In this article, you are going to learn exactly what Loss Aversion is, why is creates crippling fear in middle managers and decision-makers, and a simple model for how you can reframe your company’s thinking which encourages more innovation projects to thrive.
A few weeks ago, I was leading a discussion at Deloitte about exactly why it is so hard to get support for new ideas within established 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.
What is 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.
As the video below shows, the way this manifests itself in reality is that people are not very willing to take a risk, even when the potential overall gain is virtually assured if they need to invest something of their own to begin with.
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.
How Loss Aversion affects innovation
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.
Unfortunately, growth-focussed innovation projects don’t have a guarantee of success. There is no way to ensure that customers are going to see the same value in what you are developing as you do, and most companies are terrible at actually being able to execute on an idea. This is why less than 5% of innovation projects actually return their investment costs.
Because of all of this, innovation projects are seen as significantly riskier than “safer” operational improvement or efficiency projects, which have a proven track record from industry and large consultancies in being able to take costs out of the business but will not be able to grow the company into the future.
And the people who are therefore most affected by loss aversion are the decision-makers in middle management, who therefore have the most to lose if a project they support ends up failing.
After all, CEOs are supposed to encourage their teams to focus on big ideas and growth.
However, the rest of the staff in the business is likely to be treated very differently when their annual performance is evaluated.
According to loss aversion, any failed project will be treated as twice as bad as an equivalent project which succeeded.
Not only that, in many businesses any failure would be treated far worse than praise for a success.
In many companies, a bet that pays off results in a congratulatory handshake, whereas a bet that doesn’t pay off results in a kick up the ass.
Additionally, managers often hate being asked for permission to innovate, because they interpret it as them having to take responsibility in the event of the idea being an expensive failure.
Finally, if a company or management has previously experienced a failed project, they will be even more risk-averse in the future when determining which projects to invest in.
They are also more likely to demand more evidence that a project will work before making a decision (like from a business case) and stop an innovation project early if they are not seeing the results they expect.
But what can we do to overcome loss aversion?
Let’s look at what the numbers say.
Modeling loss aversion for innovation projects
To see how loss aversion may affect the decision making which goes into selecting new projects, let us look at a few scenarios.
The aim for all of these scenarios is to look at the impact of multiple innovation projects on the company’s net position. Green boxes indicate a successful project (which returned more than its investment) which has an upwards impact on the graph, and red projects do not return their investment and therefore have a downward impact on the net position. The aim across these 20 projects in each case is to leave the company in a more positive net position after all the projects are finished.
To start with, let us look at what happens when all projects are just as likely to succeed as fail (a 50% success / failure rate), and also where the potential net gain and net loss for each project are equal.
In figure 1 below, the first couple of projects succeed, followed by a period where success and failure alternate, so at the halfway point the company is in a net positive position.
But this is then followed by a series of projects which all fail. So by the end of the 20 projects, the company is in exactly the same position as it started.
However, using the same variables of a 50% success rate and equal gains and losses for successes and failures, the sequence of the projects is just as likely end up like in Figure 2 below.
As we can see from figure 2, in this scenario the company suffers an initial series of defeats and spends most of its time in a net negative position, even though eventually it ends up at the same position as Figure 1.
The issue is that due to loss aversion, even though the losses and gains of each project are the same, the initial losses in Figure 2 will feel more than twice as bad to the management.
As such, middle managers are likely to feel as though their projects are going worse than they are in reality, begin making emotional decisions, and are more likely to stop projects before they have had a chance to get through the challenging initial periods, learn from previous failures, iterate and improve.
So far, in the two sets of projects outlined above, we have shown what would happen in a completely balanced system where both the likelihood and impact of success and failure was the same.
However, in reality innovation projects work differently. Yes, they are more likely to fail (even though the success rate can rise significantly, up to around 70% if managed correctly). However, when they do succeed, the payoff for the company is likely to be significantly higher than the cost of failure.
In Figure 4 below, the likelihood of success is only 20%, but every successful project brings in 5x the cost of a failure. As we see now, this results in a net positive position at the end, even though the initial projects all appeared to fail.
This is also what it usually feels like over the course of a series of innovation projects, or stages within a longer innovation project. At the beginning, it looks like everything is failing as you find out that the market wants something different than what you initially hypothesised.
This is the panic feeling that loss aversion can cause.
You then have to take this information, understand the insights behind it, try to improve your offering by iterating and try again. Each time you do this it might feel like a failure, but it is bringing your team closer to the design, service or offering which ends up working and delivering a larger payout.
Figure 5 below shows a scenario with an even lower chance of success of only 15%, but the impact of the projects which do succeed bringing in 10x more than the cost of failure.