The Power of "Loss Aversion"

 

What links these three puzzles? 

1. Professional golfers do significantly better when putting to save par than when putting to make birdie.

2. A lot of people have been interested in giving teachers an economic incentive to improve their students’ achievements. Unfortunately, many of these efforts just haven't worked. Is it possible to tweak them to make them more effective? In an ingenious study, teachers were given money in advance and told that if their students did not show real improvements, they would have to give it back. The result? A big improvement in teacher quality, as measured by a significant increase in students’ math scores.

3. The District of Columbia has tried to decrease people’s use of grocery bags. One approach was to offer a five-cent bonus to customers who brought reusable bags.That approach had essentially no effect. More recently the District tried another approach, which is to impose a five-cent tax on those who ask for a grocery bag. Five cents is not a lot of money, but many people do not want to pay it. The new approach has had a major effect in reducing use of grocery bags.

All of these findings reflect the power of “loss aversion,” which means that people dislike losses more than they like equivalent gains. Golfers really don’t want to lose a stroke to par. Teachers don’t want to lose money they now have. Even a small tax counts as a loss, and it affects people’s behavior.

Loss aversion helps to explain a lot of things, including investment behavior (the prospect of losses, even if unlikely, can discourage people from making pretty good investments), advertising, educational campaigns, and the power of default rules (if people are automatically enrolled in some plan, they might not opt out, partly because they don’t want to lose what they have).

Smart companies sometimes enlist loss aversion, whether or not they use the phrase. Public policy can be informed by loss aversion as well. The simple step of automatically enrolling employees in 401(k) plans has a big effect in boosting employee savings (very possibly bigger than significant, and complex, economic incentives). We are still in the early stages of understanding the power of loss aversion -- and its actual and potential uses by the private and public sectors.

Photo: James Hardy/Photo Alto/Getty Images

Posted by:Cass Sunstein