Losses Loom Larger Than Gains.

“Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. Nobody ever saw one animal, by its gestures and natural cries, signify to another ‘this is mine, that yours; I am willing to give this for that.’”

Adam Smith, 1776

The quote above is from none other than the father of classical economics himself, Adam Smith (1776). Smith was remarking on the unique ability of humans — and humans alone — to engage in deliberate economic exchanges. In fact, in an uncharacteristically boisterous interview shortly after Smith's masterwork The Wealth of Nations was published, Smith, surrounded by his entourage of fellow economic theorists, jokingly told a reporter "I mean, I'd like to see a bunch of stupid monkeys learn to use money, right fellas?!" And he and his pals all had a good laugh.

(I am legally obligated by the estate of the late Adam Smith to disclose that the last quote cannot be officially attributed to him.)

Okay, fine — so maybe Smith didn't say that exactly, but the sentiment was clear: it is only humans who possess the cognitive wherewithal to conduct such sophisticated exchanges. For centuries, this prevailing wisdom remained widely untested. However, about a decade ago, a group of researchers at Yale (Chen, Lakshminarayanan, & Santos, 2006) set out with a bold goal in mind: to investigate the economic behavior of monkeys. The process was simple in theory: provide the monkeys (more specifically, capuchin monkeys) with a source of currency and then observe the decisions they make concerning how to spend said currency.

However, before the team could begin, they were faced with a challenge: teaching the monkeys that the currency they had chosen (small silver coins) had value. I'll spare you the details, but suffice it to say it took months of associative learning (e.g. "each time that scientist gives me a treat, she takes a coin") before the monkeys eventually got the hang of the concept. Once the monkeys became well-adept at exchanging coins for food, thus essentially establishing a small economy, the researchers could begin testing more advanced types of economic paradigms.

The Capuchin Experiment

One particular exchange of interest was a type of gambling task. A capuchin monkey would be given a choice between two experimenters. The first (Experimenter 1) held one grape in their outstretched palm, the other (Experimenter 2) stood on the opposite side of the cage and held two grapes in their outstretched palm. But the game was not as simple as selecting the experimenter who held the most grapes. Once the monkey made a selection, a coin was flipped. If the monkey had selected Experimenter 1, they either received the one grape that was in their palm, or — depending on the results of the coin flip — an additional grape was added, and they were given two grapes. Conversely, if the monkey had selected Experimenter 2, the coin flip would determine whether the monkey would receive both grapes that they were holding or if one would be removed and they would only end up with one grape.

Here's the crux of this experiment: from an economic standpoint, the options are essentially identical, as each gives the monkey a 50% chance of receiving one grape and a 50% chance of receiving two grapes. As such, an Econ — or a purely rational economic agent (as previously discussed here) — would have no discernible preference. What about our primate friends? Turns out they had a very clear preference: they chose to opt for the hand that held only one grape (which had the potential for another to be added) an impressive 71% of the time.

Why? The psychological driving force underlying the decision preferences observed in the monkeys is what is known as loss aversion. Loss aversion essentially means that the pleasure we derive from gaining something is not as great as the pain we feel from losing something of equal value. In other words, gaining $5 does not feel as good as losing $5 hurts. In the experiment above, prior to the coin flip, Experimenter 1 represented a potential gain (i.e. a grape could be added) while Experimenter 2 represented a potential loss (i.e. a grape could be subtracted). This is why the monkeys preferred Experimenter 1. Each time they chose Experimenter 2, there was a chance they would have to watch as one grape was removed, and that type of loss hurts.

Humans Are No Different

At this point many of you are probably leaning back in your chair, smirking with a smug sense of Smith-like superiority. "Stupid monkeys and their irrational, loss-averse economic decisions." Well, not so fast, other primate. Unfortunately, chances are your economic sensibilities are more capuchin than your self-assured grin might suggest.

In fact, humans are just as loss averse as the capuchin monkeys at Yale. To prove it, consider the hypothetical below:

You are sitting in a park when an individual walks up to you and offers you an opportunity to gamble for some money. He tells you he'll allow you to flip a coin, and the results of the flip will determine whether you win $1,000 or lose $1,000. Would you accept his offer?

Chances are, your response will be a polite "thank you but no thank you." Although the prospect of walking home $1,000 richer is enticing, it's not quite as compelling as the fear of walking home $1,000 poorer. In fact, to really drive the point home, here's an interesting exercise: take a moment to figure out, if the winning amount were to be kept stable at $1,000, what the potential losing amount would have to be for you to accept the offer. If you're like most people, the ratio of potential win to potential loss probably has to be in the realm of 1.5:1 to 2.5:1 (i.e. "I'll accept the gamble to win $1,000 if I'm only risking a loss of somewhere between $400 and $666).

Prospect Theory

Prior to the discovery of loss aversion, the effects of certain decisions (financial and otherwise) on net happiness (which economists would refer to as utility) was typically conceptualized as a linear impact. For instance, a $500 gain and a $500 loss would represent equivalent (yet inverse) changes in utility. However, as we can now clearly see, losses and gains do not affect us in identical ways, and therefore a linear model is incorrect; we need a model that incorporates loss aversion, making the happiness we lose when losing $500 greater than the happiness we gain when gaining $500. Moreover, a linear model ignores the relativity of changes. Sure, gaining $500 should make anyone happier, but this increase in happiness is not static across people, it depends on that person's current financial circumstance. For instance, for someone who has been deprived of a steady source of income for an extended period, a sudden $500 gain might have them grinning from ear-to-ear whereas an identical gain might not even get billionaire Warren Buffett to crack a smile. This is because the psychological effect of a $500 increase in net wealth is dependent on current wealth, or your reference point.

Enter prospect theory, a means of addressing the aforementioned issues of linear models of utility fluctuation. (Note: For those who almost fell asleep after the phrase "utility fluctuation," stick with me; I promise it gets more interesting.) The theory was forwarded by Nobel Prize winner Daniel Kahneman and his longtime collaborator Amos Tversky. Picture a graph of prospect theory in your mind, and you can clearly see that the curve is certainly not linear. The first thing we should notice is that the slope is steeper in the loss column than in the gain column; this captures the human inclination toward loss aversion. As you can see, losing $100 has a more profound negative psychological impact than gaining $100 has a positive psychological impact. The second thing to notice is that the slopes start to "level off" as our dollar amounts get larger (in the negative and in the positive). This feature captures the second issue discussed above, which is the issue of relativity. The pleasure of going from $0 to $100 has greater psychological value (i.e. will bring greater happiness) than going from $100 to $200, and so on. Just like 60 degree weather can feel cold after months of summer or warm after months of winter, gaining $100 can feel incredible to someone who has very little money (i.e. a lower reference point) and very ordinary to someone who has an immense fortune (i.e. a higher reference point).

Framing And The Endowment Effect

Loss aversion can be leveraged to guide people toward making certain decisions and resisting others. In the previous article referenced above, I also discussed a concept known as choice architecture. As some readers may recall, a central tenet of choice architecture is that by presenting identical information in different manners, organizations can fundamentally alter how people respond to available options. One way to operationalize choice architecture is by harnessing the power of loss aversion. Consider the example below:

When patients are diagnosed with lung cancer, doctors are presented with two treatment options: surgery or radiation. Surgery is the superior choice in the long run, however radiation poses less risk in the short term. There are two ways to present this data to people deciding which treatment to choose:

• Option A: The one-month survival rate of surgery is 90%.
• Option B: There is a 10% chance of death in the first month post-surgery.

Now, you'll notice that both options convey the same data; namely, that in the first month after surgery there is a 90% survival rate and 10% mortality rate. However, how the information is presented (or framed) can dramatically impact the decision you will make. In the original experiment (McNeil, Pauker, Sox Jr., & Tversky, 1982), when the results of surgery were framed in terms of survival (or gain, Option A), 84% of participants chose it. When the same probabilities were framed in terms of mortality or (loss, Option B), only 50% of participants chose it. Same information, very different decisions.

Arguably the most significant manifestation of loss aversion is what is known as the endowment effect. The endowment effect is a psychological phenomenon wherein people ascribe greater value to items simply as a result of ownership. To demonstrate this effect, Kahneman, Knetsch, and Thaler (1990) designed an experiment where two students would be paired up and randomly assigned to the role of either buyer or seller. The item provided was a coffee mug with the collegiate insignia of the respective school. The paradigm was simple: whichever student was assigned the role of seller would "own" the mug, and would state the price at which they would be willing to part with their possession, and the buyers would state the price they'd be willing to pay to acquire it. On average, buyers offered to pay $2.87 for the mug — a reasonable offer — however sellers on average said they would not be willing to part with the mug for any less than $7.12!

The massive discrepancy observed in the experiment above was due primarily to the loss aversion that is symptomatic of the endowment effect. The buyers did not own the mug, and so their bids simply reflected the amount they were willing to pay for a potential gain. The sellers, however, "owned" the mugs; they weren't just mugs, they were their mugs. As such, the inflated prices this group demanded in order to sell reflected their reticence to lose their possessions.

Another impressive demonstration of the endowment effect is discussed by Dan Ariely in his wonderfully informative book Predictably Irrational. Ariely describes the intensive process undertaken by hundreds of students at Duke University every year in an effort to score tickets to a coveted basketball game. Sparing you the extraneous details, suffice it to say that the hopeful students camp out for weeks in tents in the hopes of being entered into a lottery which will ultimately determine who will be awarded the tickets. Following the lottery drawing, Ariely and his colleague Ziv Carmon (2000) contacted students who had won tickets as well as those who had failed to have such luck. Both groups had invested the same amount of time and effort into the grueling undertaking, the only difference being some walked away with something to show for it while others walked away empty-handed. So how would they each now value the tickets? The individuals who had not been awarded the tickets, on average, said they would be willing to pay $170 for one. And those who now owned a ticket? Well, turns out they demanded, on average, about $2,400 to sell.

Why were owners valuing their tickets at such an unreasonably high price? According to Ariely, much of the inflation can be attributed to emotion. Once an individual acquires his or her ticket, they immediately begin fantasizing about the excitement that will ensue on the night of the game: the raucous cheering of the crowd, the high-spirited camaraderie of the fans, the adrenaline pumping through their veins during the waning seconds of a close game. Once these "pre-memories" have been created, selling the tickets now also includes saying goodbye to all of those imagined good times, and if you want to take that away from someone, you'll have to pay quite the price.

Virtual Ownership And Marketing Tactics

In fact, we're so sensitive to the endowment effect that it can even begin to affect us before we actually own something. Auction-style websites such as eBay take full advantage of our propensity to start imagining the joys of ownership before we've actually won the bid. This imagined (or virtual, as Ariely puts it) ownership — for instance, thinking about how nice that blender would look in your kitchen, how healthy you'd become if you could make smoothies everyday, etc. — causes individuals to value the item more, thus driving up bidding prices. It simply hurts too much to stop bidding and lose their product. And the longer the auction is active, the more exacerbated the endowment effect becomes (Heyman, Orhun, & Ariely, 2004). Part of this behavior may also be driven by the fact that selling (and, I would suspect, losing) items we had planned to use activates the regions of the brain associated with disgust and pain (Knutson, Wimmer, Rick, Hollon, Prelec, & Lowenstein, 2008).

Savvy organizations understand loss aversion and work hard to produce the endowment effect in their potential customers. Look no further than tactics such as test drives and home trials. By getting an individual to get into the drivers seat of a new car or experience a product in their own home, companies seize the opportunity to provide these undecided consumers with a sense of temporary ownership. Once we have that temporary feeling of something being "ours", we become emotional owners, overvaluing products and having trouble saying no to an opportunity to make it ours permanently. This is why many organizations offer 30-day money back guarantees. Aside from the fact that many people are too busy or lazy to return a product once they have it, companies know that if they can get something into your home and into your possession, they can also get it into your emotional embrace.

Reference Points And The Bar Effect

When my uncle graduated from a prestigious graduate school, he was offered several very lucrative contracts from large organizations. Ultimately, he opted to work for a company that had offered him a modest (albeit comfortable) salary. Many family and friends questioned his decision, failing to understand why he wouldn't just accept the highest salary possible. Wouldn't that make him happiest? Perhaps, but it also comes with risks. My uncle knew that once he acclimated himself to a particular lifestyle — one that could only be maintained via an exorbitantly high salary — there would be no turning back. Moving forward, were he to want to switch jobs, he would have to find one that matched his previous salary or raised it, otherwise it would be experienced as a loss. Similarly, when companies offer you trials of premium packages when you've only requested standard ones, it's because they know once you've known the quality of the superior offering, it will hurt to part with that and accept an inferior alternative. When the bar is set high, anything below it is consequently experienced as a loss, and as should be abundantly clear at this point, we have a strong aversion to such losses.

Loss Aversion Inside Organizations

Although harnessing loss aversion can be an effective addition to an organization's strategic arsenal, failing to address the natural tendency of loss aversion within organizations can prove costly. Richard Thaler, a brilliant behavioral scientist and one of the founders of behavioral economics, discusses in his book Misbehaving how unmitigated loss aversion in managers can stunt the growth and prosperity of an organization. Thaler notes that, in addition to the natural inclination to be averse to loss, many organizations compound this issue by creating an imbalance of incentives between rewarding risks that pay off and punishing risks that fail. In most organizations, if a manager is bold enough to take a risk and succeed, he is typically rewarded with an approving proverbial head nod from upper management and perhaps a small financial bonus; a very modest consequence. However, when he or she takes the same risk and fails, the consequences are usually far more severe (e.g. pay cuts, demotion, and even termination). This creates an atmosphere of conservatism where managers are not attempting to succeed, but rather trying to avoid failure. When this ethos pervades an organization, the company stagnates, fails to innovate, and ultimately succumbs to the will of competitors who have been bold enough to take prudent creative and financial risks.

Admittedly, not all risks are wise. Most organizations would not want their managers constantly taking foolish risks for the slim chance of a big gain. However, many risks are very much worth it, but our loss aversion prevents us from accepting them. For instance, Thaler describes a telling encounter he had with a group of managers from a large firm. He offered them each a hypothetical opportunity to accept or decline a risky proposition: an undertaking with a 50% chance of making a two million dollar profit and a 50% chance of losing one million dollars. Of the twenty three managers in the room, only three were willing to accept the risk. This hesitancy is understandable, but it is financially imprudent. Statistically, the expected payoff for each manager that accepts the risk is $500,000 (50% chance of earning two million dollars, 50% chance of losing one million dollars). This means that if every manager were to accept the proposition, the company would be expected to profit, on average, 11.5 million dollars! But due to unmitigated loss aversion, the room of managers had just left 10 million dollars on the table. If an organization wants to be optimally successful, it is imperative that they create an incentive system that appropriately counterbalances their employees' natural sense of loss aversion.

The essence of loss aversion was elegantly captured in a now famous quote from an earlier paper by Kahneman and Tversky (1979): "losses loom larger than gains." This aversion causes us to overvalue what we consider ours, avoid statistically-prosperous risks, and make irrational economic decisions. However, when properly understood, loss aversion can be wielded to the benefit of both astute organizations and informed consumers.