I just finished re-reading Thinking, Fast and Slow by Daniel Kahneman and the timing couldn't be more perfect. Today wraps up the busiest shopping days of the year (Black Friday and Cyber Monday) and there are so many lessons in this book about human behavior that can be extracted and applied to better understand why it is we feel so compelled not to miss out on deep discounts and VIP-just-for-you promotions.
For me, there's one lesson that stands out above all others as it is so often encountered when running a business: the lengths we'll go to avoid a loss. This aversion to loss causes us to buy things we don't need because of a perceived loss if we don't. And it influences decisions we make in the pursuit of results which are heavily biased toward how much time or money has been spent instead of how much will be spent.
Here are the 4 tips to tame your loss aversion:
Be prepared! Loss aversion is hard-wired. Just knowing that you will seek to minimize a loss rather than pursue a gain is powerful knowledge.
Two to one, you're done. Watch out for the loss aversion ratio of 2:1 (twice as much gain needed to offset a corresponding loss).
Check your sunk cost bias once a week. Ask yourself: Is this the best use of my time and money?
For big decisions, use a premortem and ensure any continued investment aligns with your values.
Loss aversion and sunk costs - the chicken and the egg
As Kahneman points out in his book, any organism is well served with the continued gift of life when perceived threats are given more urgency than an opportunity to benefit. The hunter stalking a gazelle (gain) on the plains of Africa needed to likewise keep an eye open for lions lurking in the bushes lest he is what's for dinner tonight. This same response to a threat pops up in business when we come face-to-face with a potential loss.
Think about it.
When your reputation is on the line, and you've invested tens of thousands (or more) of dollars into a new project or idea, the last thing you want to do is to admit that you’re wrong or cut your losses. It's easier to bury your head in the sand and face reality after you've burned out and have no hope of recovering your continued investment, right?
As a manager, you're probably all too familiar with sunk costs, but for those of us a little rusty on the subject, let's take a minute to refresh what is meant by sunk costs and loss aversion.
A sunk cost is any cost that has already been paid with no possibility of recovery. Sunk costs should have no impact on future decisions. For example, salaries, leases, research and development investment, and advertising expenses often fall into the sunk cost category as these costs cannot (usually) be recovered. The machine in the image at the top of this article can also be a sunk cost. Even though it may have cost $200k new and had $100k in repairs over its lifetime, a contractor should never consider these costs when determining whether or not to buy a new machine for an upcoming project.
Loss aversion refers to the disproportionate pain we feel from a loss versus the pleasure we receive from an equivalent gain. This is why losing $10 out of your pocket can ruin your day, while finding a $10 bill on the ground brings just a short burst of satisfaction.
Loss aversion is how we generally respond to sunk costs and this behavior can greatly influence how you make less than ideal decisions, and take a long time to do so. In fact, downright bad decisions are often made when you place too much weight on how much time and money has already been invested in an idea (project, customer, or employee) and not enough emphasis on how that time or money should best be used in the future.
Black Friday - loss aversion equals more AirPods
Getting back to Black Friday.
Retailers and marketers do a compelling job convincing us that a failure to buy causes some sort of a loss. By using time-limited offers, limited availability, and steep discounts, retailers guide people into thinking that an economic loss is imminent if they don’t purchase now. Our brain is telling us that to miss out on a savings is tantamount to a "loss", even though we could probably "gain" more by simply choosing not to buy or waiting until the items we really need go on sale again in the future.
As I write this article, an email just popped up in my inbox from a big box retailer advertising Apple AirPods at their lowest price EVER via an exclusive discount, available only to me for the next 2 hours. Talk about piling on loss aversion! Well done BB.
This fear of missing out can be a far greater motivator than never having known about the deal in the first place. That’s what marketers are counting on.
Lessons from a dealership - my experience in loss aversion
Finishing Kahneman's book and reflecting on how his lessons in behavioral economics apply to Black Friday got me to thinking about my own experience running a large heavy equipment dealership and how loss aversion can have a profound impact not just on the results of the dealership, but on the life of the general manager.
The aversion to loss is particularly salient in the dealership environment with respect to sunk costs in large part because of the nature of how dealerships operate. In the heavy equipment world, uptime is king (or queen). When a customer calls for a part, needs a service, or is looking to buy a machine, it's the job of everyone in the dealership to respond to these requests, and fast.
While this energetic environment can be exciting and sure makes the day pass quickly, it can also contribute to rapid-fire decision-making where managers rarely have the time to consistently make well-informed decisions. As a result, this often means that decisions are heavily biased toward loss aversion.
Here are a few examples where it's easy to hold on to sunk costs when you're averse to a perceived loss of time or money:
Spending much more time "nurturing" existing customers than hunting for new business
Spending significantly more time coaching underperformers than your top employees and hoping that they eventually improve (particularly if you hired them)
Continuing with a repair, with or without customer approval, way beyond what's reasonable considering the value of the machine just because you're already into it for several thousand dollars
Spending an inordinate amount of time trying to liquidate old inventory at a loss rather than focusing on selling new stock at a higher margin
Continuing to develop a customer with whom you've spent months engaging, yet they're nowhere near ready (or in the mindset) to buy a new machine
I've been there.
In running a large heavy equipment dealership, I've experienced first-hand the stubborn aversion to loss when reflecting on sunk costs. Cutting your losses is never an easy decision to make, but with a few simple guidelines, you can become much better at identifying when you should pursue the future benefit and not focus on how much is already invested.
It’s not all bad - loss aversion helps you persevere
Some loss aversion is a good thing.
Successful entrepreneurs know how to persevere through adversity, even when it seems like you are throwing good money after bad, to pursue a goal. This perseverance is a big differentiator between those that succeed and those that don't.
Alternatively, some of the most successful entrepreneurs are those who are more apt to recognize that taking a small loss now on a failing project can lead to big returns down the road when their resources are better allocated.
Step off the escalator of commitment
The more you commit, the more likely you are to keep committing. Here are 4 tips to help you step off the escalator of commitment and to only continue investing your time and money when it makes sense to do so:
Recognize that loss aversion is real. It exists, it's hard-wired into how you think, and there’s not much you can do about it. Whether you like it or not, your default position in making any decision is to minimize losses. You must actively overcome this bias by forcing yourself to take a glance in the rear-view mirror for lessons learned and focus ahead on how new investment (time or money) will drive the results you're after.
Recognize the warning sign of a 2:1 loss aversion ratio where twice as much gain is necessary to offset a corresponding loss. Or said differently, spending twice as much time coaching underperforming employees or nurturing existing customers compared to top performers or new clients.
Set a weekly reminder to ask yourself, is there a better use of your (and team's) time and money for the projects you're pursuing? I recommend you create a reminder in your calendar to pop up on Tuesday morning to pose this question (you’re busy enough on Monday as it is, and Friday is too late in the week to do anything about it).
Use a premortem where you and your team purposefully envision your project failing to identify weak points in your plan. This should be done at the outset of any new project, and periodically throughout a project (once per month is often enough) when there is a significant and continued investment of time or money.
Adjusting your bias toward loss aversion can be tough. The key is to recognize that it's natural to feel this way and that it's a perfectly acceptable response and good business practice to accept a loss and move on when there are better uses of your time and money.
Looks like I've spent too much time writing as I missed out on the once-in-a-lifetime discount for AirPods. I guess I'll just have to stick with my wired earbuds for now!