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.
To quote from Kahneman: “This is where people who face very bad options take desperate gambles, accepting a high probability of making things worse in exchange for a small hope of avoiding a large loss. Risk taking of this kind often turns manageable failures into disasters. The thought of accepting the large sure loss is too painful, and the hope of complete relief too enticing, to make the sensible decision that it is time to cut one’s losses. This is where businesses that are losing ground to a superior technology waste their remaining assets in futile attempts to catch up.”
Furthermore: “The escalation of commitment to failing endeavors is a mistake from the perspective of the firm but not necessarily from the perspective of the executive who ‘owns’ a foundering project. Canceling the project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organization’s resources in the hope of recouping the original investment—or at least in an attempt to postpone the day of reckoning.”
Reading this, I found myself saying “Yes! I’ve seen that!” For example:
- I recall a manager who, faced with declining sales of his products from retail stores, sold more and more inventory into the distribution channel. His revenue numbers, which were based on sales to distributors, looked good to his superiors in the short run. He thought he was “living to fight another day” and that he’d figure out how to deal with the inventory later. Coincidentally, though, he was also able to negotiate a new job at another employer on the basis of his apparently strong sales performance. His original employer, unfortunately, had to spend more than a year and many millions of dollars dealing with the channel inventory. Its sales also collapsed, as the distribution channel was unwilling to take more inventory until the previous inventory cleared.
- I’ve also worked with an energy technology company that spent well over $30 million developing a power generation product. Even when it became clear, however, that the product was not competitive, it took several years for the company to kill the product. Investing a few million each year allowed management to avoid the conclusion that money invested to date was not a total loss—there was always the possibility of miracle that would result in redemption. Loss aversion may provide a good explanation of why avoiding consideration of of sunk costs is harder to do in practice than in an economics classroom.
Have you ever seen this behavior?
This is the second of four posts about this book. The next post is about when to trust intuition.