Monday, June 9, 2014

To win or not to lose? The power of loss aversion

Because we feel the disadvantages of risky decisions (losses) more intensely than the advantages (gains or wins), we see risky moves as bad ideas. Opportunities that are forecast with certainty seem especially tempting since they are risk-free.
In a previous blog
, I spoke about how we need to upgrade our thinking, how we must funk up the way we think.

In his LinkedIn post titled “The Power of Loss Aversion”
, Cass Sunstein explains that “people dislike losses more than they like equivalent gains”. To illustrate his point, he talks about incentives programs for teachers to improve their student’s achievements. Unfortunately, many of these efforts have been vain. In an ingenious study, teachers were given money in advance and told that if their students did not show real improvements, they would have to give it back. The result? A big improvement in teacher quality, as measured by a significant increase in students’ math scores.

Here are some common behaviors people around us (if not ourselves) experience:
- holding onto a losing stock investment
- keeping a home with a mortgage substantially above its market value
- going to an event you don’t really want to attend because you have already paid for the tickets.

Because gains are fleeting and losses linger, people behave irrationally to avoid loss.

How can you leverage the power of “loss of aversion” to grow your business, motivate your people and increase sales?

When you promote the benefits of your products or services, frame your message towards loss prevention
. If you pitch a product to a potential buyer that is designed to increase revenue, don’t just state the obvious benefit such as: “if you use our product X, you can expect your sales to rise by $120K annually”. Instead, remind your buyer that he would face losses from not using your product: “every month that product X is not used, you leave $10K on the table. This is money left that will not be recovered. You will lose money month after month. Can you really afford losing $10K a month?” Switching the message around to remind your buyers that they face losses from not using the product is a much more powerful message than just promoting the gains.

If your business sells products or services directly to consumers, leverage scarcity. Scarcity
, one of Cialdini’s “weapons of influence,” is powerful because it represents a loss of freedom. If you are selling a product, promote its limited quantity, retire products early on a constant basis and introduce new products. Put an expiration date on your offer – car dealerships excel at this by pressing potential buyers to accept this one-time deal that may not be available if they shop around and come back two days later. If you are planning an event, make sure you mention the limited seating. Or perhaps you can offer early bird tickets, which gives you the opportunity to market to people’s loss aversion multiple times: once when tickets are announced, once when the early bird discounts are expiring and then just before ticket sales end.

When you define your pricing strategy, focus on the fear of losing money
. Retailers who sell home appliances understand this very well. They offer a one-year warranty on a $1000 flat screen plasma or a $2500 refrigerator, reminding customers that after 12 months they are not covered but that they can extend the warranty by paying $200. What do customers do? They pay $200 extra in fear of losing their $1000 purchase, of the (very small) probabilities that their plasma or refrigerator will have some technical issues 3-5 years down the road when the extended warranty is over.

The same could apply to buying insurance, or flat-rate plans for mobile phones, etc. Consumers prefer to pay monthly fees of $40 to protect themselves for potential losses as well as variability of costs for their phone bills, instead of taking the risk to pay $20 a month and $60 another month. They are afraid of paying more, rather than seeing the benefits of paying on actual usage.When you formulate pricing strategies for your different offerings and services, do not forget to utilize the power of loss aversion with your buyers. A dollar gained and a dollar lost might equal zero on a pure economic basis, but it causes great pain to most buyers when behavioral economics is factored in. Buyers will generally pay more to eliminate this pain if your pricing strategy is framed correctly. Ignoring this powerful pricing tool means money left on the table and gone forever... and we all know how painful that can be.

Another principle is the theory of the foot in the door, or the tactic that involves getting a person to agree to a large request by first setting them up by having that person agree to a modest request. You want to create “ownership.” Loss of money (and the freedom of choice that comes with it) can be a barrier to people buying your products or services. However, once they’ve taken ownership of something it’s difficult to give that up. To illustrate, think of the various websites or publications which offer a free 30-day trial period. This is very effective when they require customers’ credit card information up front
while allowing them to opt-out within the trial period (most surprisingly, most don’t opt-out simply because they already have a foot in the door). When you sell a product, think about this tactic. You can also easily apply this tactic to motivate your team by asking a small commitment which will lead to a bigger commitment. Imagine you apply the study described above with teachers to your employees… Let’s say you have a profit-sharing plan where your company gives a 10% bonus to your employees if all company goals are met. This is a nice incentive, but how can you be sure your employees give it all? How would it be different if you deposited at the beginning of the year a 10% bonus in their bank account (bonus would be frozen), and that they would have to give it back at the end of the year if your company does not meet its goals?

Power of loss aversion in your day-to-day communication.
PR firms know a great deal of leveraging the power of loss aversion when reporting news or financial results. If you have more than one piece of bad news (or losses) to report, bundle up your bad news into one single statement. If you spread out the divulgation of bad news or losses across multiple announcements, you multiply its negative impact. The pain of losing $40 dollars at one time is less painful that losing $20 in two separate instances.On the opposite, when you have multiple pieces of good news to report, you are better off spreading them across several announcements, as people experience greater satisfaction gaining two times $20 versus $40 one time only. When you have a mix of good and bad news to report, try to mix small losses with big gains, but separate your small gains from bigger losses.

In conclusion
, while you cannot model your business decisions solely based on the power of loss aversion, the opportunities abound where inclusion of these basic principles can be highly advantageous. You must upgrade the way you think in order to seek gains and put the fear of losing and failing behind you.

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