Tuesday, December 27, 2011

Loss Aversion and Psychoanalysis

One of the central findings of behavioral economics is that people feel more pain losing $100 dollars than they feel pleasure in winning a $100. Losses hurt more than gains feel good. This is called “loss aversion.” It is the basis for “prospect theory,” the behavioral economist’s response to, and critique of, the classical assumption that absolute values of wealth, rather than changes in wealth, matter most.

Some theorists use loss aversion to explain the puzzling phenomena that the rate of return on stocks is so much more than on bonds. This is called the “equity premium puzzle.” One reason, these theorists suggest, is that stocks prices fluctuate much more than bond prices. To compensate stock-owners for the pain associated with this volatility, and the losses it implies, you have to pay them much more to hold stocks.

But what goes unremarked is the psychological basis for loss aversion. Loss aversion seems puzzling particularly because research also shows that in general people are more optimistic than pessimistic. Why this sensitivity to loss on a foundation of optimism?  How can we square this circle?

I don’t doubt that psychologists can come up with common-sense explanations for loss aversion, for example, losing is more humiliating than winning is status- enhancing. But we still have to ask why. Or perhaps we could develop an explanation from evolutionary psychology. In our days on the savannah, as these explanations go, predators emblazoned in our mind the dangers we faced rather than the satisfactions we could garner. To survive we had to be danger-oriented.

I want to suggest that psychoanalysis can contribute to this dialogue, and in particular, can help link loss aversion to optimism. In psychoanalytic theory the most fundamental loss we all experience is the loss of innocence, the realization that dawns on us sometime between our infancy and our later childhood years, that we are not by definition special, that love can be withdrawn, and that we face competitors for attention and resources every which way we turn. This is the emotional meaning of what Freud termed, "the Oedipus complex."

It is also in the nature of psychoanalytic thinking to suppose that early experiences are also primary. They lay down patterns of thought in the mind that are not readily extinguished. In Wordsworth’s phrase, “the child is father to the man.” This is consistent with the idea for example, that early traumas, such as living in an orphanage as an infant, can have long lasting effects on a person’s emotional life. So in this sense all of us experience the trauma associated with the loss of innocence. Loss aversion, because it is so general, may express this underlying universal experience.

And how to explain optimism?  With this frame of reference, optimism can be seen as the fantasy that innocence can be retrieved. It is the hope for the restoration of our early childhood utopia. This also helps explain why gains in status, resources, and opportunities are never quite as satisfying as we expect them to be. They are symbolic but ultimately inadequate stand-ins for the innocence that we can never recover.

In a letter to the New York Review of books Daniel Kahneman, the co-founder of prospect theory, notes that his original research was motivated by the idea that “significant errors of judgment can arise from the mechanism of cognition, rather than from wishful thinking or other emotional distortions.” The term “wishful thinking” is of course a phrase that has much meaning in psychoanalysis. The wish in Freud’s sense is the progenitor of the dream and the symptom. This suggests that Kahneman, and his co-investigator Twersky, situated their pioneering work in a contest with psychoanalysis. Yet their sparring partner, psychoanalysis, has disappeared from view in the great stream of scholarly work stimulated by their initial theories and findings. And this surely is a great loss.


  1. In a low-tone comment, or rather association to Larry's post, I would remind that the early Freud, in fact, Breuer already, spoke of the Pleasure Principle as truly the "reduction" of tension: pleasure is merely, somewhat physiologically, the reduction of unpleasure, or of tension at all.
    As for Daniel Kanhneman's comment (not based at all on the fact he was my teacher in Experimental Psychology, many years ago, at the Hebrew University of Jerusalem) I see it much more as a critique of rationality, than as a critique of psychoanalysis.
    I remember the old book by Irving Zeitlin on the development of Sociological thought (http://books.google.co.il/books/about/Ideology_and_the_development_of_sociolog.html?id=X7m4AAAAIAAJ&redir_esc=y) whose main claim was that any and every sociologist in fact conducts a kind of critical dialogue with Karl Marx.
    Clearly enough, Kahnheman is NOT interested in psychoanalysis....and his Nobel Price was in Ecaonomics, again, as a critique of rational model of economics thinking.
    BTW, about loss, Kahneman always reminds his former colleague and friend from the Hebrew University, Amos Tversky, who died too young, and who developed, along with him, this peculiar brand of research.

  2. Great blog post! The psychological wear and tear of making decisions to get in or out harms an investors confidence and leads to performance chasing or sitting on the sidelines. It is extremely stressful and damaging longer term.