Master the Art of Business
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Loss Aversion is the tendency for people to respond twice as strongly to potential loss as they do to the opportunity of an equivalent gain.
Loss Aversion explains why uncertainty appears risky, and why perceived threats usually take psychological priority over potential opportunities.
Recently, my wife Kelsey decided to withdraw some funds from an investment account. When the brokerage deposited the money into her bank account, they deposited an additional $10,000 by mistake.
Rationally, it shouldn’t have been a big deal — it was a simple mistake that was easily corrected. Emotionally, however, Kelsey felt like she was “losing” the extra money, even though it wasn’t really hers at all.
Loss Aversion is the idea that people hate to lose things more than they like to gain them. There are very few relationships that psychology is able to quantify, but this is one of them: people respond twice as strongly to potential loss as they do to the opportunity of an equivalent gain. If you look at your investment portfolio and notice that it’s increased by 100%, you’ll probably feel pretty good. If you notice that your portfolio went down 100%, you’ll feel horrible.
Loss Aversion explains why threats typically take precedence over opportunities when it comes to Motivation. The threat of loss used to require immediate attention, because losses were extremely costly — even life-threatening. Losing a loved one to a predator, sickness, exposure, or starvation is universally a horrible experience, so we’re built to do everything in our power to prevent that from happening.
The potential losses we typically face now are rarely as serious, but our minds still give them automatic priority.
Loss Aversion also explains why Uncertainty appears risky. Depending on the study you look at, anywhere between 80-90% of adults think it would be great to own their own business and work for themselves. If that’s true, why don’t more people start businesses? Loss Aversion: the threat of losing your job commands more attention than the opportunity to create a new self-sustaining business. The thought of starting a business, on the other hand, involves the specter of potential loss, which prevents people from getting started in the first place.
Loss Aversion is particularly pronounced in recessions and depressions. Losing a job, a home, or a significant percentage of your retirement fund isn’t life-threatening, but it feels horrible all the same. As a result, people tend to become more conservative, avoiding risks that could make things worse. Unfortunately, some of those risks—like starting a new business—may actually present a major opportunity to make things better.
The best way to overcome Loss Aversion is to Reinterpret the risk of loss as “no big deal.” Casinos are in the business of overcoming loss aversion every single day—in a sense, the ostentatious buildings on the Las Vegas Strip are enormous monuments to human stupidity. If Loss Aversion is such a big deal, how do casinos encourage people to play games in which they’re mathematically certain to lose money?
Casinos win by abstracting the loss. Instead of having players gamble with currency, which is perceived as valuable, the casino converts currency into chips or debit cards, which don’t feel as valuable. As the player loses this “fake” money over time, the casino will provide “rewards” like free drinks, T-shirts, free stays in the hotel, or other benefits to alleviate the sense of loss. As a result, losing becomes “no big deal,” so players continue to play—and continue to lose money night after night.
Loss Aversion is why Risk Reversal is so important if you’re presenting an offer to a potential customer. People hate to lose, which makes them feel stupid and taken advantage of. As a result, they’ll go to great lengths to ensure they don’t lose, and the best way to ensure that they don’t make a stupid decision is to not buy your offer in the first place. If you’re in the business of making sales, that’s a big problem.
Eliminate this perception of risk by offering a money-back guarantee or similar risk-reversal offer, and people will feel the decision is less risky, resulting in more sales.
"Our doubts are traitors, and make us lose the good we oft might win, by fearing to attempt."William Shakespeare, Measure for Measure
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Master the Art of Business