Three Cheers — Psychological, Theoretical, Empirical — for Loss Aversion

Abstract

This note emphasizes the special role of prospect theory in drawing psychophysical considerations into theories of decision making with respect to risk. An example of such a consideration is the dependence of outcome value on a reference point and the increased sensitivity of loss relative to gain (i.e., loss aversion). Loss aversion can explain the St. Petersburg paradox without requiring concave utility, it has the correct psychological foundation, it is theoretically useful, and it is a parsimonious principle that can explain many puzzles. A few open questions are whether loss aversion is a stable feature of preference, whether it is an expression of fear, and what are its properties.