Diminishing sensitivity

What Is Diminishing Sensitivity?

Diminishing sensitivity is a core concept in behavioral finance, describing the psychological phenomenon where the perceived impact of a change in wealth or a specific outcome decreases as the absolute value of that wealth or outcome increases. Simply put, people are more sensitive to changes near a reference point than to changes further away. For example, the difference between gaining $100 and $200 feels more significant than the difference between gaining $1,000,100 and $1,000,200, even though the absolute change is the same in both cases. This principle helps explain various aspects of investor behavior and how individuals evaluate potential gain and loss.

History and Origin

The concept of diminishing sensitivity is a fundamental component of prospect theory, which was developed by psychologists Daniel Kahneman and Amos Tversky. Their groundbreaking work in the late 20th century challenged the traditional economic assumption of rational choice and expected utility theory. Kahneman was awarded the Nobel Prize in Economic Sciences in 2002 for his work, which integrated psychological insights into economic science, particularly concerning human judgment and decision-making under uncertainty.⁷,⁶,⁵,⁴ Prospect theory introduced the idea that individuals evaluate prospects in terms of gains and losses relative to a reference point, rather than in terms of absolute final states of wealth. The observation of diminishing sensitivity was key to understanding how these subjective evaluations influence choices.

Key Takeaways

• Diminishing sensitivity means the psychological impact of a change in value lessens as the overall value increases.
• It is a core component of prospect theory, explaining how people perceive gains and losses.
• Individuals are more responsive to initial changes around a reference point.
• This cognitive bias can influence financial decisions and risk-taking.
• Understanding diminishing sensitivity can help individuals and policymakers anticipate irrationality in economic choices.

Interpreting Diminishing Sensitivity

Interpreting diminishing sensitivity involves recognizing that individuals do not perceive value linearly. For instance, a $1,000 increase in portfolio value feels substantial to someone with a $10,000 portfolio, but far less impactful to someone managing a $10 million portfolio. This non-linear perception of value means that the subjective utility derived from an additional unit of wealth decreases as total wealth increases. This explains why people often exhibit risk aversion for gains (preferring a sure smaller gain over a chance at a larger one) and risk-seeking behavior for losses (preferring a chance at avoiding a larger loss over a sure smaller loss).

Hypothetical Example

Consider two investors, Investor A and Investor B.

Investor A currently has $1,000. They are offered a choice:

1. A guaranteed gain of $100, bringing their total to $1,100.
2. A 50% chance to gain $200 (total $1,200) and a 50% chance to gain nothing (total $1,000).

Most individuals, due to diminishing sensitivity to gains, would likely choose the guaranteed $100. The satisfaction from the first $100 gain is perceived as more significant than the additional satisfaction from going from $100 to $200.

Investor B currently has $100,000. They face a potential loss and are offered a choice:

1. A guaranteed loss of $1,000, leaving them with $99,000.
2. A 50% chance to lose $2,000 (total $98,000) and a 50% chance to lose nothing (total $100,000).

Here, due to diminishing sensitivity to losses (and its counterpart, increasing marginal disutility of loss), many would prefer the 50% chance to lose $2,000. The additional pain of losing an extra $1,000 (from $1,000 to $2,000) is perceived as less severe than the pain of the initial $1,000 loss, making the gamble seem more appealing than the certain smaller loss.

Practical Applications

Diminishing sensitivity has significant practical applications across finance and economics. In investment planning, financial advisors may observe clients making decisions consistent with this concept, such as being very careful with initial investments but taking more significant risks once their portfolio has grown substantially. Regulators and policymakers also consider such cognitive biases when designing policies aimed at investor protection. For instance, understanding diminishing sensitivity can inform how disclosures are framed to ensure investors truly grasp the implications of various financial products, particularly those involving small, frequent fees versus large, infrequent ones. Discussions at institutions like the Federal Reserve Bank of San Francisco workshop on behavioral macroeconomics often delve into how such biases affect broader economic outcomes.³ Furthermore, firms developing financial products might leverage or mitigate diminishing sensitivity in their design, aiming to make products more appealing or to encourage more rational decision-making from consumers. Insights into how behavioral biases affecting investment decisions play out in real-world scenarios are critical for creating robust financial systems.²

Limitations and Criticisms

While widely accepted in behavioral economics, diminishing sensitivity, like other behavioral theories, faces limitations and criticisms. The primary critique is that its empirical observations sometimes lack perfect consistency across all contexts and individual variations in behavior can be substantial. What constitutes a "reference point" can be fluid and influenced by numerous factors, making precise predictions challenging. Additionally, the magnitude of diminishing sensitivity can vary significantly among individuals and cultures. Some criticisms argue that while it explains deviations from traditional rational models, it may not always provide a clear, actionable framework for correcting or universally predicting behavior. For instance, the discussion in "Behavioral Economics and Investor Protection: Reasonable Investors, Efficient Markets" highlights the discrepancy between legal theory's view of a "reasonable investor" and behavioral economists' findings on investors' cognitive shortcomings.¹ The interplay with other biases, such as emotional biases or framing effects, can also complicate the isolated analysis of diminishing sensitivity.

Diminishing Sensitivity vs. Loss Aversion

Diminishing sensitivity and loss aversion are both fundamental concepts within prospect theory, but they describe distinct aspects of human value perception.

Diminishing Sensitivity refers to the idea that the marginal impact of a change (either a gain or a loss) decreases as one moves further away from the reference point. For example, the subjective difference between $0 and $100 is greater than the difference between $1,000 and $1,100, even though both involve a $100 change. This applies to both the domain of gains and the domain of losses.

Loss Aversion, on the other hand, describes the tendency for individuals to feel the pain of losses more intensely than the pleasure of equivalent gains. This means that losing $100 typically hurts more than gaining $100 feels good. Loss aversion explains why people often take greater risks to avoid a loss than they would to achieve an equivalent gain. While diminishing sensitivity explains the shape of the value function (concave for gains, convex for losses), loss aversion explains the steepness of the loss curve compared to the gain curve, indicating that losses loom larger than gains.

FAQs

What causes diminishing sensitivity?

Diminishing sensitivity is a psychological phenomenon believed to stem from how the human brain processes changes in stimuli. It suggests that our perception is more attuned to relative changes around a current state rather than absolute magnitudes, similar to how our senses respond to light or sound.

How does diminishing sensitivity affect investing?

In investing, diminishing sensitivity means investors might feel more excitement from initial gains or more pain from initial losses, but become less reactive as the amounts involved grow larger. This can lead to different levels of risk-taking depending on the size of the investment and prior gains or losses.

Is diminishing sensitivity a rational behavior?

No, diminishing sensitivity is considered a cognitive bias and a departure from rational economic behavior. Traditional economic theory assumes a linear perception of utility, where each additional dollar provides the same marginal utility, which diminishing sensitivity contradicts.

Can diminishing sensitivity be overcome?

While it is an inherent cognitive bias, awareness of diminishing sensitivity can help individuals make more objective financial decisions. Strategies like setting clear financial goals, using quantitative analysis, and seeking external advice can help mitigate its influence.

How is diminishing sensitivity related to prospect theory?

Diminishing sensitivity is a fundamental pillar of prospect theory. Prospect theory posits that the value function for gains is concave (reflecting diminishing sensitivity to gains), and the value function for losses is convex (reflecting diminishing sensitivity to losses). This shape, along with loss aversion, helps explain observed decision-making under uncertainty.