Loss Aversion and Organizational Decision Making
What do we have to lose?
There's a very nuanced and interesting question, often asked of athletes and coaches, that reliably provides the exact same answer. "Which is greater? Your love of winning or your hatred of losing?" Yet as complex and multi-dimensional a question as that may be, they always answer, "Hatred of losing," without taking a moment's hesitation.
What does that say about athletes and coaches, and the types of mindsets that are required to embrace competition? It says they're human.
Because here's the really interesting thing about that question. Everyone has the same answer. We only ask athletes and coaches, but the same is true for everyone, regardless of age, gender, socioeconomic status, political affiliation or even sports fandom. Winning is nice. Losing is death.
It's called Loss Aversion, and it describes the general tendency for people to be twice as motivated to avoid losses as to secure gains. Put another way, losses hit us twice as powerfully as wins. I would have to win $40 to match the emotional intensity of losing $20. The takeaway – stay away from the casino.
In some ways, loss aversion helped to kick off an almost 50-year explosion in interest in behavioral science. It surfaced during the research that led to Kahneman and Tversky's iconic Prospect Theory in 1979, which proved that people's attitudes towards risk were context-dependent. (In other words, your willingness to take risks is largely dependent on whether you are "up" or "down" at the gambling table.)
This may seem intuitive now, but not in 1979. The laws of economics stated that individual attitudes towards risk were fixed and the result of rational analyses. Suggesting otherwise was, at the time, sacrilegious and caused quite an uproar.
This, despite the evidence all around us. Returning to the world of sports, what usually happens to a basketball or football team that builds a big lead? They start to play conservatively, trying not to lose instead of trying to win. Which inevitably allows the other team to come back, who, playing from behind, are much more willing to take risks. Which explains why a staggering number of basketball and football games come down to the last two minutes. It's human nature.
The Endowment Effect describes how we tend to overvalue what we own. It works hand-in-glove with loss aversion. Overvaluing what we have is a great way to become disproportionately focused on not losing it.
Organizationally, loss aversion can severely affect decision-making by perceptually altering the values in a cost-benefit analysis. As with individual careers, when companies transition from aspiring for achievement to maintaining the status that achievement afforded, good decisions often move beyond the boundaries of what is willingly considered.
The good news is that there are relatively straightforward steps we can take to help us overcome the effects of loss aversion on our decision-making. The bad news is that no one wants to take them. Why, especially for high-stakes decisions?
As with all cases of systemic irrationality, the answer lies in biases, heuristics and behavioral science.
The Brain's Limitations
The human brain has enough mental energy to process only a tiny fraction of the information available to it. Were people to try to think through every decision, they would become mentally depleted, and effectively paralyzed, by breakfast.
To compensate, human beings have adopted what Daniel Kahneman calls The Dual Systems Theory. Kahneman suggests that people engage in two very different types of thinking: System 1, which is fast, easy and unconscious, and System 2, which is slow, difficult and effortful.
System 1 is like being in autopilot in sunny skies, while System 2 is like landing the plane in a storm.
By necessity, we spend the overwhelming amount of our time engaging in System 1 thinking (estimates typically reach 90% and above), reserving System 2 thinking for the relatively rare moments in the day in which we really need it.
If people are spending 90% of their time in unconscious autopilot, it begs another question: who's flying the plane? The answer to that is, "Biases and heuristics," the foundations of behavioral science.
Biases and Heuristics
Biases are mental tendencies, and heuristics are mental shortcuts that help us make decisions without expending mental energy. They fly the plane while we are in autopilot.
Fittingly, people have a bias against the word "bias," because they conflate it with racism, sexism, ageism, and all of the other isms that are worthy of our scorn.
Biases, however, are neither good nor bad. I have a positive bias for people who wear Canvas Chuck Taylor sneakers. As soon as I see them, I feel as though we have shared values and feel a kinship. It's just a mental tendency that helps me avoid spending any of my precious System 2 thinking.
Of course, bias can lead to all sorts of awful problems, especially when we perceive threats where there are none. But the answer is not to eliminate bias, because that is impossible. We could not survive without relying on biases. The challenge is learning how to recognize and mitigate the biases that our rational minds can understand are dangerous.
Heuristics face no such stigma, but play just as big a role in flying the plane in autopilot. Heuristics are mental shortcuts on which we rely when pressed to make decisions we can't "afford" to think through. The affect heuristic describes how we rely on emotions, or "our gut," to make decisions, rather than an extended thought process. Anchoring describes how we hold onto the first piece of information as our reference point in negotiations, without re-evaluating for accuracy or relevance. And the availability heuristic describes how ease of recall affects our perception of probability.
So, what is the cognitive purpose of loss aversion? The same as every other bias or heuristic: to save mental energy. On the plus side, it does make it easier to catch the end of the game.
The Emotional Purpose of Loss Aversion
We feel loss aversion at a cellular level because it comes straight out of evolutionary psychology. Despite the degree to which we celebrate risk-taking in our culture, it was our most risk-averse ancestors who actually survived, leading to us. And that misperception is ironically created by something called survivorship bias.
We only pay attention to the stories that survive. For every Steve Jobs, there are 10,000,000 failures. But no one tells those stories, so we have a very distorted view of "success." Because in reality, (if not basketball and football) risk has a higher losing percentage than playing it safe. Loss aversion feels safer, and more often than not, it is.
But loss aversion also results from our needs to build and maintain status and self-image. The aforementioned endowment effect, which causes us to overvalue what we own, is nothing more than an effort to feel better about ourselves.
If my home is worth $500,000 instead of $350,000, I feel better about myself, my investments and my accomplishments.
We inflate the worth of what we own to inflate the worth we feel in ourselves, especially in comparison to others. And as understandable as that need may be, it nonetheless can lead us to some very poor decision-making.
Another dynamic that intermingles with loss aversion is "…the devil you know." The possibility that, "Things could get worse," tends to end our critical thinking, and we zero in on how to make sure that does not happen. But we fail to ask ourselves, "Will things get worse?" The result is that we often put a great deal of energy and resources to protect ourselves from situations that never arise, and were always extremely unlikely to.
Nonetheless, "pick a lane" often feel preferable to, "wait and see." The best way to quiet the noise is to make a choice and live with it. And that choice is usually the one with the least possibility of loss.
Common Examples and Effects
Loss aversion shows up everywhere in our daily lives and business decisions:
→"Extended Warranties" would more aptly be named, "Exploitations of Loss Aversion," since an irrational aversion to loss is the only thing driving those purchases.
→The reason that most people's retirement accounts are, mathematically speaking, way too conservative is because people are way too loss averse.
→People tend to hold onto losing investments far too long because they are unwilling to lock in a loss.
→Sunk-cost fallacy, which causes us to continue investing in losing situations, happens due to loss aversion. We stay in bad relationships, maintain gym memberships we don't use, and finish books and shows we don't like.
→Scarcity, the principle of influence that describes the impact of a shortage on human behavior, is also a function of loss aversion. It's why sales have end dates, coupons expire, and supplies are limited.
→And finally, loss aversion is why no one cares about a $50 early discount but cannot abide a $50 late penalty. (They are the exact same thing.)
Loss Aversion and Organizational Decision-Making
There is no sphere of organizational decision-making that is unaffected by loss aversion. It is a tendency present in everything we do, individually and collectively. It plays a role in the general resistance to change present in every organization, from vendors to policies.
Strategically, loss aversion is behind some of history's biggest business mistakes, such as Blockbuster Video's decision to reject DVD by mail for fear of losing their late fees. Instead, they lost their business, which was dominant.
Operationally, loss aversion keeps organizations using the wrong tools for far too long, not wanting to "waste" the past investments in it. But it also drives organizations to make reckless changes and investments, such as the present-day obsession with AI integration. Everyone is scared of "losing" the chance to be ahead of the curve.
Just as with tools and vendors, loss aversion can lead organizations to stick with employees far too long, hoping to protect past investments of time, money and effort. And to the extent that culture is "the way things get done around here," loss aversion can permeate every decision across an entire organization, if that is the signal received from the employee base.
Historically, companies will continue to fund losing projects out of a desire to protect the past investment (and the reputations of the decision-makers), and often negotiate against themselves when setting prices.
Fear of losing customers can lead organizations to say yes to every request, committing itself to an unsustainable development schedule. And loss aversion can keep companies from updating their branding for fear of losing connection with customers.
The real challenge would be finding an organizational decision not affected by loss aversion.
The Existing "Solutions" for Loss Aversion
The solutions most commonly offered to combat loss aversion are very much aligned with most biases. Maintaining awareness during decision-making, using tools and processes to counter bias and heuristics, and relying on data to do so are among them.
And these solutions, when attempted, tend to produce great results. The problem is that these solutions are so infrequently attempted.
That is understandable for a number of reasons. For starters, that degree of evaluation is far too much work given the sheer number of decisions we have to make, and we have far too little mental energy to do so.
Structured decision-making is to be reserved for our most important decisions, whether individually or organizationally.
For individuals, better decision-making requires intention and discipline, while groups require coordination and facilitation. But even those not enough to overcome the availability heuristic, because they still fail to address the most powerful obstacle of all: emotional resistance.
The New Solution for Loss Aversion
If following a structured decision-making process might make someone's past or current decisions seem foolish, it eliminates their motivation to do it. No one wants to appear stupid, to themselves or especially to a group. If forced into a group structured decision-making exercise, they will be concerned exclusively with impression management, muddying the waters for an honest and objective evaluation.
The point must be made forcefully and effectively upfront: errors in judgment from biases and heuristics are as universal as breathing. Every single human has and will make countless of them, both consciously and unconsciously. And hindsight is always 20/20. To feel foolish for making errors in judgment is, quite literally, foolish. And it is a huge blocker to growth and improvement.
This mindset is a requirement for better decision-making, and facilitators must be skilled in making the point. But even that is not enough.
People's status and positions are often tied to certain decisions and/or supportive of the status quo. As such, they are strongly motivated to avoid or muddy any exercise that might threaten that order. This resistance must be eliminated as well. Fortunately, there's a framing to get us there.
"We're not doing this to question your decisions or threaten to your positions or status. We're doing this to supercharge your agility moving forward, which will protect your positions and status."
Stories of agility success, like Play-Doh, Frisbee and Netflix, and of agility failure, like Kodak and Blockbuster, help to drive the point home.
What makes this the "new" solution to loss aversion is that it addresses the emotional blockers before proceeding to the cognitive exercises. Solutions are meaningless for people not motivated to use them.
The Questions to Plan for Loss Aversion
→On what are your estimates of risk and reward based?
→What is your confidence level in your assessments of risk and reward?
→If you are overstating the possible risk by 50%, do you reach the same conclusion?
→If you are understating the possible reward by 50%, do you reach the same conclusion?
Once we accept that loss aversion is affecting us at all times, we lose the desire to defend it. Most of us put very little thought into how we arrived at our estimates of risk and reward, but nonetheless base our important decisions around them. A willingness to re-evaluate those assessments, particularly with the knowledge of our tendency for loss aversion, can be a truly eye-opening experience, both for individuals and organizations.
Is Loss Aversion Costing Your Team Wins?
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