The Power of Loss Aversion
Want to become a more effective negotiator? One of the most powerful drivers of the decision-making process is loss aversion. Understanding the psychology of this concept and how it impacts risk management can give you a decided edge during mediations. The concept is so fundamental that it is a key underpinning of behavioural economics.
Tversky and Kahneman carried out ground-breaking research that resulted in Kahneman winning the Nobel Prize in Economics in 2002 (sadly, Tversky had passed and the Nobel is not awarded posthumously). Three critical conclusions from their work impacted what we thought we knew about behavioural economics.
- Despite classical theory, humans as individuals and in groups often make irrational economic choices.
- There are consistent patterns and causes among these irrational actions that allow us to understand and influence decision making.
- One of the strongest explanations for irrational decisions is loss aversion.
Loss aversion simply means that people are more afraid of losing something than they are attracted to gaining it. The literature demonstrates that people are approximately twice as averse to a loss as they are keen for a gain.
Imagine the following scenario: A friend offers to flip a coin and give you twenty dollars if it lands on heads. If it lands on tails, you give her twenty dollars. Would you take that gamble? For most of us, the amount we could possibly win would need to be at least twice as large—forty dollars—as the amount we could lose—twenty dollars—before we would accept the risk. Once this concept is understood, an advocate can use the principle to guide the framing, structure, and timing of offers to enhance the likelihood of acceptance while avoiding any real sacrifice.
Framing:
Before we delve into the precise process, it’s important to analyze the study that set these parameters. Tversky and Kahneman presented the following parable to a host of physicians, specifically targeted because of their training to use evidence and reason to find solutions.
The community is preparing for an outbreak that is expected to kill 600 people. Two alternate programs to combat the disease have been proposed. Which program do you prefer?
Program A: If Program A is adopted, 200 people will be saved.
Program B: If Program B is adopted, there is a 33.3% probability that 600 people will be saved and a 66.6% probability that no one will be saved.
For the same scenario the physicians were then asked to choose between the following two programs:
Program C: If program C is adopted, 400 people will die.
Program D: If program D is adopted, there is a 33.3% probability that no one will die, and a 66.6% probability that 600 people will die.
A careful read will demonstrate programs A and C are identical, as are programs B and D. Logically, if a doctor chose A in round one, they should choose C in round two, and the same with B and D. However, the physicians delivered almost reverse results with 72% choosing A in round one, but 78% choosing D in round two. Why the reversal? Framing.
In the first round, the outcomes are framed as “lives saved,” while in the second round, the propositions are framed as “lives lost.” Our emotional mind weighs the value of losses and gains in very different ways. We’re hardwired to avoid losses, even in ways that aren’t rational.
The moral of the story: Offers should be framed as the avoidance of a loss, rather than as the opportunity for a gain. In one large study involving insulation sales, homeowners who were told that failing to install insulation would mean losing X cents per day were much more likely to purchase the insulation than those who were told that it would save them X cents per day.
Framing an offer as a way of avoiding a loss is much more effective than framing it as an opportunity to gain or save.
Structure:
Our cognitive biases don’t just influence weighing loss and gain, they cause us to feel differently about the way we experience that loss or gain.
In a research study, subjects were asked which of the following scenarios would make them happier?
Scenario 1: You’re walking down the street and find a $20 bill.
Scenario 2: You’re walking down the street and find a $10 bill. The next day you are walking down a different street and find another $10 bill.
Despite the fact that the outcomes are the same, the majority of people felt they would be happier in Scenario 2.
Taking the reverse approach, subjects were asked which of the following scenarios would make them unhappier?
Scenario 1: You open your wallet and discover you have lost a $20 bill.
Scenario 2: You open your wallet and discover you have lost a $10 bill. The next day you open your wallet again and discover you have lost another $10 bill.
Once again, despite the equivalent financial outcomes of these scenarios, the majority of respondents indicated that Scenario 2 would cause them greater unhappiness. What is the conclusion from the research?
People prefer to gain money in installments, and people prefer to lose money all in one lump sum.
These findings offer clear negotiation applications. It is beneficial to structure offers to categorize gains—and spread them out over time—while one should lump together any losses in an offer and deliver all the bad news in one message.
Application:
In a typical motor vehicle litigation case, when four or five heads of damages are in play, how should each side structure their offers to have the best behavioural effect on the other party?
Plaintiffs are effectively asking their counterpart to give up something they have, or suffer a loss, so they benefit by moving to lump sum offers at an earlier stage in the process, putting the cards they are willing to show on the table early. This approach also has tactical advantages beyond the cognitive impulse that will be discussed in later issues of Negotiator’s Edge.
Defendants effectively offer a gain to their counterpart, so they are better off keeping their offers segregated by heads of damages and increasing their offers (the good news) slowly and incrementally across a number of rounds. This method appeals to our cognitive preference for gains over time. Your counterpart will evaluate the string of concessions more positively than one lump sum concession.
Timing:
People can become attached to objects or gains, even before accepting any offers. Once that attachment forms, then the loss aversion behaviour pattern starts to have an impact, even though no true loss can occur because the gain has not yet been realized. This phenomenon is called Expectation Loss Aversion or Expected Loss Aversion. This behavioural pattern needs to be carefully managed to avoid problems in achieving settlement, but it can also be leveraged to finalize resolutions.
We must be cognizant that a party can form an attachment to an outcome long before that outcome has come to pass. Counsel needs to advise their clients that best-case scenarios or aggressive opening positions are not realistic or expected outcomes, but merely a negotiating tactic or tool. A client developing Expectation Loss Aversion to an unrealistic position can be an obstacle for settlement.
To enhance the chances of settlement, a party may consider an offer as their asset and become attached to it, even before it has been accepted. This allows the power of loss aversion to propel the negotiation forward. For example, if an individual is offered $100 and has time to form an attachment to it, they may then approach the next round being protective of the $100 they now believe is in their pocket, rather than aggressively pursuing a larger figure. This makes the original party more amenable to compromise. However, people need time to form that attachment. Both counsel should carefully balance the timing and pace of offers, considering both the time needed to form an attachment and the power of urgency in moving parties towards or away from any particular outcome.
A counsel who hopes the opposition will become attached to their last offer should slow the proceedings down, while counsel seeking to avoid that connection should keep the offers moving quickly.
Possessive language can harness the power of Expectation Loss Aversion while guiding a party towards settlement. Stressing to a party that the offer in hand is effectively an asset to be protected and moving forward creates a risk of loss of that asset harnesses the cognitive impulse to resolve the case and avoid the potential loss. This approach finds its clearest expression in the well-worn but effective “Going to Vegas” analogy where the current offer is referred to as “coin in hand” and proceeding is analogized to putting that coin into a slot machine and taking one’s chances.
Take-Aways:
- In the human mind, loss looms twice as large as gains.
- Gains in offers should be categorized and spread out over time.
- Losses or concessions in offers should be lumped together.
- Parties need time to form emotional attachments to an offer.
- The language of ownership can help parties become invested in offers.