Why does a salary cut hurt more than the joy of a bonus?
A short note loss aversion in behavioral economics
The following questions presented to two different groups of subjects, and they were asked to choose an option.
In problem 2, the (probable) pain of losing the $200 is less than the pain of losing the $100 (for sure). People chose the risk of losing more to have got a chance of no loss at all.
In behavioural economics, this phenomenon is called loss-aversion.
We all hate losses, but loss aversion states that the perceived value of a loss is higher than an equivalent gain. This is why a salary cut hurts us more than the joy of a year-end bonus. We evaluate losses and gains differently.
Individuals also think about losses and gains relative to their current wealth.
Our happiness increases as we get wealthier, but at a decreasing rate (i.e.), as we grow rich, the impact of an additional 1 Lakh in your bank account significantly decreases.
For a daily wage worker, an additional 1 Lakh rupees would be a life-changing event. The reverse of this also true. A loss of 1 Lakh rupees could potentially push them below the poverty line. Still, for a wealthy person, it is either negligible or manageable.
For a developing country like India, loss aversion becomes the basis of how individuals make a financial decision. One wrong decision could potentially erase your wealth and push you below the poverty line (BPL).
This explains why 86% of India’s wealth is in physical assets (Real estate and gold), where the perceived loss over a long term period is zero and low probability of capital erosion.
As financial services become digital (faceless), it becomes essential to be cognizant of the choice architecture presented in our apps. The hierarchy of options and the language of explanation shown to the users might have long term effects on their life.
‘Should we be showing the high-risk mutual fund even though you know that they might not be able to liquidate it in the short term?’
‘Should we be lending instant loans without explaining the consequences of potentially getting into a debt trap?’
Food for thought
Personal takeaway: As we earn more money, the increment in happiness reduces with more wealth added. At some point, we will have to change our definition of a happy life.