What is Loss Aversion?
Loss aversion is the tendency for people to perceive a loss as more significant than an equivalent gain – to feel that the negative utility or “badness” of losing something outweighs the positive utility or “goodness” or of gaining it. Some studies have suggested that the psychological impact of a loss is twice as much as that of an equivalent gain.
There may be an evolutionary explanation for loss aversion: if an animal or proto-human has enough food to survive but no surplus (which is a common situation in nature, because it’s often inefficient to expend energy gathering surplus), gaining some extra food won’t make much difference to them, but losing an equivalent amount of food may make the difference between life and death. So the species evolves to fear losses more than it values gains, because the individuals who fear losses and act to prevent them will out-compete the individuals who put their energy into pursuing gains instead, and will pass on more of their genes to later generations.
Loss aversion has also been observed in non-human animals, including great apes and capuchin monkeys, which lends support to an evolutionary origin for the phenomenon.
Many modern humans across the world who live close to the poverty line are in a similar situation to the ancestral animal described above: gaining some money would be nice for them, but losing the same amount of money could be catastrophic. For them, loss aversion is often a rational behavior, even if it isn’t rational for people in a rich consumer society, as we will see below.
Marketers exploit the irrational side of loss aversion in various ways. They give customers a service for a free trial period, and then the customer must sign up for a payment contract if they wish to continue with the service, otherwise it will be cancelled. Loss aversion means that this strategy makes people more likely to sign up, because they are reluctant to lose the service they’ve been enjoying during the trial period. Whereas if there were no trial period, and they were simply asked “do you want to pay for this service?” they would be more likely to say no, because they undervalue gaining a service they don’t currently use, but overvalue the impact of losing a service they’ve been using. For the same reason, marketers using free trial periods can increase their prices for the same service, because people are willing to pay more to avoid losing the service they’ve been trialing than they would be willing to pay to start using it.
As with free trial periods for services, so with money-back guarantees for goods. Some companies will sell you a big-ticket item like a premium mattress or sofa with an unrestricted 30-day money-back guarantee. If you don’t like the item for any reason, no matter how silly or personal, you can return it for a complete refund. That sounds like a really good deal: you can try the item with no risk, and you can even effectively “rent” it for a month for free. But the company selling the item knows that at the end of the month it will be a lot harder to give up the item than it would have been to resist buying it in the first place, because of loss aversion. The company knows that many customers who bought the item intending to return it will end up keeping it.
Another marketing tactic is to frame changes in prices differently, as qualifying for a discount versus avoiding a surcharge. One is a gain, and the other is avoiding a loss, and consumers react differently to them even if the financial effect is the same.
Insurance and Extended Warranties
Some forms of insurance are necessary, or even legally mandated. If there is a risk of a negative event which would ruin you financially if you had to absorb the costs yourself, like your whole house burning down, then it is worth paying for insurance against that.
But there are salespeople out there whose job it is to persuade you to pay for insurance you don’t need, and they often rely on loss aversion as a sales tactic.
Do you really want to pay $5 to cover your $50 food processor against accidental damage? If you did that for ten appliances, you’d have spent as much as another appliance on warranties. It is vanishingly unlikely that all ten of them will break. Perhaps one of the ten will break, in which case you can buy a new one with the $50 you saved by not buying warranties for any of them. In any case, you know that the cost of the warranty is more than the company expects to have to pay out – otherwise they wouldn’t offer it, or they’d charge more for it. So it’s not in your interests to buy it.
Salespeople use loss aversion to try to persuade you to pay for insurance or warranties against your interests. They emphasize the loss of the item in question, and remind you how much you would hate to lose it. This is especially relevant when you’re buying a replacement or upgrade for an item you already own: you already have a smartphone or a dishwasher or whatever it is, so you’re not really gaining anything, but you can imagine and dread the loss represented by not having one anymore.