That Sinking Feeling

One of the most fundamental drives that motivates human beings is the desire to avoid losses. A long evolutionary history has assured the strength of this drive. One school of thought links loss avoidance to a more cautious lifestyle, resulting in greater longevity. Those people who weren’t hard wired to focus on avoiding losses led shortened lives, with less ability to pass along their genetics. But while it may have been a useful trait in prehistoric times, could this propensity to avoid loss lead to counterproductive decisions in the complex, modern world? A large body of scientific research seems to support this premise.

Decision science researchers have spent a considerable amount of time studying how people perceive losses and how it affects the decisions they make. One key finding of this research is a concept called loss aversion. Loss aversion is the idea that people are disproportionately impacted by losses as opposed to gains. In fact, the research typically shows that people find a loss twice as powerful emotionally than an equivalent gain. A typical experiment would ask subjects a question like the following:

  • Would you be willing to make a bet with the following rules (50% chance of winning $2000 and a 50% chance of losing $500)?

Although the bet is highly favorable, the majority of subjects will reject it.

Closely related to the idea of loss aversion is something called the endowment effect. The endowment effect states that people will value something more simply by possessing it. The economist Richard Thaler first demonstrated the phenomenon in 1980 with a landmark study at Cornell. In the study, half the students in a class were given coffee mugs. They were then allowed to create a market for these mugs, offering to sell them to classmates that had not received one. Very little trading occurred. Those possessing the mugs set minimum prices that were higher than the offering bids of their classmates. Thaler observed that the mere act of briefly possessing the mug raised its value to the owner. The prospect of parting with the mug was viewed by owners as a large loss. The prospect of owning the mug was viewed by buyers as a smaller gain.

Another concept related both to loss aversion and the endowment effect is the sunk cost fallacy. Sunk cost fallacy is a concept from behavioral economics stating that people tend to overweight past investments when deciding whether to continue with an endeavor. It is the proverbial, “throwing good money after bad” and has been demonstrated by significant scientific research. An example of sunk cost fallacy would be as follows. A man is given a ticket to this weekend’s football game by his uncle. He finds out that his neighbor is a season ticket holder and they decide to carpool to the game. On game day, the weather report is miserable. The forecast calls for a driving rain, occasional sleet and possible lightning. The man who received the gift ticket decides to stay home and watch the game. His neighbor, not wanting to waste the $150 he spent on the ticket, decides to go.

Both men were faced with the same decision: Will the enjoyment of seeing the game live exceed the discomfort experienced from the weather conditions? Alternatively, the decision could simply be framed in the following manner: On the whole, would I enjoy watching the game in the stadium more than in my family room? Notice that looking forward, both men are faced with the identical decision and alternatives. However, due to sunk cost fallacy, the neighbor is incapable of putting aside the past investment he made in the ticket.

This is all interesting from a philosophical and theoretical perspective. But where is the practical value in recognizing these issues? How can we avoid these thought traps and make better decisions in our personal and professional lives? Let’s start with loss aversion. Loss aversion can impact us in two ways:

  • It leads us to miss out on opportunities for gains
  • It motivates us to make unneeded expenditures to avoid losses

Regarding missed opportunities, loss aversion can cause us to avoid highly favorable situations because of a small risk of failure. It could be a worthwhile investment or a great job opportunity. A classic example from the investing world would be the overly cautious individual that keeps their entire 401k in money market funds. Regarding unneeded expenditures, many people buy extended warranties for products. An informed analysis shows that they are a losing proposition for the consumer. That is, the chance that you will benefit from this “insurance” is small. Yet the cost of a “policy” can run 25 to 33% of the cost of the good. Unfortunately, loss aversion causes us to value the “peace of mind” greater than the cost of the warranty.

As with all cognitive biases, the first step in combatting them is to be aware of the pernicious influence they have on your decision making. From a practical standpoint, the key to avoiding the impact of loss aversion is to mathmatically analyze an opportunity. Looking at probabilities, expected values and returns, in black and white, can help show the advantages of a particular course of action.

The endowment effect is seen in everyday life, causing people to hold on to objects that rationally should hold little value. In the home, it’s that “restoration project” that’s been taking up one garage space for the last 10 years. You haven’t found the time to start the effort and probably never will. But you just can’t “pull the trigger” and part with it. In the workplace, the endowment effect is seen when people refuse to “sunset” something they created. For example, a project manager saw themselves as the “father” of a payroll system. This system is now antiquated, unable to be expanded and no longer able to meet the needs of the business. Rather than replacing the system, the manager advocates for continued investments in the old system, not able to bear the thought of its retirement.

As with loss aversion, the key to combating the endowment effect is to coldly layout the pluses and minuses of proceeding in either direction. Let’s look at the classic car example. Although it’s hard to quantify the emotional costs of selling the vehicle. It is possible however, to lay out the costs of not selling the vehicle. There’s the insurance, the inconvenience of parking one car in the street, the cash tied up in the vehicle and the regular fights with your spouse. Recognizing these costs, and being mindful of your tendency to be influenced by the endowment effect, can provide a better framework for decision making.

Examples of sunk cost fallacy are prevalent in our daily lives. It is notable in the realm of government, where politicians argue for the continuation of ¬†wasteful programs. “We’ve already spent $3 billion on this effort, we can’t stop it now.” It’s similarly seen in the workplace. Anytime significant effort or resources have been invested, there’s a call to continue a program. Never mind that the results have been poor or that the ongoing cost/benefit picture is negative, keep plowing forward.

To combat sunk cost fallacy, one needs to take a “forward looking” view. What has been spent is water under the bridge. Looking forward, does this effort make sense? Do the expected benefits exceed the projected costs? Obviously, when looking at large scale initiatives it’s not practical to do this assessment on a continual, real-time basis. However, it is appropriate to look at them as a part of a regular budget cycle to determine if they should continue to be funded.

Loss aversion, the endowment effect and sunk cost fallacy are related thought traps that all involve cautiousness and regret. They cause us to miss out on opportunities, buy unneeded insurance and overweight the value of past decisions and investments. These biases are deeply tied to our innate human emotions. They are therefore difficult to cast aside. However, having a strong knowledge of their impact and utilizing coping strategies can give you a fighting chance. By doing so, you’ll ultimately make better decisions that benefit you and your firm.

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