I’m halfway through a book called Nudge which is about the shortcuts we all employ to be able to make decisions quickly without needing to understand all the details. As the authors point out, as the world gets more complicated and the pace of change accelerates our need to rely on these shortcuts is increasing. Their interest is in understanding how those shortcuts work and in using that knowledge to help people (i.e. nudge people) to make better decisions – e.g. in the way we save for our retirement. One of the most common shortcuts we rely on are the default options that are presented to us, and hence thinking carefully about which options are chosen as the defaults is a powerful way to ‘nudge’.
Occasionally these shortcuts lead to decisions that are different to those we would take if we were in possession of all the information and had the time to make a fully rational decision, and it is one of those that I want to talk about today, the human tendency to over focus on avoiding loss. According to Sunstein and Thaler, the authors of Nudge, research has shown that we prefer avoiding losses to making gains by a factor of 2 to 1.
Like all shortcuts loss aversion has solid rational roots. In most scenarios in life keeping what we have is much easier than getting replacements – but in a pure business sense this level of loss aversion is clearly not rational. Gaining two customers is better than losing one (assuming the no reputational issues and a market with a large number of customers).
However, anyone who is involved with lots of businesses will have seen irrational loss aversion play out time and time again.
In the venture capital industry an over focus on loss aversion manifests itself in over consideration of the downside at the point of aversion and too often ‘putting good money after bad’ by following on in companies that are unlikely to make it (and in which the fund wouldn’t invest if it came to them as a fresh opportunity).
In startups loss aversion manifests itself in the following ways (amongst others):
- disproportionate effort in trying to ‘save’ difficult customers
- continuing to chase (and often forecast) big deals long past the point where they look likely to come in
- continued investment in failing product lines
- refusal to give up on poor performing employees (difficult as it is to say)
Time (alongside cash) is the most precious resource for most startups and getting focused on making gains rather than wasting time chasing difficult or lost causes can be the difference between success and failure. If the scenarios above are present in your company I’d encourage you to take a step back, gather all the facts and make a full analysis of the situation.