Loss aversion means that people are more sensitive to losses than to gains. This asymmetry is backed by ample experimental evidence. Loss aversion is not the same as risk aversion, because the aversion is disproportionate towards drawdowns below a threshold. Importantly, loss aversion implies that risk aversion is changing with market prices. This means that the compensation an investor requires for holding a risky asset varies over time, giving rise to excessive price volatility (relative to the volatility of fundamentals), volatility clustering across time, and predictability of returns. All these phenomena are consistent with historical experience and form a useful basis for trading strategies, such as trend following.

based on Yang, Liyan (2019), “Loss Aversion in Financial Markets.”
and quotes from
Blake, David, Edmund Cannon and Douglas Wright (2019), “Quantifying Loss Aversion: Evidence from a UK Population Survey.” and
Kahneman, Daniel., Jack. Knetsch, and Richard Thaler (1991). “Anomalies: The endowment effect, loss aversion, and status quo bias.”

The below are quotes from the papers. Headings, cursive text and text in brackets has been added.
The post ties in with this sites’ summary on implicit subsidies.

What is loss aversion?

“Prospect theory…was proposed in 1979 based on extensive experimental evidence by two psychologists, Amos Tversky and Daniel Kahneman, who eventually won the 2002 Nobel Prize in Economics for their work….One of the most salient features of prospect theory is loss aversion, which was introduced to capture the experimental evidence that people tend to reject lotteries such as a 50:50 bet to win $110 or lose $100…People get both pleasure and pain directly from gains and losses and that they are more sensitive to losses than gains.”

“Loss aversion means that people perceive more disutility from losses than utility from equal-sized gains…Experimental evidence suggests that people are more sensitive to losses than gains by a factor of about two.”

“We estimate…loss aversion for 4,016 respondents who form a representative sample of individuals in the United Kingdom…The average aversion to a loss of £500 relative to a gain of the same amount is 2.4.” [Blake, Cannon and Wright].

“Essentially, loss aversion affects financial market through influencing people’s attitude toward risks…[It is important to understand that loss aversion is not the same as risk aversion]. Risk aversion refers to a general preference for safety over uncertainty in potential gains or losses. Loss aversion emphasizes a strong distaste for losing money.”

“A central conclusion of the study of risky choice has been that such choices are best explained by assuming that the significant carriers of utility are not states of wealth or welfare but changes relative to a neutral reference point. Another central result is that changes that make things worse [losses] loom larger than improvements or gains.” [Kahneman, Knetsch, and Thaler]

How does loss aversion affect financial market volatility?

“Loss aversion [is]…a useful ingredient in helping us understand financial markets…Loss aversion affects people’s risk attitude through three ways…

  • First, the value function concave [meaning losses hurt more than gains please], meaning that…the investor is reluctant to accept a bargain with an uncertain payoff rather than another bargain that has more certainty but also a possibly lower expected payoff. When it comes to the financial market, a loss-averse investor is more inclined to put her money into T-bills with a low but relatively guaranteed return rather than into a stock that has high expected returns, but one that also involves a high chance of losing value. As a result, this global risk aversion induced by loss aversion helps to explain the nonparticipation puzzle, and it can generate a high equity premium in an equilibrium model
  • Second, the value function has a ‘kink’ at the origin [the point that divides gains from losses, as shown in the graph below]…it means that the investor is locally risk averse…The kink often implies that the investor’s optimal decision is sluggish in response to exogenous changes in environments…[Also] the investor is afraid of holding stocks if she is close to the kink.
  • Third, in a dynamic setting, loss aversion can cause a time-varying risk attitude… A time-varying risk attitude can generate excess volatility and predictability of stock returns through affecting how much compensation a loss-averse investor would require for holding a risky asset.”

“For financial investors, loss aversion helps to explain their reluctance to allocate any money to the stock market (the ‘nonparticipation puzzle’)…Loss aversion is useful for explaining the nonparticipation puzzle: loss aversion means that investors are more sensitive to losses than to gains and since stock returns are volatile, holding stocks would make investors often face losses and thus they are reluctant to invest in the stock market.”

“The equity premium puzzle has to do with the fact that the average return on the aggregate stock market has historically been much higher than the average return on Treasury bills over the past century. The equity premium can range from 4% to 8% on an annual basis, depending on the source datasets. The problem is that traditional models can only generate an annual equity premium smaller than 0.5%.
One of the most robust predictions of loss aversion is a sizeable equity premium in an equilibrium model. The intuition is simple. Loss aversion means that investors are more sensitive to losses than to gains. Since stocks often perform poorly and thus investors often face losses, a large premium is required to convince them to hold stocks.”

Stock return volatility…is surprisingly high, relative to the volatility of dividends (which are a proxy for fundamentals). For instance, the U.S. stock market has a return volatility of 20% on an annual basis while the volatility of dividend growth is around 6% for the post-war period. This fact is termed the ‘excess volatility puzzle’ in the literature.
The reason that loss aversion helps to explain the excess volatility puzzle is that loss aversion can generate a time-varying risk aversion in a way such that people are more risk averse after bad news than after good news. The intuition is straightforward—after bad (good) news, the stock market goes down (up); people thus become more (less) risk averse and more (less) anxious holding the stock, pushing the stock price down (up) even further, which amplifies the volatility of the stock market that can be justified by the volatility of fundamentals alone.”

Dynamic loss aversion also helps to explain volatility clustering found in low-frequency stock returns…After a large shock or several shocks of the same sign, investors not only become more or less risk averse, but they also become perturbed and thus more attentive to subsequent future news. This implies that any prominent news today will cause stock prices to react more to news tomorrow and hence future return volatility becomes higher, leading to volatility clustering in stock returns.”

Future stock returns can be predicted by past returns. On a six-month-to-one-year horizon, returns exhibit ‘momentum’: stocks that have done well (poorly) over the past six months tend to keep doing well (poorly) over the next six months…[This] works through the time-varying, risk-aversion feature implied by dynamic loss aversion…Bad news pushes down prevailing prices and raises investors’ risk aversion, leading to higher expected future returns as compensation for this raised risk aversion. The same mechanism also generates a value premium in the cross section: a stock with a low market-to-book ratio has often done badly in the past, accumulating prior losses for the investor, who then views it as riskier and requires a higher average return.”

Dividend volatility is a robust predictor for future returns. Specifically, higher dividend volatility corresponds to a more volatile investment environment and hence more fluctuation in the investment values, which implies that potential losses faced by investors are now larger. This causes investors considerable pain and makes the risky asset less desirable. As a result, they require more compensation when facing more volatile dividend processes, which, in turn, results in lower prices and higher equity premia.”