Imagine a friend of yours offers you a bet. They offer that you bet $100 on a coin toss. If lands on heads, you get $100 more! If it’s tails, you lose your $100…
Would you take that bet?
According to psychology studies, most people wouldn’t. In fact, those same studies show that people perceive the loss of giving up what they have as greater than the utility or gain associated with acquiring it.
Although you could win $100 in that bet, you could also lose $100. Because the two amounts are equal, our human psyche perceives the bet as risky. This is known as loss aversion where we are more scared of losing than the potential of winning. This causes us to fear taking fair, calculated risks since we typically require more than a fair bet to take the risk.
Examples of loss aversion
Loss aversion is present in every situation where you are risking something you currently have for the chance to get something more or better. Your brain would rather not take the risk unless the potential win is much bigger. Most studies point to about double as in the graph below.
Many people are scared to enter the world of investing, especially the stock market, because they see it as a big risk. While the market might be able to increase your money, you already have the cash in your account, so why risk it?
But if you’ve ever heard really good investors like Warren Buffett talk about their strategies, they don’t feel like they’re taking a risk at all. They’ve done their math and figured out that they’re on the right side of the risk. For example, you might calculate that for a particular investment, you have a 90% chance to make 20% on your money and a 10% chance of losing 20%. There’s still a risk of losing money, but mathematically it’s a great bet.
Have you ever been or known someone that’s been stuck in a toxic relationship? Loss aversion could be one of the reasons they stayed.
Once you’ve been in a relationship for some extended period of time, you really feel that you’ve invested a lot into it. You feel committed to it, stuck with the status quo. There’s a fear of starting over because it means that everything that was invested in the past is all for nothing. However, this fear is usually far more destructive to both people in the long term than just ending the relationship.
Starting a business
Striking out on your own, being your own boss, and starting a business is a dream for many people. It’s potentially more lucrative and gives far more freedom than any day job ever could. But still, people are scared of “taking the leap” from their set-salary day job to the crazy world of business.
We hear all the stories about how “90% of businesses fail within the first 5 years.” That fear of failure and loss, both of time and money is loss aversion. Even if you have a great business idea and the money to make it happen, it still seems scary because of the potential losses.
How to overcome loss aversion
The key to overcoming loss aversion is to take a more holistic view of your bets. Often times, we’re so focused on the negatives that we totally skim over the positives. Here are a few tips for doing that.
Get the numbers
To get used to seeing the bet as a whole rather than just looking at the negatives, it helps to get the real numbers. For what you’re doing, is there some way to get rough numbers that resemble the risk vs reward?
If you’re investing in the stock market, you’ve got historical data. If you’re going to the casino, then you can look up what all the probabilities are. If it’s something more complex like starting a business, you can always look at how much money you will invest vs the profits you hope to make. If the profits are many times your investment, then it might make sense to go for it. Although there is some risk, the numbers are justifiable.
Split your bets
A simple trick for reducing your risk is to split your bets.
For business owners, having multiple streams of income is the best way to stay strong. If one of your income streams drops or disappears, you’ve still got the other ones to cover you. You’ve split up your bets into multiple places so if one loses you still have a chance on the others.
If you’re investing, splitting your bets is famously know as diversifying. You invest in different assets to reduce your risk. Another way is to use Dollar Cost Averaging. Instead of investing all of your money at once, you invest little by little, effectively diversifying your investments using the variable of time.
In any bet, there are always the non-tangibles, the things that can’t be calculated that still contribute to the gains or losses.
People are scared to enter into relationships because of the potential loss and fear of getting hurt. But they’re forgetting all of the non-tangible things they have to gain. Personal growth is a big one; you learn a lot about yourself in a relationship. And the happy moments you have along the way are worth a lot, even if they’re not quantifiable.
The same goes for starting a business. Yes, there is the chance for financial loss and gains of course. But even if the business fails and you lose money, you’ve still gained a ton of professional experience along the way. You can probably switch over to a management role at another company pretty easily. On top of that, you’ve gained experience and personal growth that very few people have the courage to go for. That’s something you can definitely look back on and smile at in the future.
This article is part of a mini-series on cognitive biases. Stay tuned for more! Check out the others so far here:
Substitution Bias: How to Make Sure You Don’t Miss the Details
Availability Bias: Don’t Let Your Surroundings Affect Your Decisions
Confirmation Bias: How to Be More Open to New Ideas
Framing Bias: How to Make Better Decisions
Anchoring Bias: How to Avoid Getting Ripped off on Salary
Hindsight Bias: How to Be Smart About Reviewing Your Past Decisions
Thinking, Fast and Slow by Daniel Kahneman