What is loss aversion?
Loss aversion is a cognitive bias that refers to the human tendency to prefer avoiding losses to acquiring equivalent gains. In other words, the pain of losing is psychologically twice as powerful as the pleasure of gaining.
Where does the loss aversion bias come from?
Loss aversion was first identified and studied in 1979 by cognitive mathematical psychologist Amos Tversky and his associate Daniel Kahneman. It wasn't until 1992, when the researchers outlined a critical idea behind the bias, that it became more notable. They found that people react differently to negative and positive changes.
This cognitive bias is common in the fields of decision theory and behavioural economics. In our everyday lives, loss aversion is particularly prominent when we deal with financial decisions. For example, an individual is less likely to invest in a stock if it is seen as risky with the potential for a loss of money, even though the reward potential is high. This is because the pain of losing their investment would be twice as large as the pleasure of gaining financial reward.
Why does loss aversion happen?
It is caused by a combination of our neurological makeup, socioeconomic factors and cultural background:
1. Our neurological makeup
Three specific regions of the human brain become activated in situations involving loss aversion; the amygdala (part of our brain which processes fear), the striatum (part of our brain that handles prediction errors) and the insula area (part of our brain that works with the amygdala to make us avoid certain types of behaviour).
The mixture of neurological actions contributes to impulsive, uncontrollable reactions. For example, our response to aeroplane turbulence or a spider.
These regions of the brain that light up when a loss occurs, mean than fear and losses are closely related. If you wouldn't choose to put yourself in a situation you would fear, why would you put yourself in a position where loss is possible?
2. Socio-economic factors
Social hierarchy has proven to be a good indicator of an individual’s level of loss aversion. Ena Inesi, an Associate Professor of Organisational Behaviour at the London School of Economics, found that people in power are less loss averse. This is because powerful individuals are typically in a better position to accept a loss if it should incur, due to their wealth and network.
Wealth also plays a role in an individual’s loss aversion. Like powerful people, wealthy people typically have an easier time accepting losses they incur because they can much more easily overcome these losses due to their financial status.
3. Culture
Cultural background has been linked to how loss-averse an individual may be. Research has shown that collectivist cultures are more less loss-averse. One theory for this is that a person living in a collectivist environment is likely to have more (and closer) social connections, meaning that if they made a poor decision and incurred loss, these individuals would have support from their friends, family, and community. However, individualist cultures express higher loss-aversion, believed to be due to their lack of community pillars and social safety net in the case of poor decisions.
Studies around the loss aversion bias
Over a 2-year period between July 1981 and July 1983, a 10% increase in the price of eggs led to an 8% decrease in demand, whereas a 10% decrease in the price led to a 3% increase in demand (Putler, 1992).
In another study, consumers were asked to either build up a basic pizza by adding ingredients (e.g. sausage and pepperoni), or scale down from a fully loaded pizza by removing ingredients. Consistent with loss aversion, consumers in the subtractive condition ended up with pizzas that had significantly more ingredients than those in the additive condition (Levin et al., 2002).
Why is loss aversion important?
With any decision we face loss or gain. Loss aversion is a natural human tendency that exists to keep us from incurring losses. Though being risk-averse is useful in many situations, it can prevent logical choices. Loss aversion can prevent people from making the best decisions for themselves to avoid failure or risk; it’s essential to avoid loss aversion when making decisions with potential gains.
Loss aversion in marketing
Marketing campaigns, such as free trial periods, take advantage of our tendency to opt into a presumed free service. Given that there is no upfront financial commitment, there is no risk of loss. However, as the consumer becomes more and more familiar with that software, incorporating it into their daily routines and business strategies, they are more likely to purchase it. Giving up the software would be an emotional loss (as opposed to financial) as their free trial has allowed them to become dependent/reliant on said software for everyday life. Losing it would now be twice as painful as keeping it and paying the monthly fee.
How can you apply the loss aversion bias in retail?
There are numerous ways in which loss aversion can be applied in-store and online. This bias can make it better for your brand and better for shoppers too.
- Frame your offers – the way a transaction is framed can influence an individual’s perception of loss aversion. Framing a question as either a loss or a gain can change an individual’s response or decision; ‘save’ is a better message than ‘extra free’ as shoppers want to hang on to what they already have rather than get some more.
- Focus on what’s left – when shoppers consider your brand, remind them of what they won’t lose, more than what they’ll gain. For example, refill packs, retain the original container and give more product whilst helping shoppers retain more of their money.
- Incite fast-purchasing behaviour – provide shoppers with an indication of not just how much can be gained, but also importantly, how much can be ‘lost’ if they do not choose to buy it now (use scarcity tactics like ‘only 3 left in stock’).
Summary
Loss aversion is an important aspect of everyday economic life. The idea suggests that people have a tendency to stick with what they have unless there is a good reason to switch.
Putting loss into perspective is a simple way to tackle loss averse. We must remind ourselves to ask what the worst outcome would be if the course action was taken. Usually, this helps us to rationalise our decisions.
Check out No.38: The Mere Exposure Effect
