Lesson 2.1 · 1 of 5 · Emotions and money
Loss aversion explained: the 2.25 ratio and what it does to investors
Loss aversion means a loss hurts more than a gain of the same size pleases. In 1992 Tversky and Kahneman estimated a median ratio of 2.25. A 2024 meta-analysis found an average of about 1.96, and some researchers dispute the effect. In investing, it pushes you away from risk when you check your portfolio often.
Terms in this lesson
- Portfolio
- All your investments in one place: stocks, ETFs, bonds, cash.
- Volatility
- How much the price usually goes up and down in a year.
- Maximum drawdown
- The largest fall in price from a peak to the lowest point after it.
The test: two choices with the same money
Answer the two questions below honestly before you read the explanation. There is no wrong answer. Both come from Daniel Kahneman and Amos Tversky’s 1979 paper, with the amounts shown in pounds (the original used Israeli currency).
The rest of this lesson is in the subscription
The subscription unlocks every chapter of Intermediate, Trading school, Investor psychology and Advanced, with their exercises and unlimited reviews.
Create a free accountWhat loss aversion is: prospect theory
Definition
What does prospect theory (Kahneman and Tversky, 1979) say?
What matters is the change from a reference point, and losses weigh more than gains.
In their 1979 paper in Econometrica, Kahneman and Tversky describe a “value function” that tracks gains and losses rather than total wealth. With gains, each extra pound matters a little less, so we pick the safe option. With losses the pattern flips and we end up seeking risk. The curve is steeper for losses: “the aggravation that one experiences in losing a sum of money appears to be greater than the pleasure associated with gaining the same amount”. The data came from students and university staff answering hypothetical questions.
| 1979 problem | Safe option | Risky option | What most chose |
|---|---|---|---|
| Gains (N = 95) | 3,000 for certain | 80% chance of 4,000 | 80% took the safe option |
| Losses (N = 95) | -3,000 for certain | 80% chance of -4,000 | 92% took the risky option |
Problems 3 and 3' in Table I of the paper. In both cases the risky option has an expected value of 0.8 × 4,000 = 3,200, as a gain or as a loss.
How strong is loss aversion? What the research says
The 2.25 figure comes from Tversky and Kahneman’s 1992 paper. They worked with 25 graduate students from Berkeley and Stanford, who were paid $25 to take part, not according to their choices. The median ratio was 2.25, and the authors wrote that an even-chance bet is acceptable only if the possible gain is at least twice the possible loss.
Loss aversion and investing: why checking often costs you
From the research
Paul Samuelson’s colleague and the coin toss
He turns down one bet but would happily take 100 of them.
In 1963 the economist Paul Samuelson described a bet he had offered a colleague: a 50% chance of winning $200 and a 50% chance of losing $100. The colleague said no, because he would feel the $100 loss more than the $200 gain. He added that he would gladly accept 100 such bets. Shlomo Benartzi and Richard Thaler open their 1995 paper on “myopic loss aversion” with this story.
Benartzi and Thaler call the mix of loss aversion and frequent evaluation myopic loss aversion. The more often you look at your portfolio, the more often you see a fall, and the less appealing shares feel. In their model, shares and bonds become equally attractive when the investor reviews the portfolio about once a year. A 1997 experiment by Thaler, Tversky, Kahneman and Schwartz found the same thing: the people who got feedback most often took the least risk and earned the least money.
- Decide how often you lookOnce a month, say, or when you rebalance, not every day. Put the frequency in your plan.
- Judge the whole portfolioOne share in the red inside a portfolio in the black is not a failure of the plan.
- Decide in advance what you do in a fallWhat you do at -10%, -20% and -30%, written while you are calm. The lesson on what to do when your investment falls has a template.
- Remember the maths of big lossesA 50% fall needs a 100% rise to get back. The full calculation is in the Trading School lesson on recovering from a loss.
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: D. Kahneman, A. Tversky, “Prospect Theory: An Analysis of Decision under Risk”, Econometrica 47(2), 1979, pp. 263-291 (problems 3, 3', 11 and 12); A. Tversky, D. Kahneman, “Advances in Prospect Theory: Cumulative Representation of Uncertainty”, Journal of Risk and Uncertainty 5(4), 1992, pp. 297-323; D. Gal, D. Rucker, “The Loss of Loss Aversion: Will It Loom Larger Than Its Gain?”, Journal of Consumer Psychology 28(3), 2018, pp. 497-516; A. Brown, T. Imai, F. Vieider, C. Camerer, “Meta-analysis of Empirical Estimates of Loss Aversion”, Journal of Economic Literature 62(2), 2024, pp. 485-516; S. Benartzi, R. Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle”, Quarterly Journal of Economics 110(1), 1995, pp. 73-92 (NBER WP 4369); P. Samuelson, “Risk and Uncertainty: A Fallacy of Large Numbers”, Scientia 98, 1963, as cited by Benartzi and Thaler; R. Thaler, A. Tversky, D. Kahneman, A. Schwartz, Quarterly Journal of Economics 112(2), 1997, pp. 647-661.