We find it difficult to sell our house at a price lower than the original purchase price. The fact that every other house has also dropped in value is seemingly irrelevant. Depreciation is regarded as a loss on investment. Therefore we stick to an inflated price and we lose out on potential buyers. The difficulty in taking a loss is called loss aversion (Kahneman, 1990). In this blog post we will discuss some implications, particularly for risk readiness.
Loss and risk
Loss aversion has some paradoxical aspects, especially in relation to risk readiness. You might expect that we would be willing to take more risks if things are going well. During such phases we are more resilient and can easily handle setbacks. In that line of thought, we ought to be more careful when things do not go smoothly. The reverse, however, turns out to be the case. Once we are in the winning mood, we mostly play safe. We limit our risks because we want to preserve the achieved profit. Should things go less well, we hope to set things right by taking more risks, thus evading our loss. So whilst we are enjoying success we are more cautious, when we are losing, we take more risks.
What is a loss?
The question is when are we influenced by loss aversion. There are several events that can evoke a sense of loss. Apart from the above example, depreciation of property below the purchase price, loss is also perceived when we need to make an additional investment or when we are late for an appointment. Actually, every time we are about to miss a target, we experience it as a loss.
Because goals are often sharply formulated in business, the possibility of a loss experience at the end of a period is not imaginary. When we are about to miss a deadline, there is a temptation to take shortcuts, bypass safety procedures or skip a pilot phase. Due to this, the occurrence of a possible risk increases. The greater the potential loss, the more we are prepared to make a last desperate attempt to save the whole activity. In sports, we speak of a final offensive: applying pressure to an opponent towards the end of the game to the point where even the goalkeeper is allowed to attack. By this they risk everything in the pursuit of victory and compromise the whole defense, leaving the goal literally wide open and accepting that degree of complete vulnerability.
The downside of targets
While targets are intended to encourage people to perform better, they also have a downside. They can seduce us into risky behavior, something we wouldn’t do given sufficient time or resources. Unreasonable risks are seldom taken at the onset of a project, but usually at the end. This can lead to serious damage. The financial crisis was partly caused by the banks failures to meet their own benchmarks. Even respected banks were tempted to purchase products with a high-risk profile although they didn’t have enough funding to compensate potential losses. Some of them were bankrupted, many needed government support. Considering this, all of us still reap the bitter fruits of loss aversion.
It helps to realize that loss aversion exists and that we can all suffer from it. As soon as we gear up a project just to meet a deadline, our alarm bells should start ringing. A sudden willingness to take an additional risk won’t help anybody in the long run. We put our environment and ourselves at risk. In general, we should be alert especially in cases where a project is behind schedule. If there is pressure on the boiler, it is advisable to maintain an awareness of circumstances and to offer support if needed. The main message is that risk management benefits from organizing work in such a way that everyone can rely on a good outcome. This allows us to opt for the most secure way of working.
About the Author
Juni Daalmans is author of Human Behavior in Hazardous Situations and works for the Daalmans Organizational Development Office. Save 30% on your very own copy of Juni’s book. Just enter “SAVE3013″ at checkout.