Psychological Effects: Loss Aversion

March 11, 2015 | By Shaun Geertshuis

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Loss aversion is a psychological effect in which people strongly prefer avoiding losses rather than acquiring gains. It is an irrational effect on behaviour, which leads us to weigh the potential of loss as more important. This leads to the avoidance of risk, even if there is a high potential for gain. It also leads to people to committing to an unfavourable course of action (continued investments in a failing project) if getting out of the situation will lead to a clearer loss.

To give a clear example of this in real life, here is a summary of an anecdote from the book Sway (Brafman & Brafman, 2009):

At Harvard Business School, a professor performs an experiment on the MBA students. This takes the form of the auction of a $20 bill. Everybody can place a bid, but there are two rules. The first is that bids must be made in $1 increments and the second is that the first person wins the $20, but the runner up must still honour their bid with nothing in return. In other words, the person who bets the highest gets the $20 and the second person forfeits their bid and gets nothing in return.

The bidding starts quickly as people sense they have an opportunity to make money. The professor says the bidding starts in a flurry until the betting hits the range where somebody is on $16 and the runner up is on $15. This is the point where the bettors realise they are not the only ones with an idea of making some money. It is also the point where they realise that the professor has made his money back. Everyone starts getting jittery and all except the two highest bidders drop out of the auction.

The two students with the highest bids get locked into the process. The one bidder has a $16 bid and the other has a $17 bid. The one who has bet $16 must raise his bet to $18 or suffer a 16 dollar loss. Their eagerness to make a profit turns into a motivation to avoid loss. They begin paying money not to lose. The betting starts to run away from the bidders and it goes up $18, $19, $20, $21... Of course as the betting goes past $20 there is quite a bit of laughter.

From a rational perspective, the bidders should cut their losses and stop, but the bidding actually goes out of control with both parties not willing to accept being the bigger loser. The students are pulled into the energy of the betting - their commitment to their path and their avoidance of their ever increasing losses pushes them deeper and deeper into a bad situation.

The highest bet ever reached in the professor's class is $204. The professor has never lost any money with this experiment. There are many other real-life examples of loss aversion and it applies most to business, where we make decisions around profit and loss every day. This effect can also influence our personal lives, where we invest a lot in relationships, projects and our futures.

The best way to combat irrationality and a natural but incorrect influence on our thinking is by first becoming aware of it and then monitoring your own thoughts. As you become more aware of your own biases and influences, you can at least control them. This "thinking about your own thinking" is called metacognition and it is the prerequisite for effective, accurate thought and personal development. The main point is: let go and do not become overcommitted to an illogical course of action because of the time, effort, thought and money you have already invested.

Enquire about our cognitive thinking skills courses, which all teach the skill of metacognition.

Brafman, O., & Brafman, R. (2009). Sway: The irresistible pull of irrational behaviour. London, UK: Virgin Books.