Loss Aversion

Many of us tend to refuse opportunities for gain when significant risks are involved. Imagine being faced with a game where you can win $2000 or lose $1000 with a 50% probability for each outcome. Even if you don't have to invest any money, the idea of potential losses can generate anxiety and reluctance. Interestingly, the loss suffered is perceived as heavier than the happiness of a similar win. In fact, the possibility of losing $1000 seems to weigh more on our mood than the gain of $2000. This psychological inclination leads us to avoid it, not even wanting to face the risk of loss, even if the probabilities are balanced. The fear of loss, therefore, strongly influences our financial and gambling decisions.

Prospect theory teaches us that people tend to evaluate losses and gains differently. If we were given the opportunity to play a game estimated to generate an expected gain of $500, most of us would be willing to participate, especially knowing that it could be played many times. However, when the risk of an immediate loss of $1000 presents itself, the fear of losing outweighs the attractiveness of the possible gain. This behavior is represented in the prospect theory graph, where the loss curve is steeper than the gains curve. This implies that losses have a greater psychological impact than equivalent gains, underlining the importance of emotions in economic decisions. Our loss aversion pushes us towards cautious behaviors, even when the probabilities appear favorable.

In the context of economic and financial decisions, the utility curve plays a fundamental role in describing individuals' preferences. The difference in curvature and slope implies that the reaction to losses and gains is not symmetrical: a loss of $1000 has a greater negative impact than the benefit of a $2000 gain. This phenomenon is linked to our loss aversion, which leads us to feel more affected by losses than by equivalent gains. Moreover, the transition between risk aversion and risk-seeking represents a critical point on the curve, highlighting how choices can depend on the reference situation. In summary, emotions and perceptions deeply influence our economic behaviors, making decisions more complex than they may appear at first glance.

Risk aversion is a fundamental concept in economics, which describes the tendency of individuals to prefer certain outcomes over uncertain ones, even if the latter may be more favorable. In particular, prospect theory offers an interesting framework, highlighting how people evaluate gains and losses asymmetrically. While on the left side there is a typical risk aversion, on the right side, decisions are influenced by a certain predisposition to take risks when it comes to potential gains. This behavior is linked to the concept of a reference point, where choices are influenced by expectations and past experiences. Understanding these dynamics is crucial for analyzing the economic and financial decisions of individuals in contexts where risk is a determining factor.