You’re offered a gamble on a coin toss:
If it’s heads, you lose £100.
If it’s tails, you win £150.
Would you take the offer?
Despite the fact that you stand to win more than you can lose, and your chances of either outcome are equal, you probably don’t like the offer.
This is because of loss aversion.
Daniel Kahneman and Amos Tversky, in ‘Prospect Theory: An Analysis of Decision under Risk’, defined loss aversion for the first time. They found that ‘losses loom larger than gains’ when there is a ‘mixed prospect’ (when the outcome is unsure.)
We don’t like losing. This is programmed into all of us, and the root of this inclination is found in evolutionary biology - the species that avoids risk is more likely to survive.
Could we do better?
In 2007, Tiger Woods told The New York Times:
‘Any time you make big par putts, I think it’s more important to make those than birdie putts. You don’t ever want to drop a shot. The psychological difference between dropping a shot and making a birdie, I just think it’s bigger to make a par putt’
Tiger Woods could have earned an extra $1,000,000 a year if he had not been loss averse. Or so behavioral economists at The University of Pennsylvania assessed in their essay Is Tiger Woods Loss Averse?
They did a study in which they compared the putts of golfers going for par vs golfers going for a birdie, accounting for 2.5 million puts in total.
They found that professional golfers make the putt for birdie 2 percentage points less often than they make comparable putts for par.
This is because to putt a birdie is a ‘win’, and to miss par is a loss; a loss made certain because of the reference point of par. Golfers clearly try harder to avoid loss than they do to seek gain.
Interestingly, the research showed that:
‘Early in the Tournament, the reference point of par is likely to be very salient; later in the Tournament, alternative reference points, such as the scores of competitors, are likely to become salient’.
This is vital to note: reference points are multitudinous and shift all the time.
The reference point is a key concept to understand in loss aversion, because it is the personalising factor; it is the part of this theory that moves into the real world by acknowledging that choices and preferences change with circumstances.
Irrational decisions - the endowment effect
Reference points do not have to be goals; they are usually an internal measurement about our status quo, and the endowment effect, despite being a precursor to Kahneman’s ‘loss aversion’ and ‘reference points’, is an important part of understanding why we are loss averse.
Loss aversion is not just about being averse to what we might lose in a gamble, but about losing what we already have; and the reason for that is explained, in part, by the endowment effect.
It was cited by Richard Thaler, and it all started when he began to notice the strange behaviour of his economics professor, Richard Rosett.
Rosett was an avid wine collector, and one of his bottles had recently been valued at $100 by a local wine merchant. Rosett enjoyed drinking the wine, and never sold a bottle, but ‘would never dream of paying $100 to acquire one’. As Thaler writes, in Misbehaving:
‘If he is willing to drink a bottle that he could sell for $100, then drinking it has to be worth more than $100. But then, why wouldn’t he also be willing to buy such a bottle?’
Standard economic theory dictates that Rosette’s buy and sell price should be the same. In reality, his buy price was around $30, and his sell price over $100. This disparity highlights how we value possessions we own greater than the ones we don’t, especially if the thing we own was never intended as a proxy for something other than use - the wine wasn’t bought for exchange.
This is just an introduction to the endowment effect. The following example illustrates how it relates to reference points, loss, and choice.
‘The instability of preferences produces a preference for stability’
Two identical twins (let’s assume their minds are identical too, for simplicity’s sake), Sarah and Izzy, have two new scenarios to choose from.
Scenario A - one of them will receive an extra £1,000 a month,
Scenario B - one of them will receive an extra day of holiday a month.
They are indifferent to the choice - they value each scenario equally, and so they toss a coin.
Sarah gets A (£1,000), Izzy gets B (the extra day).
After some time, they are offered to switch.
They are not willing to change. Despite their initial indifference to the choice, they now have different reference points and that is because they have been endowed with the initial proposition.
Therefore, both now view the switch, not as an equal opportunity for gain as they did before, but as a loss. Sarah would lose £1,000 a month, and Izzy would lose one day of holiday a month.
This leads to Kahneman’s important assertion in Thinking, Fast and Slow:
‘Tastes are not fixed; they vary with the reference point’.
This is a vital truth to understand for business purposes.
The business case - how can you utilise this?
The main focus here is market research. If you are going to ask questions, make sure you frame them in order to gain answers of value.
Understanding your customers’ reference points is essential for this; better yet, engage with their referring point by offering perspective to qualify the answers you receive.
For example, do not simply ask: ‘Which of these do you prefer?’ and show two near-identical shoes.
‘If you were on holiday at the beach, and you could take one pair of shoes with you, which would it be?’
Suddenly, the customer has focus. You are tapping into their desire not to lose an option, so the focus will be greater. Like real life, they would have to make sacrifices. That kind of qualification will bring the theoretical questions into a grounded, and actionable, answer.
There are numerous ways to tap into the loss aversive instinct. Essentially, it is important to think about the consumer, and how you frame questions, so that you get answers that reflect how people attribute value in real life.
Framing the choice - data, loss, and you
This next example is to demonstrate the importance of framing, and how you should take care to evaluate the data presented to you.
A deadly strain of flu has infected 600 million people.
There are two drugs that can help, and you can only put one into production; note, if you do nothing, everyone will die.
Drug A - guaranteed to save 200 million people.
Drug B - ⅓ chance of saving all 600 million people, and a ⅔ chance that no one will be saved.
Which would you choose?
Now consider this scenario. You have to pick between only these two new drugs:
Drug C - 400 million people will die.
Drug D - ⅓ chance that no one will die, and a ⅔ chance that 600 million will die.
Which would you choose?
If you chose Drug A in the first scenario, and D in the second, you’re not alone. As Kahneman and Tvestky note, 72% thought A was better than B, and 78% that D was better than C.
But notice, A and C are the same, and B and D are the same. Is it not strange that most people choose A in the first scenario, and shun its equivalent, C, in the second?
This can be explained through loss aversion, and the reference point that frames the choice.
In the first scenario, the choice is framed around how many people will survive; you seek out the survival choice - the sure thing of saving 200 million people. This scenario does not talk about loss, so it does not stimulate our loss aversive instinct.
In the second scenario, the choice is framed by loss - so we run to the more risky scenario that we shunned earlier, because the truth that 400 million will certainly die is hard to stomach.
Let’s not deliberate which is the morally correct choice; the point to highlight is the swing in judgement caused by phrasing alone.
Again, like our article on Denominator Neglect, you have to be on guard as to how data is presented to you, especially when the stakes, and your instinct to avoid loss, are raised.
Thinking like a trader: how to avoid aversion
Loss aversion affects different people differently
This is what behavioral economist John List found at a baseball card convention, where people can exchange their cards with other enthusiasts.
He offered people to participate in a short survey in return for a small prize - either a cup or a chocolate bar of equal value, handed out randomly.
After they completed the survey, List said to the participants, ‘We gave you a mug (or a chocolate bar), but you can trade for a chocolate bar (or mug) instead, if you wish’.
As the prizes were given out at random, you would expect a 50% exchange rate - as 50% of the participants would have preferred one over the other.
18% of inexperienced traders would exchange.
48% of experienced traders would exchange.
The inexperienced traders would have had preference, as we all would, at the start. But those preferences disappeared when they were endowed with the product.
The experienced traders showed no such cognitive bias, and pursued the product that had most value to them.
While loss aversion is difficult to overcome, it clearly can be worked against. In business, when it comes to making decisions that involve a trade-off, be like the experienced traders - evaluate opportunities for their real value. This should help you avoid the sunk cost fallacy, which can plague even the most experiences executives.
When creating surveys to understand consumer preferences, it’s important you also understand (or allow for) their different reference points.
Only by getting them to think about what they’ll be giving up in order to switch to your product or service, will you get a more accurate viewpoint of their willingness to make the exchange. Otherwise you may be receiving an overly positive reaction relative to their response in real life.
And of course, when it comes to making your own decisions, consider whether you’re genuinely evaluating choices based on their own merits, or whether there’s an element of loss aversion that’s creeping into your rationale.
If you need more help and expert advice on creating surveys that produce accurate, actionable consumer insights, get in touch with us today!