversky found that most people chose Option A over Option B and Option D over Option C. This indicates that humans are more willing to take risks involving uncertainty when facing losses than when seeking gains, leading to the phenomenon of loss aversion. Loss aversion is not just a theoretical idea; it is an empirical aspect of human behavior.

Mathematical models can provide insights into human behavior, but they are not flawless. Rather than replicating life exactly as it unfolds, mathematicians aim to simplify phenomena into straightforward narratives. This simplification focuses on the most relevant aspects, rather than trying to encompass all elements of a phenomenon..

In the modern era, we have mathematical tools that allow us to incorporate more complexity from real life without sacrificing simplicity. In investment thinking this could be as simple as considering something else other than the conventional accepted mean-variance framework for optimizing portfolios. For example, De Lopez Parado devised the probabilistic Sharpe ratio, which enhances the conventional sharp ratio by considering skewness and kurtosis (asymmetry). Another ancillary approach to MPT is? the Sortino ratio, which emphasizes downside risk over upside risk. Despite technological advancements, our mathematical understanding of human behavior may not have kept pace. Conventional wisdom must shift from oversimplifying human preferences. Push the envelope. Question conventional wisdom & doubt dogma. It is no longer adequate to dismiss what we do not comprehend, especially when we have the tools to comprehend our reality; I hate the fact that I was taught that all consumers were perfectly rational decision makers in my economics class when we've known its been false for over forty years.