Risk aversion or loss aversion?

Economists used to think people were risk adverse, but they couldn't figure out why people behaved in a manner so grossly in violation of the principles of probability. Then psychologists figured out that it isn't risk that people are adverse to, it is loss.

A common example is one where you are a general in charge of a military operation. Your troops are cut off, you know that there are only two ways out, one would lead to a loss of 50% of your force and the other could allow you to escape without casualty if undiscovered, but if found by enemy scouts your troops will be murdered, taking a 75% loss. It is estimated that you have a 70% of being discovered while making your escape.

When faced with a guaranteed loss, or the slim chance of not having to take a loss most people gamble on the riskier second option. The mathematical expectation of these two options is different, in the first you have a 100% chance of taking a 50% loss, so the expected loss is 50%. The second option has a 30% chance of no losses and a 70% chance of a 75% loss, the expected loss is therefore 53%. Expectation says the first option is the better one, but most people would take a gamble on the second option so as to possibly not have to take losses at all.

The phenomenon when applied to investment and gambling is what makes people play in a riskier and riskier manner after taking a loss. The intense desire to walk away without taking a loss prompts them to gamble in a reckless manner in the hope of making their money back. Traders are guilty of this too, especially those that use Martingale methods of "money management".

Loss aversion is a powerful barrier. Because of the reckless behaviour that people exhibit when trying not to take a loss they usually end up losing more money than they would have if they just cut and ran. Every big loss was a small loss once that somebody refused to take. They hang on relentlessly while something just goes right down the tubes, all the while holding out some slim hope that fortunes will be restored. This is not the expected behaviour of a risk adverse organism.