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Loss Aversion’s effects on asset prices

The Prospect Theory Value Function

Loss aversion is found to have effects on how assets are priced, including assets like stocks, bonds, apartments, and houses. In behavioral economics, Loss aversion states individuals are more sensitive to losses than gains. Losses and gains are determined by a certain reference point, which could be the price of a previous purchase, a long-run mean of a particular asset price, or some other factor. Asset pricing estimates the market value a specific asset is worth. Estimating an asset’s value can be found through relative value models, option models, or discounted cash flow models.
Loss aversion is a subtopic of Prospect theory, both of which were proposed by Daniel Kahneman and Amos Tversky in 1979. Prospect Theory proposes individuals consider losses and rewards differently when risk is involved. Even when the probability of gaining was higher than the probability of losses, Kahneman and Tversky found individuals prefer to gain a small amount than lose the transaction at all.
Loss aversion is different than risk aversion. Risk aversion is when a person consistently chooses the options with lower risks compared to high risk options. Risk aversion occurs in loss aversion when prices are far below the reference point. . Risk preference appears in loss averse individuals when prices are far above the reference point.

Financial Assets

Financial Asset Reference Points

Stock trade analysis finds evidence of loss aversion in financial assets. In the Tel Aviv Stock Exchange (TASE) in Israel from 1991 through 2001, investors traded stocks at higher prices, above the reference point of the mean asset price, on a daily basis and at lower prices over a week's period of time. This finding shows two key components of loss aversion; when a price is above the reference point, investors will become risk preferring and will purchase more stocks, and loss aversion rises when the evaluation period to purchase an asset is small.

Loss aversion in stock prices is also present in United Sates financial markets, in stock and bond trading data from 1889 through 1985. U.S. investors, over this time, purchased more stocks when the stock price rose above a point of initial income, becoming risk preferring. This shows loss aversion due to investors’ risk preference when stock prices are above the reference point.

Financial Asset Price Levels

Price levels of financial assets can be affected quite a bit due to loss aversion. In TASE, prices of stocks tend to be lower over longer periods of time because of loss aversion. TASE stock’s price, in the long-run, will decrease from the right-side of the Kahneman-Tversky Value Function (KTVF), because investors will prefer to gain nothing on the stock’s return than to lose any money on the investment.

U.S. stock prices tend to rise when loss averse investors see a decrease in their income, becoming risk averse, raising the asset price level to the reference point. Referring back to the value function, if U.S. investors lose on a particular stock, their stock’s value decreases and will fall to the left-hand side of the value function. Loss averse investors will become risk averse at this point. This allows investors who are not loss averse to demand more stocks, raising the price back to the reference point.

Real Estate Assets

Real Estate Asset Reference Points

Multiple real estate markets show evidence of loss aversion. Israeli real estate data from1998 to 2007 illustrates loss aversion. In these data, buyers of new houses were strongly influenced by the long run mean of Israeli real estate, being the reference point for the value function. Similar to investors in TASE, Israeli real estate consumers demonstrate loss aversion by purchasing more houses when these house prices are above the long-run mean reference point.

The apartment market in Helsinki, Finland also shows loss aversion. Apartment sellers in Helsinki sold more apartments when they gained no return on the apartment price. This high rate of selling at a 0% return shows strong evidence of loss aversion in this apartment market. At a small loss, the rate of selling apartments drops to half of the rate of those selling with no return on the apartment.

Real Estate Asset Price Levels

Loss aversion affects the prices of real estate in Helsinki apartments and the Israeli real estate market. Loss averse sellers of Helsinki apartments do not sell their apartments when the selling price is below the original purchase price, fearing a loss. This tendency to sell at around the same price has the effect of keeping apartment prices static. For example, a Helsinki apartment price would be on the left side of the vertical axis. Being loss averse, these apartment sellers will be less likely to sell at a loss and will try to sell for no gain rather than a loss.

Loss aversion has the same effect of creating static prices in Israeli real estate. In the short-run, price levels are affected by the momentum of transactions, like when house prices go greatly above or below the long run mean price and many individuals take advantage of good prices. In the long-run, prices of Israeli real estate tend to revert to the long-run mean real estate price. Graphically, short-run prices of Israeli real estate can be on either the right or the left of the vertical axis of the value function. Prices, in the long-run, will return back from either side to the vertical reference point due to loss averse investors trading to avoid losses at any possibility.

Conclusion

Loss aversion has effects on asset prices depending on the asset market. Buyers and sellers may focus their selling and buying around the reference point of the asset due to loss aversion. In the short run, loss aversion causes asset prices to be dynamic, shifting above and below the reference point quite a bit. In the long run, loss aversion causes asset prices to be static as asset sellers and buyers find ways to cut losses.