Loss aversion is a term in cognitive psychology and decision theory which was identified by Nobel Laureate Daniel Kahneman who along with Amos Tversky established a cognitive basis for common human errors. It refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.
As an example, assume that a person gains $10,000 from the government as a first home owner grant. Naturally they feel very happy about it. At another home, some accident happens with the hot water system and the owner has to replace and get installed a completely new system at a cost of $10,000. According to loss aversion theory, the magnitude of the satisfaction loss for the later person is significantly greater than the magnitude of satisfaction gain for the former.
While coping with big losses such as the death of a loved one is itself a complete subject, the focus of this article is little losses in everyday life. One can momentarily feel quite bad about getting a speeding ticket and paying $300, or a sudden car breakdown with a $800 bill paid to the mechanic. I was thinking about it because I do not feel unpleasant emotions when I receive my electricity or gas bills, even when they are large — as long as they are within the expected mean and variance of the season. This lead me to the idea that perhaps expecting and being prepared for such a thing makes the unpleasant emotions quite weak.
So I devised this method for dealing with little losses which I call a 4-1 rule. For every 4 gains in any dimension of my life (money, relationship satisfaction, health), I prepare my mind to get ready for a loss of 1. I am taking 4 steps in the forward direction and the friction of life brings me 1 step back.
This expectation does not mean that one should start feeling sorry beforehand but that one should treat this as a part of the package. This method is somewhat similar to the philosophy of `you gain some, you lose some’ in life and that we should focus on how much we have rather than how much we lost. The difference is that this method prepares my mind in advance without taking anything away from the current satisfaction. The simplest example that comes to my mind is the income tax. No matter where we are in the bracket, we all are prepared to give the taxman their cut.
Two points are in order here.
- The rule can be 10-1 for some and 3-1 for some others depending on their life situations but the fundamental idea stays the same.
- Notice that I have not mentioned any units of the quantities 4 and 1. This is because it is applicable to different areas of life with different magnitudes in comparison.
Furthermore, this rule is in line with other observations around us. For example, most movements involve overcoming gravity in one form or another. Even the regular electricity conductors take their share in the form of heat during the conduction process. Interestingly, if you take the ratio 4/1 in percentages, it becomes 80/20 which is applicable to numerous areas of life as a fundamental law of nature. This principle is richly recorded in the books by Richard Koch such as The 80/20 Principle: The Secret of Achieving More with Less and The 80/20 Principle and 92 Other Powerful Laws of Nature.