How Loss Aversion Affects Your Bottom Line

August 19, 2010

Loss aversion is a psychological term for the human tendency to prefer avoiding a loss rather than acquiring a gain. This article uses an example of someone offering $100 with no strings attached or the chance to win $200 by betting on a coin flip. Most people choose to take the $100 with no strings attached rather than risk getting no money at all. The loss seems more substantial than the gain.

Unfortunately, this psychological phenomenon can lead to a lot of sunk costs, or costs that cannot be recovered in your business. For example, let’s say your company invested $5,000 in accounting software. The software has so many bugs that the company ends up spending another $10,000 in IT costs and training. Then, a manager finds better accounting software for $2,000. Loss aversion causes the company to stick with the faulty software because they have already sunk so much money into it. Though it would be worth $2,000 to get better software, they don’t want to add to the time and money already invested. As a result, your company throws more money at the problem rather than spending it on a new solution.

Simply being aware of loss aversion can prevent sunk costs. Be sure that your team is looking at the big picture when it comes to spending money. There are many books on the subject, but I recommend Sway: The Irresistible Pull of Irrational Behavior.