with Cal Furlong

BACKGROUND OF THE LOSS AVERSION BIAS

Reciprocity, as we have seen, is a powerful heuristic for understanding human behavior in many situations, one that can help us diagnose why certain decisions or choices are made, as well as give us strategies for engaging people in reciprocal relationships. As described at the beginning of the previous chapter, both the Law of Reciprocity and this model operate as virtual “natural laws,” deep cognitive patterns that strongly affect our behavior in managing conflict and relationships. This second powerful law for understanding behavior is the Loss Aversion Bias.

Consider some of these strange but common behaviors:

• Taxes vs. Rewards: To reduce the use of plastic bags, it was found that imposing a cost of $.05 per bag reduced plastic bag use by 42%. Yet offering to pay a reward of the same $.05 for not using a plastic bag resulted in no reduction at all.¹
• Free Trials: One of the most commonly used and effective marketing tools is offering a free trial of a service to potential customers. Netflix is one of the most successful companies to market using this approach, converting almost every single one of their free trial users into paid subscribers. Many, of course, initially signed up to get free access for a while, fully intending to cancel before having to pay; 93%, however, stay and pay.
• The Stock Market: When a stock goes up, many people who own the stock choose to sell it and capture the gain. When a stock goes down, however, stockholders are much more likely to hold on to the losing stock, behaving like they haven't lost anything until they actually sell it.

What is going on? Why would rational people sell a stock going up in value sooner than sell one that's losing money? Why would many people stop using plastic bags when charged five cents but not stop using the bags when offered the exact same amount as a reward?

It turns out that people have a powerful built-in bias, one that motivates us to avoid anything seen as a loss much more powerfully than seeking anything seen as a gain. The thought of losing, in other words, is far more abhorrent than the excitement of winning the exact same amount is appealing. And the vast majority act accordingly, even when it may not be in their best interest.

Loss aversion unconsciously guides a great deal of human behavior. Although the idea of seeking gain and avoiding loss seems pretty obvious, what isn't obvious is the fact that feeling the pain of losing registers at least twice as sharply as the satisfaction of winning or gaining.² In other words, the feeling of losing is amplified by at least a factor of two. The result is that the fear of losing overpowers any desire of winning by a large margin.

In our previous examples, this means:

• Our use of plastic bags is unchanged even when we're rewarded for the behavior, as the gain is simply not as valuable to us as avoiding a tax. When we directly lose money for using the bags, however, we change behavior quickly.
• Subscribers to Netflix, once they have the service as a free trial, are very reluctant to lose access to that service, even when it starts costing money. This aversion to losing the service will keep them paying for it, even if they use it far less than expected.
• Investors refuse to sell a plummeting stock and crystalize their loss, thinking that it isn't really a loss until it's sold. At the same time, they will sell a rising stock to make sure they don't “lose” the increase they have today. The net result is a portfolio accumulating far more losing stocks than winning ones.

How does this amplification of losses unfold in our lives? Loss aversion drives behavior in two specific ways.

• When presented with a chance to win or gain something, we avoid risk and want certainty. For example, given the choice of $900 cash right now, or a 90% chance of winning $1,000 instead, almost everyone chooses the certainty of $900 now. A majority of people will even choose $500 right now against a 90% chance of winning $1,000! When seeking gains, certainty and risk avoidance are preferred.
• When presented with a loss, however, the opposite is true—risk-taking is preferred over certainty. For example, given the choice of losing $900 right now, or a 90% chance of losing $1,000 (i.e. a 10% chance of losing nothing), most choose to take the risk—they choose rolling the dice for a 10% chance of losing nothing, even though it means a 90% chance of losing even more! Trying to avoid the loss drives people to take very large risks. In gambling, after losing a bet, the famous “double or nothing” becomes very attractive. It has caused many a person to double their losses in pursuit of avoiding any loss at all.

In all of our negotiations and interactions, loss aversion is pulling our decision-making in one direction—avoiding losses at almost any cost. The question we should ask is this: Is this unconscious bias helping us make good decisions or bad ones?

DIAGNOSIS WITH THE LOSS AVERSION BIAS

Essentially, loss aversion distorts the facts and information we are using to assess a situation as we try to make a decision. As in Figure 9.1, a smart approach is to logically assess and balance the gains against the losses a situation presents us and use that assessment as the basis for our choice. If the gains outweigh the losses for a particular option, even if only marginally, it would be rational to opt for that choice.

Unfortunately, in most situations we are unable to assess gains and losses rationally and precisely. As we see in Figure 9.2, the simple fact that losses carry more weight than gains distorts this assessment by a factor of two or more, even when the potential gain and potential loss are equal.

When losses are amplified by the Loss Aversion Bias, the balance tips toward any decision that minimizes the chances of losing, even if it means giving up any sort of gain. Our goal quickly shifts away from maximizing our gains and toward minimizing our losses.

The idea of loss, however, is complex. Loss is evaluated individually—everyone “codes” for loss a bit differently. Different types of loss may include:

• Monetary: Money is probably the easiest measure of value to quantify, assess, and compare. It serves as a metric or a counter for gains and losses in many situations, and is easy to calculate.
• Emotional: In many cases, however, money represents winning or losing, which is an emotional gain or loss, and the actual money is insignificant. In a $1.00 gentleman's wager, what's really at stake is the emotional gain of bragging rights. Other emotional needs³ include:
  • Respect: Losing respect is seen as a significant loss, and people will often strongly react to anything that makes them feel as though they are being disrespected.
  • Status: Loss of social standing in group settings is a powerful type of loss that motivates many seemingly irrational behaviors.
  • Face: Losing face, being seen as weak, is one of the strongest types of loss—often resulting in self-detrimental decisions. When agreement would be seen as “backing down” or “giving in,” even if, on balance, it works well for many of the parties' substantive interests, it is often rejected. Loss of face will trump monetary gain in most situations.

When diagnosing the impact loss aversion is having in a situation, listen and watch for how each party (yourself included) is coding or assessing wins and losses:

• Are the parties speaking of various solutions from a win or loss perspective?
• What issues or concerns are they most emotionally tied to? Ask them what they feel they are losing.
• Are the parties unable to accept a solution because it requires a sacrifice, even a relatively minor one? Are they struggling to let a particular issue go?⁴
• What data or information does their assessment of the gains and losses rest on? Is there good information that justifies their assessment, or is it mostly based on worst-or best-case assumptions?

With the answers to these questions, you can assess how much their position is based on the avoidance of what they see as a loss and how much is based on a wholistic and factual analysis of the situation.

Next, get a clear picture of their “frame” on the situation, why they see something as a benefit or a cost. To do this you need to find the point from which everything else is seen as either a gain or loss. This will give some insight into how they contextualize the situation.

• Where is the neutral point that they see as neither loss nor gain?
• Do they see the status quo as their starting point for deciding what is a loss and what is a gain?
• What are their goals? What do they want to achieve in this situation? How were these goals set?

By diagnosing a situation as described here, a clear picture of what each person sees as a loss can emerge, and the lens of loss aversion can then shed light on why each party is behaving the way they are.

CASE STUDY: LOSS AVERSION DIAGNOSIS

When the promotion was first announced, Bob figured it was almost certainly his for the taking. After all, he had a long track record of reliable productivity and had more than a decade of seniority over the only other candidate, Diane. The promotion, in his mind, was already his. It would not only be recognition for his long service but would come with a pay increase as well. When he lost the initial competition, however, he felt like it had all been taken away in an instant—the pay raise, the recognition for his years of service, everything that was rightfully his, all gone. He filed a grievance.

When the first competition was overturned, everything felt restored, for a short time. But when he lost the second competition by an even larger margin, the loss hit him again, harder. To make matters worse, his own union deemed the competition fair, and he was powerless to challenge the result. Bob shifted from trying to win or gain the promotion and tried to minimize his losses. When his reporting relationship with Sally was taken away, he simply went around Diane to Sally—and was threatened with disciplinary action. After more than 11 years working directly under the manager, he was now reporting to an intermediary supervisor, and the loss of access felt to him like a demotion.

Diane was elated when she found out she was going to be promoted, but Bob's grievance and the subsequent discussions between Sally and the union had led to her appointment being revoked. Although she had initially felt the promotion was a bit of a long shot, having been offered it once made her feel like it was rightfully hers. Had the promotion been overturned she would have felt like something was being taken away from her. Fortunately, that didn't happen, and she was excited to start her new supervisory role. That excitement, however, was short lived, as Bob refused to acknowledge her authority, take any instruction, and consistently went over her head. Diane had gotten the pay raise but was being deprived of her supervisory status and responsibilities in relation to Bob. She started thinking about how she might discipline Bob to make him give her the respect her new position was owed.

Bob's borderline insubordination also had an effect on Sally, who felt like her authority as manager was being eroded and undermined. Bob's work-to-rule approach also made her feel as though she had lost a productive worker in Bob.

All three participants reacted emotionally and angrily to the situation. Even though Bob still had the same job, pay, and benefits he had been happy with for over a decade, even though Diane had a promotion and pay increase, and even though Sally was expanding her team and its capabilities, all three focused on what they perceived they had lost. The Loss Aversion Bias had focused everyone on trying to minimize their own losses instead of on productive, collaborative problem solving.

STRATEGIC DIRECTION FROM THE LOSS AVERSION BIAS

Loss aversion is one of the most difficult cognitive biases to recognize and address. That said, there are choices and strategies that can be used to refocus the parties' decision-making away from minimizing losses and back toward maximizing gains.

Loss aversion is both driven by, and dependent on, each person's definition or assessment of what is a loss and what is a gain. How are gains and losses determined? First, everyone unconsciously sets an anchor or neutral point against which anything better is seen as a gain and anything worse is seen as a loss. This anchor is called a “reference point,” and it's from this reference point that all gains and losses are determined. This reference point influences the framing of each outcome as either a loss, a gain, or neutral.

Typically, there are two main types of reference points that people use to judge outcomes:

• Status Quo: The status quo is the simplest and most common reference point. In other words, what exists today is unconsciously seen as the neutral point, and anything better than the status quo is a gain, whereas anything below the status quo is a loss. For example, if an employee regularly receives a $1,000 bonus each year from their employer, then any bonus larger than $1,000 is a gain, and any amount below $1,000 is a loss—even though any amount of a bonus is, well, a bonus!
• Goals: When we establish or set goals for ourselves, we are establishing reference points based on these goals. If an employee earning $50,000 per year decides to look for a better job and sets a goal of finding a new job paying $55,000, that figure becomes the employee's reference point. If the employee is offered a new job that pays only $52,000, their initial reaction would be to see this as a loss of $3,000, not a gain of $2,000 over their current salary.

Knowing the reference points and understanding the gain/loss framing, therefore, are the keys to mitigating loss aversion both in ourselves and others. The practitioner therefore needs strategies that can help change the way a situation is seen, away from a sense of loss to either a neutral outcome or a gain. In doing so, the practitioner can help the parties make different decisions.

Strategy #1: Reframe gains and losses

During diagnosis, the first step is to understand how each party is framing the gains and losses. Once this is known, the practitioner can influence each party's frame on their gains and losses, even when the reference point remains the same.

For example, in a situation where a company has had a poor financial year and needs to reduce the annual company bonus by 40%, the staff will see this as nothing but a loss. The status quo in this case sets the reference point for the bonus at $1,000 (the same as last year), and anything less is framed as a loss. As we saw in Figure 9.1, a bonus of $1,000 would be balanced, neither a gain nor a loss.

As soon as the bonus cut of 40% is announced, the balance changes dramatically. Employees now see this from a pure loss frame, well below the status quo reference point. As we see in Figure 9.3, the Loss Aversion Bias amplifies how the staff experience this loss. Notice how the employees are actually better off than if the company didn't offer a bonus at all because they still receive an additional $600—and yet they see the situation as only a loss from their reference point of $1,000.

Using Strategy #1, the company could focus on reframing the gains and losses back into balance without moving the existing reference point. First, they could communicate to all staff the fact that, historically, the total bonus paid out to all staff was 25% of company profits. This typically resulted in a bonus of $1,000, the status quo amount that everyone received in preceding years. For this year's $600 bonus, the company would still be paying out 25% of company profits just as they had always done. In Figure 9.4, if the bonus can be reframed and seen as 25% of profits, the calculation of the bonus would then move back into balance because it would no longer be seen as something the company has changed or removed. If this were communicated openly and transparently, many employees would see that they had actually stayed at their neutral point and not had something taken away.

Next, to tilt the balance further away from a loss and toward a gain, the company could institute an employee input committee to review the profit and bonus numbers on an annual basis to ensure a fair process was followed.⁵ As in Figure 9.5, this employee committee would be seen as a gain for all employees in having a voice in the process. Without changing the status quo reference point, employees might now see the whole situation as a small gain, tipping the outcome away from loss altogether.

Strategy #2: Shifting the reference point

The second strategy is more dramatic and involves directly moving or shifting the reference point until a new status quo is established. One of the most common ways to do this is to help the party move away from measuring everything against their vision of what the future should be and help them make decisions based on accepting the situation as it actually now exists. In other words, this means moving the fulcrum from being a status quo reference point (i.e. $1,000) to one based on a new reality (i.e. the possibility of no bonus at all). Once a new status quo is set, some outcomes initially seen as losses may start to be seen more neutrally, or even as gains.

Returning to the example, the company knows that because of reduced profits this year the bonus must be reduced. Because the bonus plan has not been reviewed in many years, they could embark on reviewing and redesigning the company's entire compensation policy. Based on this review, the company would then communicate to all staff that bonuses in future years would be based on both profit and achievement of goals, as follows:

• 25% of the bonus will be based on individual achievements,
• 25% of the bonus will be based on departmental achievements, and
• 50% of the bonus will be based on overall company profit.

The new system would be designed so that average performance would result in a target bonus of $600 per employee, and high performance would result in a possible $1,200 bonus. To receive the higher bonus, above average performance in one or more of those measures would be required. The new system would be implemented for the following year.

The company would still have to decide what to do about the bonus for the current year, given that profit has been sharply reduced. To communicate this, they could announce that senior management is assessing whether any bonus can be paid this year at all.

As in Figure 9.6, the announcement that a bonus may not be possible at all this year would be seen as a significant loss, amplified by the Loss Aversion Bias. It would also, however, cause the reference point to shift sharply to the left, setting a new status quo based on the possibility of zero bonus this year. The old status quo would be completely upended.

Because of this perceived loss, some employees might start thinking about their alternatives, such as quitting and looking for another job. As discussed, when faced with a loss people sometimes become risk seeking and consider taking even larger risks in an attempt to minimize this loss.

Finally, after fully considering the situation, the company and the board of directors could announce that out of fairness, there would still be a bonus in spite of the reduced results. For this year, as in the past, the bonus would be based on 25% of profit, $600 per employee. The following year, the new bonus system would be in place, along with the employee input committee.

As in Figure 9.7, there would still be some impact from the Loss Aversion Bias because employees would be well aware that the bonus is lower, but with the reference point now shifted toward zero, the $600 bonus would not be seen as a loss, simply a smaller gain—a result much easier to accept. The employee input committee would remain an additional gain as well. Seeing the bonus and the committee as gains would change the assessment, and now the employees' tendency would be to seek certainty—the gain of $600 as a certainty is much better than the risk of looking for a new job. Resetting the reference point is a powerful way to manage expectations.

It should be noted that Strategy #2, Shifting the Reference Point, can provoke strong and negative responses, at least initially. In many cases, parties to a conflict must confront their Best Alternative To a Negotiated Agreement⁶ (BATNA), or other worst-case scenarios, in order to shift the reference point in a different direction. Reality testing can be painful. That said, however, if a status quo or goal-based reference point is neither realistic nor at all possible, helping a party to shift their reference point may be necessary.

CASE STUDY: LOSS AVERSION STRATEGIC DIRECTION

Using Strategy #1, Reframe gains and losses, the first step for the practitioner would be to meet with Bob to understand what he saw as his most significant concerns in terms of not receiving the promotion, and identify the most important ones. If, for example, Bob saw it as a loss of status in the eyes of other staff, the practitioner could work with Bob, Sally, and Diane to reframe this loss into some gains without changing Diane's promotion. For example, they could explore:

• Giving Bob a leadership role in certain special projects, along with a “project lead” title so other staff would see that he remained an important employee in the department, and
• Showing Bob how Diane would now be taking on some of the more tedious administrative tasks as part of her new role, freeing him up to take on some project lead work.

This approach could help Bob see some direct gains in Diane moving into the new position, which could help rebalance his framing of the losses and gains enough for him to accept her promotion.

If, however, Bob saw the most significant loss as losing his connection and direct relationship with Sally as the manager, a different strategy might help reframe the new status quo. The practitioner could help Sally and Diane look at ways of establishing some direct communications between Bob and Sally, in a way that still supported Diane to be effective as a supervisor.

Using Strategy #2, Shifting the Reference Point, the practitioner might recognize that Bob's reference point was stuck on his goal of being promoted into the supervisor role. As long as that remained Bob's reference point, he might continue to see any solution where Diane remained in the AS-1 role as a significant loss. To address this, the practitioner could meet with Bob and Sally and discuss his options if he continued to refuse to work with Diane. These would boil down to Bob resigning from the organization, taking a transfer to the nearest office where he would not report to an AS-1 as of yet (a substantial increase in commute time for Bob), or in the worst case, termination. Exploring Bob's interests in each of these options would help Bob see that the goal of owning the AS-1 position might not be a relevant reference point to base his decisions on. The practitioner would then seek to help shift his reference point to the new status quo—Diane in the AS-1 role. Based on this shifted reference point, Bob could see that his other options carried significant losses, much larger than the new status quo. His new reference point would start to include Diane as the AS-1, and the modifications to his job duties discussed with Sally and Diane would start to be seen as gains, even if small. Loss aversion would then virtually cause him to seek the certainty of the small gains rather than risk much larger losses.

ASSESSING AND APPLYING THE LOSS AVERSION BIAS

Loss aversion is a challenging bias in human interactions, in that it causes an overfocusing on anything perceived as a loss and an undervaluing of anything that could be seen as a gain. This process often distorts human interactions significantly and can drive parties to take greater and greater risks in an effort to minimize their own losses. Ironically, attempting to minimize losses through risk taking usually ends up maximizing them, due to the costly nature of conflict itself.

The strategies discussed here are useful for helping the practitioner address this bias in two major ways. First, as in the examples, the strategies can be applied reactively—used to help people reframe away from the negative, the loss, and rebalance the reference point after the fact. Second, by understanding the Loss Aversion Bias, practitioners can learn to anticipate the impact of the bias and can help parties proactively frame difficult situations ahead of time. This can be done by deliberately changing the reference point before a loss is perceived by the parties. Although each situation is unique, understanding the amplification of loss that loss aversion creates can help parties navigate one of the most difficult cognitive and emotional biases people have.

ADDITIONAL CASE STUDY—LOSS AVERSION

In this case study, the practitioners relied heavily on Strategy #2, Shifting the Reference Point, as well as some of Strategy #1: Reframe Gains and Losses.