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Imagine two scenarios:
In the first one, you make a $10 bet with a friend. You lose. The next day, fortune smiles on you as you walk down the street. You see a $10 bill lying on the sidewalk.
In the second scenario, nothing happens. You neither enter into any bet with anyone, nor do you find any money lying on the street.
In both scenarios, your net gain is $0.
Would both of these scenarios affect you the same psychologically? Or would one have a greater emotional impact than the other? Which scenario would you choose?
If you picked the second scenario, you made the right choice.
The Loss Aversion Principle
According to the loss aversion principle, people prefer to avoid losses than receive the equivalent amount in wins.
In both scenarios above, the end monetary result is zero. Yet, the first scenario has a negative psychological impact because the emotional impact you feel from the $10 loss is greater than what you feel from the $10 gain. Meanwhile, the second scenario has no psychological impact because you experience neither wins nor losses.
This concept of loss aversion was first discovered in 1979 by researchers Amos Tversky and Daniel Kahneman, who found that people consider taking on a risk only if the gains are at least twice as great as the losses. So if a friend were to make a bet where there was a 50/50 chance of winning, you would need to potentially win $20 to your friend’s potential win of $10 (i.e. you pay your friend $10 if you lose) for you to take the bet.
Let’s consider a different scenario. Your long-lost aunt passes away, leaving you with a hefty inheritance of $240,000. She gives you a couple choices on how you want to receive the money.
Now, let’s assume interest, return on investments, and present value of money does not come into play. For the purpose of this exercise, the value of money stays the same over the period of time.
Which option would you prefer?
- A one-time lump sum of $240,000 immediately
- Monthly payments of $10,000 over the course of 24 months
- Or a third option?
Many, if not most people, would choose the lump sum. Money in your pocket now beats money in your pocket later. You also get to choose how you spend your money right away: You can purchase some blue chip stocks, go on a lavish getaway, or enjoy a new car.
But according to loss aversion principles, the second option of monthly payments is better. You actually gain more satisfaction from receiving small gains over an extended period of time rather than an equivalent one-time gain.
You know what’s even better? Receiving increasing gains over a period of time. For instance, you receive $1,000 the first month, then $2,000 the next month, and so on.
At first glance, it doesn’t seem to make sense. Wouldn’t you be more satisfied getting as much as you can upfront?
Why We’re So Afraid of Loss
There’s an explanation for our behavior. Back thousands of years ago, resources such as food and water were not readily available. Hence, it was more advantageous from a survival perspective to get batches of food and water over a period of time rather than one large sum of food and water at once.
Not only would a large amount of food spoil quickly and lead to wastage, but it would be difficult to carry across long distances. Assuming also that people long ago survived on a day-to-day basis, having a surplus of food would provide little benefit, while a shortage could lead to death.
So if we time travel to the present day, these tendencies have a number of implications on our behavior. For instance, marketing research has found that consumers react more strongly to avoid losses than to create gains. When consumers are threatened with a price increase, they are twice as likely to switch brands compared to when a competing brand offers a price decrease.
Also, studies have found that people quit participating in money-making scenarios when faced with the threat of loss, even when they stand to gain further down the line. Unfortunately, this tendency explains why it’s so hard to keep going with an endeavor.
When you start on a new business or personal goal, you put in a lot of time, effort, and money with no immediate results. Although there’s the chance of a large reward at the end, most people give up because of all the losses incurred before they reach that point. Without any semblance of success in sight, it’s easy to give up.
How to Focus on Wins
While loss aversion helps prevent irreversible damage, the fear of losing out can prevent us from potentially large wins. Opportunities are lost along the way. Poor decisions are made.
So in order to cope with our tendency towards loss aversion, here are a few ways to manage it:
1. Take a long-term perspective.
Since losses cause more pain than gains cause happiness, experiencing a series of ups and downs can cause disappointment, even if the long-term results are positive. For this reason, it’s a good idea not to scrutinize something outside your control.
One example is when you’re expecting a reply from someone. Constantly checking your email and hoping to see a message is distressing every time you hit refresh and come up empty.
Long-term investments are another example. Looking at your portfolio performance frequently may seem productive and rewarding. But once again, seeing your investments go down temporarily feels worse over time than seeing them rise back up again.
If something doesn’t require your immediate attention, make it difficult to access. For instance, don’t place the link to your stocks on your browser or keep your email tab open.
2. Focus on the process.
There are two parts to your actions: the process and the result. While you can work on the process, the result is outside your control. Unfortunately, we tend to concentrate deeply on results, willing it to be what we wished for.
As you know, focusing on what you can control is a healthier and better use of your time. Ask yourself: What can I do about this issue right now? Is it something I can act upon?
If the answer is “no”, then look at the results only once in a while. You can put a set time when you check on your results, such as on a weekly, monthly, or quarterly basis, depending on what you’re working on. In the meantime, spend your time on the things you can change.
3. Remember that results are not incremental.
While we’d like to believe there’s a correlation between effort and results, that’s not quite how things work. Hard work can lead to great results, but the relationship between the two isn’t linear. Results don’t increase on an incremental level against time and energy.
One extra unit of time spent does not lead to one extra unit of result. Instead, results increase in “jumps”. While you put in the effort, your progress remains stagnant for periods of time. But one day, you break through the barrier and suddenly experience progression.
For instance, if you’re learning to play the piano, you might find yourself getting stuck at a certain part of the piece. You keep practicing, but have trouble playing that one part of the song. Then, things click and you suddenly master the technique.
At these points of stagnation, many people give up. They put in the effort and time, but see a lack of progress. So, they decide not to go further anymore.
If only they knew about the concept of “jumping” results.
Sometimes You Need to Lose to Gain
Losing is painful. When we feel our precious resources slipping away, we instinctively do what we can to survive. We hold onto what’s left, bowing out before any more is lost.
It’s hard to fight our instincts. But what we can do is shift our focus to doing the things that allow us to grow, to learn, and to see what’s at the end of the tunnel. Because, ultimately, it’s the results in the long run that matter most.