Yesterday I discussed how much I admired Daniel Kahneman’s book, Thinking, Fast and Slow, and wrote about the advice he has for avoiding biases in planning and forecasting.
Today, I want to focus on Prospect Theory, loss aversion, and how these explain why it seems companies often throw good money after bad.
Loss aversion is a key part of Prospect Theory, for which Kahneman won his Nobel. Simply put, loss aversion says that humans are more averse to losses than they are happy with gains. Few people will take a bet with equal chance to lose $1000 or win $1000; they feel the pain of losing $1000 more intensely than the joy of winning $1000.
Going further, although they are economically equivalent, we feel better about a 90% chance of a $1000 loss than a 100% chance of a $900 loss. One reason is that we are subject to decreasing sensitivity to losses as they get larger. We experience a $900 loss more than 90% as intensely as a $1000 loss. We are also subject to a certainty effect. We give less psychological weight than warranted to events that are highly probable but not certain.
These factors make managers prone to unfortunate gambles when faced with difficult choices.