What's loss aversion? How does it affect my decision-making?

You've always used the $30 movie subscription service that included zero ads, unlimited movie streaming, and being able to share the account on four devices. Nowadays, however, you don't really watch movies, and you're the only one to use this service.

There's an offer for a $10 movie subscription that includes zero ads, seven movies a week, and only one account can use it. Do you take it?

You've stuck to this $30 plan for a long time, and now you're hesitant to switch to a plan that fits you better. Why?

This difference can be explained using loss aversion (aka prospect theory). What is it? How can it affect your decisions, and how can you avoid this trap?

Loss aversion means people see situations as worse when they’re described as a loss instead of a gain.

This theory suggests that people experience loss much more intensely than the pleasure of the same amount. This influences people to make decisions that would avoid losses, such as clinging to what they have rather than trying new things.

Example

You dislike your job and would consider changing careers, but you believe the loss of income and security outweighs the benefits of finding a better opportunity. That's loss aversion: the potential loss seems much more impactful — you're tempted to stick with your job. You deny yourself the opportunity to try new things since you can't be sure your sacrifice is worth the gain.

Loss aversion can affect your decision-making by making you:

• Avoid taking risks (to guarantee gains). You may choose a small gain over a riskier, larger gain, even if the risky option has a better value (ex. choosing the guaranteed $10 over the 50-50 chance of getting $20).

• Start taking risks (to potentially avoid a loss). You may choose to hold on to what you have instead of cutting it off, thinking you will get a huge gain later (ex. continuing to gamble, thinking you'll hit big and make your money back).

• Maintain the status quo. You may settle with what you have because you're used to it and don't want to "miss out" on potential gains (ex. staying in an unhappy relationship to avoid loneliness).

How can you make smarter choices without letting loss aversion influence you?

• Look at the big picture. Look at the whole situation and not just the choices. According to Psychology Today, this will help you better understand the impact of your decision.

• Consider long-term consequences. Decide how the loss/gain will affect you in the long run. A small, temporary loss may not be so bad if it is insignificant later.

• Prioritize what's important. Know what you want and need. It will help you decide what risks you may or may not need to take.

• Accept losses. Life includes ups and downs, so don't feel defeated if things don't go your way. Learn from the experience and move forward!

Maisy is looking through insurance plans for her new house:

• Plan 1 covers all of the basics, such as fire and flood protection.

• Plan 2 is more expensive but covers the basics and more, such as tornado and snow damage protection.

Despite living in an area where tornadoes and snow are nonexistent, Maisy wants to go for Plan 2.

What are some signs of loss aversion happening here?

A. Maisy fears that if she doesn't take Plan 2 now, she'll lose the opportunity to upgrade her plan in the future.

B. The second plan covers more, which convinces Maisy that it is the "better" option for the price.

C. Maisy sees the potential losses as huge and wants to avoid them by taking the plan that covers the most.

D. The stress of experiencing a large loss convinces Maisy that it outweighs the potential of saving money with a cheaper insurance plan.

You realize that the familiarity of having the $30 plan and the "loss" of losing unlimited access is what's stopping you from switching to the $10 plan. Knowing how loss aversion affects you now, you're better prepared to make the choice that's best for you by weighing the gains and losses equally and looking at the big picture.

Loss aversion is powerful, but understanding that life is a mix of both gains and losses can reduce the stress of making decisions. Make the choice that's best for you, and don't worry; more opportunities lie ahead! Make smart choices by understanding how loss aversion affects you: