Skip to main content
About HEC About HEC
Summer School Summer School
Faculty & Research Faculty & Research
Master’s programs Master’s programs
Bachelor Programs Bachelor Programs
MBA Programs MBA Programs
PhD Program PhD Program
Executive Education Executive Education
HEC Online HEC Online
About HEC
Overview Overview
Who
We Are
Who
We Are
Egalité des chances Egalité des chances
HEC Talents HEC Talents
International International
Campus
Life
Campus
Life
Sustainability Sustainability
Diversity
& Inclusion
Diversity
& Inclusion
Stories Stories
The HEC
Foundation
The HEC
Foundation
Summer School
Youth Programs Youth Programs
Summer programs Summer programs
Online Programs Online Programs
Faculty & Research
Overview Overview
Faculty Directory Faculty Directory
Departments Departments
Centers Centers
Chairs Chairs
Grants Grants
Knowledge@HEC Knowledge@HEC
Master’s programs
Master in
Management
Master in
Management
Master's
Programs
Master's
Programs
Double Degree
Programs
Double Degree
Programs
Bachelor
Programs
Bachelor
Programs
Summer
Programs
Summer
Programs
Exchange
students
Exchange
students
Student
Life
Student
Life
Our
Difference
Our
Difference
Bachelor Programs
Overview Overview
Course content Course content
Admissions Admissions
Fees and Financing Fees and Financing
MBA Programs
MBA MBA
Executive MBA Executive MBA
TRIUM EMBA TRIUM EMBA
PhD Program
Overview Overview
HEC Difference HEC Difference
Program details Program details
Research areas Research areas
HEC Community HEC Community
Placement Placement
Job Market Job Market
Admissions Admissions
Financing Financing
Executive Education
Home Home
About us About us
Management topics Management topics
Open Programs Open Programs
Custom Programs Custom Programs
Events/News Events/News
Contacts Contacts
HEC Online
Overview Overview
Degree Program Degree Program
Executive certificates Executive certificates
MOOCs MOOCs
Summer Programs Summer Programs
Youth programs Youth programs
Article

Loss Aversion and Decision-Making

Decision Sciences
Published on:

Can decision-making under risk be improved without taking into account the difference in people's sensitivity to gains and losses? Mohammed Abdellaoui does not believe this is possible, and proposes a model for measuring loss aversion under Prospect Theory.

Prospect Theory, a theory that describes decisions between alternatives that involve risk, was developed by Daniel Kahneman. He was awarded the 2002 Nobel Prize in Economics for his work in Prospect Theory, which revealed an important element of behaviour under risk: the phenomenon known as loss aversion. This refers to the tendency for people strongly to prefer avoiding losses than acquiring gains. Loss aversion explains many empirical observations, especially in the financial markets. Mohammed Abdellaoui is leading a research programme that aims, among other things, to measure this phenomenon, with the specific aim of improving decision-making.

Fundamental questions relating to decision under uncertainty

Mohammed Abdellaoui's work on decision under uncertainty focuses on three key questions: how can rational decisions be made under uncertainty (normative considerations)? How do individuals and organizations make choices in situations where they have to decide between alternatives with uncertain outcomes (descriptive considerations)? How can a decision-maker who has to choose between alternatives with uncertain outcomes be helped to make the right decision (prescriptive considerations)?

The recent appointment of a research team to study Behavioral Decision Making in the GREGHEC research laboratory aims to answer these questions through research conducted by HEC. The business school provides an ideal environment for this kind of research, which is why questions relating to the improvement of decision-making are given priority in the HEC team's research programmes. 

Measuring preferences: a prerequisite for improving decision-making

Decision Analysis, a discipline that uses a standard model of rational choices in risk situations to improve decision-making (2), was developed by Howard Raiffa in 1968. The main idea behind Decision Analysis is to reveal a decision maker's preferences when faced with simple choices, and use them as a basis for determining how they're likely to react in more complex situations. A decision maker's preferences are revealed through the subjective values they attribute to the consequences of their decisions (utility functions) and their beliefs about the likelihood of the uncertain events they're dealing with (subjective probabilities).

Several laboratory and field studies have shown, however, that it's impossible to ignore certain tendencies when measuring individual preferences (in simple risk situations). Prospect Theory allows us to measure preferences that take these tendencies into account. Moreover, the possibility of measuring loss aversion enables us to take into account decision makers' trade-offs between gains and losses more explicitly. 

Examples of phenomena explained by loss aversion

Loss aversion was first proposed as an explanation for the endowment effect (3)—the fact that when people buy and sell goods, they place a higher value on objects they own than objects that they do not. The general explanation for this is that when a person gains possession of an object, it's integrated into their assets and serves as a reference point. People are therefore more acutely aware of being deprived of an object (loss) than gaining possession of it (gain). Loss aversion has also been used to explain a phenomenon observed in the financial markets, known as the equity premium puzzle (4).

Equity premium refers to the difference between return on stock and government bonds. The equity premium is approximately an annualized average 8% (5). This value, based on expected utility hypothesis, means that individuals must have implausibly high risk aversion. The possibility of loss when holding shares is compensated by the requirement for compensation in terms of equity premium. Mohammed Abdellaoui addresses the need for a common definition of loss aversion that would make it possible to take into account—in a reliable and simple way—trade-offs between gains and losses to improve decision-making. 

 

Based on an interview with Mohammed Abdellaoui and his article “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”1 (Management Science, October 2007). 

Methodology

methodology
In Loss Aversion Under Prospect Theory: A Parameter-Free Measurement, Mohammed Abdellaoui, Han Bleichrodt, and Corina Paraschiv propose the first non parametric method for measuring loss aversion6. This method has enabled the authors to compare and study the feasibility of different definitions of loss aversion in the laboratory and also (recently) for the benefit of finance professionals in the United States. This research also opens up the possibility of establishing ‘risk profiles’ for decision makers, and especially for investors in financial markets. This will enable banks to produce precise risk profiles of investors—after conducting preliminary interviews with people wishing to make investments with some element of risk—and offer them products that are best suited to their preferences. The development of such techniques, which is being carried out at GREGHEC and in collaboration with other researchers in France and abroad, uses some of the methods outlined in the study above. 
1. Abdellaoui,M. ; Bleichrodt, H. ; Paraschiv C., “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”, Management Science , Vol. 53, n° 10, octobre 2007. 2. von Neumann J. et O. Morgenstern (1944), Theory of Games and Economic Behavior , Princeton University Press. 3. Kahneman, D., Knetsch, J. L. et Thaler, R. H. (1990), “Experimental tests of the endowment effect and the Coase theorem”, Journal of Political Economy , 98, 1325-1348. 4. Benartzi, S., et Thaler, R. H. (1995), “Myopic Loss Aversion and the Equity Premium Puzzle”, Quarterly Journal of Economics , 110, 73-92. 5. Mehra R., Prescott E. (1985), “The Equity Risk Premium: A Puzzle”, Journal of Monetary Economics , 15, 2, 145-161. 6. Abdellaoui,M. ; Bleichrodt, H. ; Paraschiv C., “Loss Aversion Under Prospect Theory: A Parameter-Free Measurement”, Management Science , Vol. 53, n° 10, octobre 2007.   

Related content on Decision Sciences

Decision Sciences

Risking the future? How Delayed Consequences Can Bias the Perception of Risk

By Emmanuel Kemel

Brian Hill GREGHEC
Brian Hill
CNRS Research Professor
Emmanuel Kemel HEC professor
Emmanuel Kemel
CNRS Research Professor
Economics

How Much to Reveal to Persuade a Decision Maker?

By Tristan Tomala, Marie Laclau, Frédéric Koessler

Photo Credits: Fergregory / Adobe Stock

Decision Sciences

Black Swans and Other Challenges to Rational Decision Making

By Stefania Minardi, Itzhak Gilboa