In the decision-making course I teach to graduate students in business, I introduce them to prospect theory and the related cognitive biases. One of these biases, loss aversion, helps explain why many individuals and organizations are unable to realize their full innovation potential.
Prospect theory and loss aversion
In their 1979 paper Prospect theory, the Israeli psychologists Daniel Kahneman and Amos Tversky introduced the theory that earned them a Nobel Prize. They described how people choose between options (or “prospects”) when their decisions involve risks, but where the odds of success or failure are known. Their findings are fascinating:
- Relative positioning. People deciding rationally would look at the final outcome of a decision, and if it leads to gain or loss in their final income and wealth. In reality, however, people are most concerned with their gains or losses relative to an external reference point. For example, if you get a bonus of 2 months’ salary while your colleague gets 4 months, you’ll be unhappy, despite getting a nice bonus, because you compare your gain to your colleague’s.
- Loss aversion. People have a more extreme response to losses than to gains. The pain of losing money is greater than the pleasure of winning the same amount. Losses can make us unhappy even if we gain overall. Imagine winning a thousand baht betting on football, but then losing 900 baht of it on your way home. Even though you’re 100 baht richer than before betting, you’re going to be unhappy because of the loss rather than happy because of the gain.
- Certainty. People love certainty, and will even give up income to avoid it. Given the option between a guaranteed win of $1,000, or an 80 percent chance of winning $1,400 (but a 20 percent chance of winning nothing), most people will choose the guaranteed win, even though the riskier option would, on average, yield $120 more. Avoiding loss can prevent innovation and progress
Why do so many businesspeople talk about innovation, but never actually innovate?
Loss aversion leads to cognitive biases that hold organizations back from innovation. What are some of these biases?
- The status quo bias is another name for our conservative nature. In contrast, innovation changes the status quo, introducing new products and concepts. But for most people, the pain of losing something familiar is greater than the potential gain of the unfamiliar. Everett Rogers’ innovation diffusion theory says that only 16% of people are quick to embrace change.
- System justification is defending and bolstering the status quo, even in the face of clearly better alternatives. “If it ain’t broken, don’t fix it” is the motto of people practicing system justification.
- A third cognitive bias, the Semmelweis reflex, is as widespread in academia as it is in business, and is the rejection of new evidence or theories because they contradict established belief. Think of the skepticism that greeted the heliocentric theory of the solar system, or the way business people scoffed at the idea of doing business on the web.
- Most people prefer to do nothing rather than do something that involves risk. This is called omission bias. We judge harmful action to be worse, or less moral, than equally harmful inaction. We say, “Better safe than sorry.” That bromide, however, hides the cost of inaction. In business, failure to innovate — that is, to act on an idea — risks losing out to more dynamic competitors, and even going out of business.
- Many business leaders have realized the importance of developing creativity and innovation in their people and organizations. Innovation promises gains, but the upfront investment needed represents a risk should the innovation fail. Because of loss aversion, many managers who express an interest in innovation eventually decide not to start an innovation project when they look at the costs. (It’s especially unfortunate when those costs include the fees that innovation companies like mine charge for innovation training or workshops.) Besides loss aversion, this behavior exhibits flawed framing. In this situation, framing the question as one of short-term cash flow leads to a flawed decision, whereas framing it as a question of medium-term profits, even long-term survival, results in a better decision.
- To help with framing problems, at my company we counter loss aversion and, hopefully, positively influence our clients’ buying decisions by reframing “spending thousands of dollars” as “investing a small percentage of annual revenues in developing in-house innovation capabilities”. This technique is known as the framing effect. People draw different conclusions and make different choices, depending on how data is presented. Realizing our cognitive limitations, and knowing about our cognitive biases, can help us make better decisions.
Conclusion: When making a decision, ask yourself: Is my decision based on the pain of losing something? Am I wrongly trying to maintain the status quo? Am I ignoring facts that contradict my beliefs? Am I looking at the situation through an inappropriate frame? How can I more usefully reframe the situation?
If you want to find out how we can help your firm and your people to avoid cognitive biases in innovation and in business in general, then contact us and let us know more about your situation. As part of our business thinking skills training program, Thinkergy Training also offers a training course in Decision Making that may address your needs. But make sure to also have a look at our innovation training courses that resolve around our systematic innovation methods.
© Dr. Detlef Reis 2014. This article is published in parallel in the Bangkok Post under the same title on August 14 2014. All rights reserved.