Risk Aversion, Risk Seeking, and Loss Aversion

Risk aversion, risk seeking, and loss aversion are part of behavioral economics and all show how our behaviors can deviate from traditional economic theory. Keep in mind that the same behaviors do not always happen for a certain person, usually they vary based on the situation that a person faces.

Risk Aversion

Imagine you’re shooting baskets in the gym with one of your friends.

Here’s Choice 1:

Your friend tells you if you take the shot, you’re guaranteed to get $500.

Now here’s Choice 2:

Your friend tells you you’ll get $1000 if you make your next shot but none if you don’t make the shot.

Risk aversion would be if you choose Choice 1, where you are basically guaranteed to get $500 whether you make the shot or not. By taking the guaranteed half a million dollars, you are avoiding the risk of potentially getting no money even though there is a 50% chance that you could get $1000.

Risk seeking behavior

You’re in the same gym shooting baskets with your friend but you’re given two different choices to choose between.

Here’s Choice 3:

You either have to pay your friend $1000 whether you make your next shot or not.

Now here’s Choice 4:

You don’t have to pay anything if you make the next shot or you have to pay $2000 if you make the next shot.

You would be following risk seeking behavior if you chose Choice 4 since you are taking a risk where you have a 50% chance to not have to pay anything but also a 50% chance of having to pay $200.

Human Tendencies

Most people typically choose Choice 4 in this scenario and follow risk seeking behavior since in this scenario you are being faced with the possibility of losing money. Usually, people like to minimize the probability that they will lose money. So, by picking Choice 4, you have a 50% chance of not having not lost any money while you have a 100% chance of losing $1000 with Choice 3.

Now going back to the previous example, on the other hand, people usually choose Choice 1 and follow risk averse behavior since that scenario involves the possibility of gaining money. Typically, people like to maximize their chances of getting money. This is why they pick Choice 1 where they will definitely get $500 instead of Choice 2 where there is a 50% chance they get no additional money.

Risk Neutral

Being risk neutral is basically not being either risk averse or risk seeking. Risk neutral people would not really think about or consider risk when making a decision relating to losses or gains. In other words, risk neutral people will not always lean more towards a choice that has more or less losses or more or less gains either.

The graph above shows how utility varies based on amount of money for risk aversion, risk seeking, and risk neutral (if you are confused what utility means check out The Money of Utility article which should be the second-last article on the Blog page).

Loss Aversion

You do not have to shoot the basketball. But, if you do and you make it, you get $1000. However, if you miss, then you lose $500. Even though there’s a 50% chance you’ll gain more money than the other 50% chance that you’ll lose half the amount you could potentially gain, most people would choose not to play this game at all. This is the essence of the idea of loss aversion: we tend to respond much more cautiously and strongly to losses than gains, even if the number of gains are higher.

Disposition Effect

The Disposition Effect is essentially the idea that individuals exert risk aversion for gains but exert risk seeking for losses. This is a very big human tendency since people prefer the sure way to make money rather than a simply probable way and people tend to try to avoid losses at all costs. To apply this for a second to investing and markets, people typically like to sell gains made in the market but not sell losses made in the market. Behavioral economics says that we should do the opposite of the Disposition Effect to have a successful stock portfolio. Whether this is true or not we will be investigating and testing in a future article.

Images:

https://marketbusinessnews.com/wp-content/uploads/2017/03/Risk-Seeking-vs-adverse-and-neutral.jpg

Citations:

“Risk Averse: What It Means, Investment Choices and Strategies.” Investopedia, https://www.investopedia.com/terms/r/riskaverse.asp. Accessed 29 November 2023.

“What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation.” Wei Xiong Research Page, https://wxiong.mycpanel.princeton.edu/papers/disposition.pdf. Accessed 29 November 2023.