How is loss aversion affecting employees?

Why it is so hard to get support for new ideas within companies? This is despite CEOs repeatedly state that creativity is one of the most important capabilities they want from their staff.

While there were a number of reasons which all contribute, one of the most fundamental is that along the company hierarchy will be managers who believe it is their responsibility to protect the company (and their jobs) from risky decisions which could end up failing and costing money and damaging people’s reputations.

And one key psychological reason behind this lack of appetite for risk is based on an unconscious bias which all people have called loss aversion. In psychology and economics, loss aversion refers to people’s tendency to prefer avoiding losses to acquiring equivalent gains.

Put another way: It is better to not lose $5 than to find $5.

The theory was first formalised in a 1992 research paper from Amos Tversky and Daniel Kahneman called Advances in prospect theory: Cumulative representation of uncertainty. One of the most important things they found was that losing something you already have feels about twice as significant as gaining something of the same value. This is related to another psychological trait called the Endowment effect, where people place a higher value on a good that they own than on an identical good that they do not own.

From an evolutionary point of view, this makes a lot of sense. For an organism operating close to the edge of survival, the loss of a day’s food could cause death, whereas the gain of an extra day’s food would not necessarily cause an extra day of life.

It fits very well with the old idiom: A bird in the hand is worth two in the bush

In fact, loss aversion has even been seen in studies with capuchin monkeys, suggesting that this bias is hardwired into our nature. Just like monkeys with grapes, companies also have limited resources.

The difference is that in those cases, these resources include money and time to invest in new projects, as long as the reputation which goes with successful projects and the damage to a reputation which a failed project can cause.

Put simply, Loss Aversion dictates that managers are going to want to FEEL CONFIDENT about at least a 2x return on any investment into innovation projects before supporting them. So the logical thing for companies to invest in are projects which are likely to succeed.

So knowing all of this, and understanding how loss aversion makes it natural to avoid supporting risky innovation projects even if the end result is positive, what can companies do.

Fortunately, there are a number of things which leaders can change to improve the support and success rate of innovation projects.

  1. Think of the overall net position if a small proportion of your innovation projects work: To overcome loss aversion,a simple trick is to shift your focus away from thinking about the success or failure of each individual project, and instead think about the overall net impact. If a number of projects fail, but some innovation projects succeed more, then the net position is still positive. This reduces the risk and challenge of having to predict exactly which orders are likely to fail or succeed. This will feel strange mentally since your brain has evolved to avoid such ways of thinking, but when combined with some of the other methods below it can change an organisation into one which actually supports innovative, experimental projects and programs.
  2. Move from a project to an innovation portfolio approach: Getting management support for individual innovation projects is challenging, especially if you can’t prove that they will be successful. Management will also be suspicious of positive predictions knowing that most of what they approve might not pan out as expected. This is why companies should instead manage an innovation portfolio rather than individual projects. A portfolio approach gives a dedicated team the authority to manage an overall budget for innovation and assign it as they best see fit, and manage smaller projects in a faster, more agile way. It also gives them the ability to try out various types of innovation, some more incremental and some more transformative and long-term, which is likely to result in a larger number of successful innovations over time. But most importantly, looking at a portfolio overall means that individual failed projects can be seen in the context of the overall innovation efforts, allowing leadership to think about the net positive outcomes overall rather than each individual failure needing to be investigated and blame assigned.
  3. Lower the cost of failure: It may seem simple, but a portfolio approach and the management flexibility it brings can also significantly reduce the cost of failed projects. Instead of treating projects individually with a fully assigned budget, using principles like Lean Innovation Management mean that projects can be done faster, cheaper and with lower risk. This reduces the overall cost of each project, allowing more projects to be done in the portfolio and increasing the likelihood of them succeeding.
  4. Increase the likelihood and payoff of success: Again, this sounds impossible but it can be achieved if the right frameworks and methods are used. Most companies just don’t know how to successfully run innovation projects. By using some of the best frameworks (I’ve listed them here), or concepts like Jobs to be Done, it is far more likely that you will end up developing something which consumers actually want. This not only makes success more likely, it makes it more impactful as well.
  5. Understand the effect of loss aversion and other biases on decision making: Finally, leaders and decision-makers should be aware of some of the tricks which psychology plays on them. Evolution is what caused loss aversion, but by simply understanding what it is and how it affects you, it makes it more likely you will be aware of when it might be impacting your judgement.
    So now you understand the impact of Loss Aversion a bit better, and what can be done to counteract it.

Use this knowledge wisely, and let it help you put some impetus back behind those innovation efforts.

Check out my related post: Two pizzas at a meeting anyone?

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