Why You Need To Know About 'Loss Aversion'

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What is Loss Aversion and why is it something you should keep in mind when betting and trading? On the blog today, Cassini offers his thoughts on this peculiar phenomenon and how an awareness of it can help improve your betting returns.

HarvardYale

Numerous studies have shown that the pain of losing something is felt more strongly than the joy of gaining something. In economics, this is known as loss aversion, and some studies suggest that losses are twice as powerful, psychologically, as gains.

The evidence suggests that this trait is deeply rooted in the human psyche, and reveals itself in the world of sports in perhaps surprising ways. For anyone who trades sports, understanding the nature of loss aversion can be beneficial in two ways.

  • Firstly, if you are aware of loss aversion and understand it, then you are better placed to avoid the consequences of it.
  • And secondly, if you are aware of how it can affect the emotions of the players involved in the sport you are trading, then you might gain a valuable edge there too!

Loss Aversion In Golf

A detailed study carried out by two professors from Wharton College in the USA, Devin Pope and Maurice Schweitzer, looked at golf, specifically the PGA Tour, and compared the results of putts for birdie, for par, and for bogey.

In most PGA Tour events, the number that matters is the total after 72 holes. A birdie can be viewed as a point gained, while missing a par putt can be viewed as a point lost. The results showed that, after accounting for other factors, the results of a putt for birdie and a putt for par revealed loss aversion.

Putts for birdies were missed more often than putts, from the exact same spot, for par. In psychological terms, it was if in the first instance, (the birdie putt) the player considers his position a win, and plays conservatively to ensure it doesn’t turn into a loss, while in the second instance (the putt for par), the player plays more aggressively.

Although not making either putt means the player is a shot worse off, losing a point is viewed, at least subconsciously, as more serious than not winning a point. Further evidence that loss aversion is in play here is found when the result of the putt is looked at. More birdie putts came up short, than par putts – the player was ensuring that at worst, the par was going to be made, rather than play aggressively and risk missing the hole and leaving a more challenging par putt.

Loss Aversion In The NFL

Similar studies have shown that loss aversion exists in other sports too. A study of the NFL showed that teams were more likely to ‘go for it’ on fourth and one if they had been in that position for a couple of plays rather than if they had arrived there after gaining nine yards in three plays. The decision making on that fourth and one is influenced by what went before.

When a team completes a first down at the one yard line, they have four plays at gaining that one year, and psychologically the attacking team has the expectation of scoring a touchdown, a win. After three tries at advancing, they are still at the one yard line, and the attitude is “I am not going to let this touchdown get away” and the next play is more likely to be another attempt at a touchdown than if they had started on the 10 yard line and advanced over those three plays. The attitude in this situation is, well we came close, but let’s take the three points. Incidentally, the study did factor in the score at the time, and the time remaining, because obviously a team down by two with five seconds left is going to kick the field goal!

We’ve all experienced the feeling of our favourite football team being ahead until the last minute, when the opposition scores a late goal and the result is a draw. In a league match, we get one point, the same as our opponents, but the game was, in our minds, won, and we lost something that we felt was ours, i.e. we dropped two points. The mood of our opponents to their one point is quite different. They had psychologically accepted that they had lost, that they were coming away with nothing, so ending up with a point was a gain for them.

Wins Are Not Equal

Back to the American code of football for possibly the best example of this, a college game between two famous Ivy League schools Harvard and Yale back in 1968. Yale went into the game as big favourites, with a record of 8-0 on the season, riding a 16 game winning run, and being nationally ranked.

A brilliant headline in the Harvard Crimson student newspaper the day after the game read “Harvard Beats Yale 29-29”, a headline which became the title of a documentary made forty years later which is well worth watching even if you have no interest in American football.

The story behind the headline is that with 42 seconds of the game remaining, the score was Yale 29 Harvard 13, and with Yale in possession, it was an almost certain win for Yale. After a fumble was returned for an unlikely touchdown, and a two-point conversion (the two-point conversion has been around in the College game a lot longer than in the NFL) attempt was successful, Harvard recovered the onside kick, scored another touchdown, followed by another two-point conversion, to tie the game. With no overtime back then, that was how the game ended.

Incidentally this game featured future Oscar winner Tommy Lee Jones in the Harvard team, although his room-mate Al Gore didn’t play.

Loss Aversion In Baseball

A study by authors Tobias J Moskowitz and Jon Wertheim looked at baseball, and the 3-2, or full, count. While this count can be reached in more than two ways, the study looked at 3-2 counts that started either 0-2 or 3-0.

For those who are not familiar with baseball, the three is the number of non-strikes against the hitter (referred to as balls) while the two is the number of strikes. A player is out with three strikes, or on base with four balls.

This study is thus looking at situations where the count started off as a good one for the pitcher – at 0-2 he is thinking in terms of an out, i.e. a ‘win’, while a 3-0 start is good for the batter, who is thinking he is going to get on base, a ‘win’ for him.

The loss aversion influence was seen here too. With the pitcher up 0-2 and then falling behind, he is in the position where he expected to win, but is now at risk of losing that win. Conversely, the pitcher down 3-0 has gone from psychologically accepting a loss, to a position where he is now in with a chance of a win.

How do pitchers approach the next pitch? In theory, it shouldn’t matter how the 3-2 count was arrived at. All that matters is getting the batter out, but the evidence reveals that a pitcher is more likely to take an aggressive approach if they had earlier been 0-2 ahead than if they had been 0-3 behind. (An aggressive approach can be measured by the type of pitch thrown, with a change-up or curve-ball being more aggressive, with a fast-ball being the more conservative).

The mental reasoning here is, in the first instance, the win is mine and I am not going to lose it, versus in the second instance, well, I thought I was going to lose anyway, so no big deal if I do.

The emotional desire to keep the win is stronger than the desire required to gain the win.

Journey, Not Destination

Clearly the ‘result’ is not all that is important, but how you arrived there too. You might think that having a net worth of £5 million would please anyone, but someone who had 10 million the day before, only to lose half of it in a stock market plunge, is going to feel a lot less happy about it than that day’s lottery winner who paid for his ticket with his last pound.

It is often said in sports that a win is a win, but clearly all wins are not equal at all. As a game or an event unfolds, we adjust our win / loss expectations accordingly and our emotions, as proven by the above studies and others, influence our next move. As spectators, our emotional high is much higher with an unexpected comeback win than in a game where our team held a big lead only to hang on for the win after the opposition made a strong comeback. After a big lead has set the expectation level so high, to only just win is a relative low, and for the opponents who had all but conceded defeat, the stirring rally that came up just short leaves their supporters on something of a high.

Swings And Trades

While such swings are few and far between in sports such as football, they are certainly anything but unusual in a momentum sport such as basketball where almost every night during the NBA season, teams rally from double-digit deficits, and if they don’t always rally to win, they do make the sport one of the best to trade on the betting exchanges, and trading itself is very much a game, with traders, like players, not immune from the influences of loss aversion.

You often read on forums comments along the lines that ‘no one ever went broke taking a profit’. While that statement may be partially true, the problem is that the goal over the long-term is not to finish in profit, but to finish with as much profit as possible, and any one individual ‘win’ is insignificant. Locking in a profit isn’t, in itself, successful trading.

What makes traders successful in the long-term is maximizing profits and minimizing losses, but this is made harder by our natural aversion to loss. If it affects the putting of Tiger Woods, which the gold study proved, and he has admitted in interviews to playing too carefully, then there’s a very good chance that almost all traders are affected too.

Loss Aversion In Trading

So how does loss aversion show itself when trading?

Having taken a position, for a trader the market can move favourably or unfavourably. It could do nothing for a while, but ultimately it will move in either direction.

Aggressive

If the move is favourable, you mentally start considering the win is yours. Perhaps the price drops to a level you consider too low, but you hesitate at greening up because you don’t feel like giving away some of ‘your’ win. You want it all. Greed drives your betting decisions at this point, and then the market starts to come back. You’re still in profit, but not by as much as you were, but it’s starting to feel like a loss. The win that was yours is diminishing. The current price is value, but you hesitate to lock in your smaller profit now, because you owned that earlier, and bigger, win. In essence, you are trading aggressively to keep what you felt was yours.

Conservative

If we take a look at the reverse situation, i.e. your initial entry point was unfavourable, and the market moved against you before recovering a little, you are in a situation where mentally you had accepted that you would be taking a loss, and the recovery feels like a win to you, and the emotion of fear encourages you to take the smaller loss, which feels like a win.

The two scenarios can be compared to the situation described earlier, where the pitcher started out either 0-2 (favourably) or 3-0 (unfavourably). The former leads to a more aggressive approach, the latter to a more conservative approach.

Of course, if you are staking correctly, the emotions of fear and greed are reduced, if not totally eliminated, and understanding the very real phenomenon of loss aversion will also help you to make sound trading decisions.

The Calendar Trap

One other handicap that several traders make the mistake of introducing to their trading is that of assigning some significance to their trading during an arbitrary time period. All that matters is maximizing profits in the long run, not that you made a profit on any one day, week or month. (‘Annually’ I might concede, since losing money over twelve months would be tough to accept mentally, and quite probably also means that you do not have the edge you thought you had).

To make decisions towards the end of an arbitrary period based on what went on earlier in the period makes no sense at all. While a day, week or month is a longer time frame than an at-bat in baseball, again the same principles hold true if you make the mistake of assigning some mythical importance to them.

Conclusion

Loss aversion is a powerful psychological force and understanding it can only enhance our ability to make correct decisions. The evidence suggests that it is so deep rooted that it is extremely unusual for anyone to be able to fully ignore it, but understanding it is at least a start.

 

 

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And visit Cassini's blog : GreenAllOver.blogspot

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