Friday, October 4, 2013

Loss Aversion

I hate to lose more than I love to win, once said Larry Bird. And this says it all, it is in essence what loss aversion is all about. And it's not just Larry Bird, we all feel like that and this feeling we have makes us do things that don't make much sense and that are one the best of our options.
But let's take a closer look at this loss aversion bias before we set in the context of Project Management, OK? And for more information on irrationality, check these other articles.

Defining Loss Aversion

As the other "irrational" topics I've been writing about on the blog, loss aversion is not something new at all. But loss aversion only recently (1979) got the spotlight with Daniel Kahneman's Prospect Theory (later on -2002- those works of his got him the Nobel Prize for - not Psychology, not Sociology but - Economics). If you check Wikipedia for it you'll see loss aversion defined as "people's tendency to strongly prefer avoiding losses to acquiring gains". Simple, but what does this mean?

30 day money back guarantee

One common example that shows how this loss aversion thing works is  the "30 days money back guarantee". How does this work? Suppose you want to buy some new furniture but you're not sure if this particular item will be right for you. If the salesman says that you can take it home and try it out for 30 days and return it then if you're not satisfied, what is there for you to lose? Nothing, right?
Well, actually that's wrong. The fact is: if you take the furniture home, odds are you'll never return it. Why? Because if you do return it it would feel like you were losing something... once you get it, you feel like you own in and you'll never return it as much as you wouldn't offer your own microwave oven to a supermarket.


Some games, such as Farmville, take advantage of this loss aversion to keep gamers returning to play. This is simple to do, all you have to do is make the gamers miss something if they don't get online. On Farmville they do it making the gamers lose their crops if they don't collect it on time.
It's not that the gamers will get something if they do get online; it's the fact that they'll lose their crops if they don't. Still can't see the difference? Just suppose that you didn't ever lose your crop on Farmville, you just needed to get online and pick it up to have your "win". The scenario is exactly the same, just without the "lose" side, right? That is the difference, it is that possibility of some loss that makes the gamers return online.
And when they come online to pick up the crop so they don't lose it, then then will also plow this field - and do this and that. And so the game goes on. And on...

Sunk costs

What does lost aversion have to do with Project Management? You can have a few takes on this, but sunk costs (that is, the money already spent that you can't get back) is an obvious one.
So from the beginning: have you noticed that the more you spend in a project the more difficult it is to stop it? Even if the return won't ever cover the costs? Or even it doesn't make sense anymore? Have you ever notice this?
The Concorde story is the same on many projects: sometimes a project gets to a point where you have to put some additional money if you still want the same benefits. And so you do it, you put some additional money on the project. And then the same happens again, and again you put some more additional money into the project. And then the same happens again and again and again....
You end up in a situation where your project (and this is actually what happened with the Concorde) where the money spent is a lot more than the money you'll ever make with the project.
How is this possible? Loss aversion is at play in these cases, and here's how this works. Imagine yourself managing the Concorde project. Your situation is as follows: if you put 1 million USD into the project you'll get all the prestige (and money, loads of money, maybe 10 times more than that additional 1 million USD) that these airplanes will bring. If you don't put 1 more million, you'll get nothing, zip. And you'll lose whatever you've already spent. What? How much would I lose? No way, I'll find a way to get 1 more million into the project, but I won't lose the money I've already spent without getting anything in return!
And this how things like the Concorde happens. And how to avoid it? The best approach is as simple as the following (and it's called cost-benefit analysis):
  1. Take a scenario
  2. Sum all the costs related to this scenario
  3. Sum all the benefits related to this scenario
  4. Register the difference between benefits and costs
  5. Choose the scenario with biggest difference
This way, following this procedure, it is really difficult for someone to find an argument  for not choosing the scenario with the biggest difference between the benefits and the costs - but be prepared because some people will try it nevertheless!


Irrational behavior is all around us. And it is all around Project Management as well, and in particular it is such a bias of ours that is involved in the sunk costs fallacy - very much a Project Management thing. We can even reason (or at least try to) justifications for this, but bottom line is we have to learn to live with such behaviors - they are all but natural behaviors.
And keep in mind that irrational behavior is not stupid behavior. But in this case of the sunk costs fallacy, you must take a rational approach when you're evaluating scenarios such as the ones on the Concorde case.
And if you want to know a bit more about this loss aversion bias, check this paper "The Sunk Cost Effect In Pigeons And Humans". Yes, pigeons are involved in the experiments. And yes, we would take the same options as the pigeons on those experiments. Check it out if in doubt! And in this case, also check the Endowment Effect that builds on the loss aversion bias.

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