Loss Aversion and the Importance of Changing Your Lens

There is a concept called Loss Aversion that suggests that we hate losing exactly twice as much as we love winning.  That concept drives our behaviour in predictable ways and is a key driver for our aversion to failure in our work.  For that same reason I think it is twice as important to focus on areas of challenge with the right lens in order to accept our failures early and maximize our potential for success long term.

In the late 1970’s there was a study done by psychologists Daniel Kahneman and Amos Tversky that demonstrates the loss aversion phenomenon.

In the first experiment they asked students to choose between two bets:

  • a bet with 100% chance of winning $3,000
  • a bet  with an 80% chance of winning $4,000 and a 20% chance of winning nothing

In this experiment they found that 80% of the students would choose the $3,000 bet even though the second bet had a higher expected payoff.  (Bet 1 expected payoff = $3,000, Bet 2 expected payoff = $4,000 * 80% = $3,200).

The second part of the experiment saw them ask another group of similar students to choose between another two bets:

  • a bet with 100% chance of losing $3,000
  • a bet with an 80% chance of losing $4,000 and a 20% chance of losing nothing

On the second go-round 92% of the students chose the second bet even though it meant the potential for a greater expected loss.  They were so persuaded by the 20% of losing nothing that they ignored the expected value and opted for the greater risk.

Loss aversion causes us do behave irrationally, opting for safety when we are looking at potential gains and for risk when we are looking at potential losses.  It causes us to hold stocks as they fall to an uncertain bottom rather than selling when the market turns to a loss position, it causes us to hold to decisions even when we can see that they are not trending in the right direction, and it has caused countless projects to lead to significant waste and losses when they could have been fixed (or killed) much earlier without all the pain and fallout.

The problem with loss aversion is that we instinctively allow it to colour our decision making, letting our emotions drive decisions when we should be looking with a logical and pragmatic lens.

If the students had taken the time to figure out their expected loss and gain and simply decided based on that value rather than according to their loss averse emotional feelings they would have maximized their return from the two bets.  Instead, they chose to maximize their losses:

Given 100 students and the ratio of results:

  • For Experiment 1, 80% selected the $3,000 payout and 20% selected the potentially higher return.  This results in a total return for the group of:
    • $3,000 x 80 students = $240,000
    • $4,000 x 20 students x 80% chance of winning = $64,000
  • For Experiment 2, 92% selected the gamble for a lower loss and 8% selected the guaranteed lower loss.  This results in a total loss for the group of:
    • $3,000 x 8 students = $24,000
    • $4,000 x 92 students x 80% chance of losing = $294,400
  • So the total return for the students in this ratio for the two experiments is a loss of $14,400

If the results were exactly opposite the group would have had a positive return of $14,000 instead of a net loss.

The key to protecting yourself from the perils of Loss Aversion is to constantly check yourself against the logical view and options that exist before you.  Lose the emotion and look at your project with an impartial lens and give yourself permission to be in a failing position (and accept it).

If your project is hemoraging money and going nowhere fast, perhaps it’s time to pull the plug (or at very least stop and take stock of where you are and reset expectations for where you’re going).  If you’re holding a stock that is in a losing position and continues to drift downwards, perhaps it’s time to cut your losses now rather than holding on all the way to the basement (or even worse yet doubling down to recoup your losses).

Loss Aversion is an emotional state.  Success through failure is a logical approach (even though it feels illogical).

If you can force yourself out of the comfort zone of your emotional being and into the learning zone of applying a logical lens to your issues and challenges you will be taking the first step to maximizing your expected returns.

I’d love to hear your thoughts and stories on how this concept has worked for you in the past (or how you have been negatively impacted by loss aversion).  Feel free to share your comments and thoughts!

About Tim Empringham, MBA
Tim Empringham is a passionate advocate for Innovation in organizations of all sizes as a mechanism to drive growth, create uncontested market space, create new customer value, and drive efficiency into the internal organization. His focus is on disruption of thinking and markets through integrative thinking, structured Innovation frameworks, and leadership development of Innovation and Change leaders within the organization.

Posted in Blog and tagged , , , , .

Leave a Reply

Your email address will not be published. Required fields are marked *