The Psychology Of Loss
When working in financial services you become accustomed to discussing the influence of loss aversion on customer behaviour. However, loss aversion is an important factor in more decisions than we probably realise. It is certainly relevant across all sectors and channels.
What is loss aversion?
Loss aversion is a human characteristic that describes how people are intrinsically afraid of losses. When compared against each other people dislike losing more than they like winning. Thus losses loom larger than gains even though the value in monetary terms may be identical.
Research studies into the psychological value of losses and gains have identified a loss aversion ratio of between 1.5 and 2.5. This means that a loss that is identical in money terms to a gain is valued up to 2.5 times more than the gain. This is an average of course as some people are more or less loss averse than others.
For example professional risk takers such as fund managers are more tolerant of losses. This appears to be due to professionals being less emotionally attached to what they are trading than the amateur investor. The key here is to think like a trader, don’t get emotional about a purchase, and see it as simply a transaction.
Implications of loss aversion
Loss aversion inevitably leads to risk aversion and a number of predictable behaviours in certain situations:
1. Threat to lifestyle
If a potential loss could be ruinous or would threaten their lifestyle, people will normally dismiss the option completely. This is one reason why spread betting companies have pre-agreed stop losses on most of their accounts. This protects customers from their bad bets by limiting potential losses. If there was no automatic stop loss in place most customers would never consider this type of gambling.
2. Winners & losers
Where people are presented with a situation where both a gain and a loss are possible people tend to make extreme risk averse choices. For example, a person is presented with the choice between a small guaranteed gain over 5 years (e.g. a deposit based account) and a stock market linked product that carries a low risk of a large loss. People have a tendency to focus on the large potential loss and often select the former, less risky option. This is why advisers will focus on the large upside potential of a stock market linked investment and try to play down any potential for large losses.
3. Bad choices
Where the choice is between a certain loss and a larger loss that is just a probability (i.e. there is a chance of no loss), diminishing sensitivity can result in excessive risk taking. This helps explain why people will continue to gamble after racking up substantial losses. Their mind set is focused on the potential for their next bet to win the jackpot and wipe out their losses. People can become so emotionally involved in such situations that they fail to see that they are just adding to their losses.
4. Power of ownership
Where a person buys an item with the intention of consuming or using it the minimum price that they are prepared to sell the item for is often higher than the maximum price they would be prepared to pay themselves. This is called the endowment effect. The ownership of goods appears to increase the perceived value of an item, particularly for goods that are not frequently traded.
This is the result of our reluctance to give up an item that we already own. Such behaviour can be seen in the housing market where sellers often have to lower their initial asking price as buyers frequently are not prepared to pay the price sellers value their homes at. The endowment effect is most prominent for new goods, such as cars, where owners value their goods much closer to the original purchase price than potential buyers do.
5. Status Quo bias
- Loss aversion is a powerful conservative force that favors minimal changes from the status quo in the lives of both institutions and individuals.
— Daniel Khaneman, Thinking, fast and slow
Loss aversion is also powerful force in preventing change. People have a general preference towards the current state of affairs (e.g. their existing supplier) over changing to a better alternative. This is often attributed to a combination of loss aversion and the endowment effect. However, fear of regret in making a wrong decision may also play a part in inertia.
This explains why it is often difficult to encourage customers to switch suppliers even when you may have a superior offer. This suggests that it is important to consider both loss aversion and emotional factors when targeting your competitors’ customers. Money back guarantees and free trials are great ways of reducing the risk of loss or regret that many people feel when considering switching away from what they know.
How people react to risk or probabilities
As I’ve mentioned, loss aversion and risk are intrinsically linked. Research into the psychological value (i.e. the weight) that people give to different probabilities has identified two key biases that influence human decision making in the face of uncertainty.
1. Possibility effect
The possibility effect results in highly unlikely (low probability) events being given more weight than they justify. People naturally overestimate the probability that these events occur and so are more willing than they should be to respond to offers that tap into these perceptions.
This helps to explain the attractiveness of betting on unlikely outcomes (e.g. England winning an international football tournament!) and insurance policies that cover uncommon events (e.g. extended warranties).
2. Certainty effect
The certainty effect leads to events that are almost certain being given less weight than their probability justifies. Due to loss aversion it is human nature to want to eliminate risk rather then reduce it.
For example, rather than offering 4 for the price of 3, people respond better to 1 free with every 3 purchased. The latter is more compelling because the zero price has more certainty. For websites it also means that if visitors are slightly unsure about how genuine or secure a website is they will have a tendency to magnify the risk. This can lead to visitors abandoning a transaction. It also explains why guarantees are such powerful promotional tools. A guarantee eliminates any uncertainty about a situation, whether it’s about an application being accepted or getting the advertised offer/rate. People are often unsure if they will quality for offers so a guarantee removes this concern.
A study carried out by Khaneman and Tversky for their Prospect theory indicated that unlikely events (1% to 2% probability) are over weighted by a factor of 4. However, for an almost certain event the difference is even larger. In experiments a 2% chance of not winning was given a weighting of 13% (or an 87.1% chance of winning).
The risk of a rare event
Where the odds of an event are very small (e.g. around 0.001% or less) people become almost completely indifferent to variations in levels of risk. Rather emotional factors and how a risk is framed are the key drivers of how people react to these levels of risk. This helps to explain why people are often too willing to bet on extreme events happening or why they buy multiple lottery tickets when there is a large jackpot.
- When the top prize is very large, ticket buyers appear indifferent to the fact that their chance of winning is minuscule.
— Daniel Khaneman, Thinking, fast and slow
Research has also found evidence that rich and vivid descriptions of an outcome (e.g. fantasies about your lifestyle as a lottery winner) help to reduce the impact of probabilities. In particular people are more heavily influenced (in terms of weighting of probabilities) if an event is described by using frequencies (e.g. the number of people) than by using standard indicators of probability or risk. This is why gaming sites tend to promote the number of winners rather than the chance of winning. From a conversion perspective it suggests using rich media to bring events to life and avoid using abstract concepts of probability that people struggle to understand.
As we have seen loss aversion and related biases are an important driver of human decision making in many situations. On the one hand it can encourage extreme risk averse behaviour, and yet in a different situation it can lead to excessive risk taking. It is also a key reason for customer inertia and causes people to over-value the goods they own. As such loss aversion should be a key consideration when designing a user experience and for generating hypothesis for conversion optimisation experiments.
Thank you for reading my post and I hope it has generated some ideas for future online experiments. I would also be interested to read your thoughts on loss aversion and how it influences your website design.