The perils of a blanket model: Financial anomalies and loss aversion

Loss aversion, the notion that the subjective weight on losses is larger than that of gains, is often used to explain important patterns in financial markets and economic behavior. The current review outlines challenges in the indiscriminate use of loss aversion as a unifying (or "blanket") model. First, the demonstration of loss aversion is not replicated for small to moderate stakes and in repeated decisions from feedback. Second, laboratory studies that purportedly documented loss aversion were exposed to several experimental artifacts. Third, the application of loss aversion in financial markets often requires auxiliary assumptions which are often questionable. Fourth, the predictions of loss aversion are often confounded with other effects of losses, such as effects on attention. These four challenges suggest that the applicability of loss aversion is lower than what is commonly assumed. The field of experimental finance should go beyond assuming or demonstrating loss aversion, and carefully evaluate its relevance.