29 August 2012

It’s Hard to Say “Good bye” – Applied Loss Aversion and Prospect Theory

One characteristic of human nature is that we all hate to lose. In more scientific terms it is called loss aversion. There are some differences in what and mainly HOW we lose. My focus is on HOW we lose things, particularly if there is an active decision of the “loser” to lose or admit a loss.

People can feel “loss pain” when they lose something. The easiest example is when one loses 10 Euros just because they felt out of the pocket. But, this is not so interesting, since it is obvious that no one will be happy to have lost money, a phone or whatever. Similarly people feel “loss pain” when something is stolen (oh… I remember how I felt when my first bike was stolen) and to the “loss pain” a feeling of injustice is added. We can feel that we lose something that we never had. People feel the pain of los even when they lost something that they never had. For example someone can feel “loss pain” when informed that they could have got something, but didn’t get it. Here regret (if only I would have done something different) plays a role. However, feelings of injustice or regret are not the topic of this post.

In the situations mentioned above, loss is independent of the person who suffers it. Of course the “loser” could have done the appropriate thing to get that reward. Of course, the “loser” could have been more careful with money and take some preventive measures to avoid theft (like using 3 locks on the bike, which I now do). But more or less the “loser” didn’t do anything to actually lose.

What I find very interesting is active losing or in more plain language – Saying “Good Bye” to something.

Active losing implies that loss is one step away. Let me give you an example to clarify. Let’s say someone has a lot of shoes (yes, there is a sex difference in the number of shoes someone has). Due to the high number of shoes, there is no more space in “shoe storage area” and some shoes don’t have room in the “storage area”. Now, to experience loss, she has to throw away (donate to charity) some pairs of shoes. In this case our “loser” has to actively do something to actually experience loss.

In the “shoe example” loss in not inevitable, because she can keep all her 200+ pairs of shoes and if she does so, she will not experience “loss pain”. In this case a person has to make an effort (minimal) to actually lose. Prospect theory tells us that at least for relatively small losses, the pain of a loss is roughly double in magnitude compared to the pleasure of a similar gain. To translate this into shoesin order to compensate for the loss of one pair of shoes, she will need to have two new pairs. This is the scientific explanation for the ever growing number of shoes, clothes and many other things including (power) tools that are used at most twice a year (yes guys… we don’t collect shoes, but look in your “tool box”).

Another case of loss that is “one step” away is when the loss is inevitable, but one has to acknowledge the loss, to actually make it tangible. Take the example of investments in assets. Imagine someone that invested in a piece of real-estate (don’t you just love real estate???) and buys at 2500 Euros/square meter.  In the next year the price goes down to 2200 Euros/square meter. This person has lost a great deal of money… 300 euros * surface of the property. However, the loss is not “real” unless the investor sells and acknowledges the loss. By real I mean actually experiencing “loss pain”. The investor will think that:

“Maybe the prices will go back up to 2500 Euros… or maybe even higher… after all the prices were rising for a long time and what reason do they have to not do so in the future??? I should wait some more for the prices to “come to their senses”… moreover, I’ll go to church and say a special prayer”.

You get the idea of inevitable losses that are not acknowledged, right? You might think that only naïve investors do foolish things like this… don’t feel alone! Even professionals hold on to assets decreasing in value in the hope of “prices coming to their senses”.

In both the “shoe” and “real estate investment” examples we have a case of “it’s hard to say good bye” because the person has to actively “say good bye” and acknowledge a loss. Because people hate to lose, it is hard to say “good bye”. Before presenting the reasons why “saying good bye” is in fact good and telling you how we can use loss aversion and prospect theory in our favor, let me give you another example of “hard to say good bye”. This example was brought to my attention by Dana Ududec.

Dana is an “environmental friendly” person and she recycles stuff that other people would just put in the garbage can. Dana told me a story about her washing a plastic box (previously with some food inside) before putting it in the “plastic recycling” bin. (Yes my Dutch friends, in less developed countries plastic is recycled). Her dilemma was if the act of washing the plastic box was, in fact, more detrimental to the environment than the act of recycling it. Now, I will leave that answer to the environmental professionals who can make the cost-benefit analysis. My question is “after washing the box did she actually throw it away (recycle)?” I’m not referring to the particular case of my friend (after all, I can simply ask). Rather I’m curious if one makes an effort with regard to an object that is basically useless will that person get rid of the object?

If we make an effort (investment) in something, does its value suddenly increase? What if someone else made the effort?  The answer is “yes”. If we made an investment in something, regardless of how useless it is, we will hold on to it. Let’s drop the plastic box into the recycling container and think about a job… if someone had to put up with a “lot of sh*t” to get a job… he or she would hold on to the job even if they get even more “sh*t”. In comparison, someone that got a job without making a huge effort would be more likely to leave the job when “sh*t” is served. The key idea here is that in the cases of the plastic box and of the “sh*tty job” what is lost is not only the “thing” (box or job), but mainly the effort put into that “thing”. The extra effort is what makes it “hard to say good bye”.

What if someone else made the effort? You can answer that question by simply looking around the house and count the perfectly useless things that you have received as gifts from people who are more or less close to you. If you counted more than one, then you suffer also from “it’s hard to say good bye”. The idea is that by getting rid of all those useless and sometimes kitsch objects you don’t only lose the “thing” but also the nice gesture that your friend or mother in law made.  

Now let’s go back to the “why loss is good” part. Economists (that “special”, but somehow useful species of people) have developed the concept of “opportunity cost”. It basically refers to what else could you have done with that resource (money, time etc.). 

For example by holding on to an asset that loses value in the hope of “prices to come to their senses”, the investor gives up all the other things that could be done with the remaining money if the loss would have been acknowledged. In more simple words… if the investor puts 250.000 euros in a 100 square meters real estate property (at the price of 2500 euros/ square meter) and in the next year the value of the property goes down to 220.000 euros our investor has two options. First, (s)he can wait for the prices to “come to their senses” and not acknowledge the loss. Second, (s)he can sell, acknowledge the 30.000 euros loss and invest the remaining 220.000 euros in other assets such as Apple stocks (although I’m not sure if that is a good investment) which have a better return on investment. By going for the first option (holding on, hoping and praying) the investor loses the benefits of the second option. This is the “opportunity cost”.

So, sometimes it is not necessarily bad to loose. Maybe in a loss there’s a hidden opportunity of a gain in another area.

Leaving the investment world… and going back to the “shoe storage” area… why is it good to lose some of the shoes (or tools or whatever). First, it is very useful to give up on some shoes for simple practical reasons. Imagine what you could do with all that space… Second, by accepting to lose some of your stuff the relationship quality will increase. Everyone that lives in a couple has experienced those annoying discussions like the following ones:

She: “I’ve told you 10 times to clean up the garage / basement / attic! It’s full of your tools and paint/ silicone/ stuff left overs!”
He: “But honey, those are MY tools and I need all 2458 of them. Plus, the left over materials are perfectly good; why throw them away? Who knows when I might need them?”


He: “Whenever I want to get something out of the closet your damn shoes fall on my head! You should get rid of them!”

She: “But honey, I don’t have “that many” shoes! Gloria has more! And by the way I still have some outfits for which I don’t have matching shoes. Saturday I’m going shopping with Gloria.”

This is not exactly the evening chat that one wants to have… Now really what is more painful? Fights on a regular basis with your “better half” or experiencing some “loss pain” once? Rationally speaking one instance of “loss pain” is better than a regular discomfort of marital disputes. However, being rational is quite hard… and for this decision design can help a bit. Let me tell you how.

Here are some insights that can be applied.

First, set a rule with your “better half”, with a friend or even with yourself. For each new thing that you buy (shoes, tools etc.) you should throw away (donate) one of your old things. As I said earlier the pain of a loss is roughly double in size compared to the pleasure of a similar gain. When faced with a loss one would be more reluctant to buying new stuff. I’ve tried this with my wife and we managed to keep the number of shoes constant in the house. Lately she offered to through away some of her clothes so that she can buy new ones.

Second, set up regular clean-ups. At least twice a year go through all your stuff and look for things that you haven’t used in the last 1-2 years. Most of them are perfectly useless if you haven’t used them. And if the phrase “Who knows when I might need it” let me tell you a painful truth. If you don’t know when it might be useful, then it is not useful. In the same line of thinking go through your clothes and whatever you haven’t used in the last year, put it in a bag and give it away to charity. Never mind those cool trousers that you had in your college years. They are not cool anymore and most likely they don’t fit you anymore. And NO! Don’t hope that you’ll get back to your “good days” silhouette.

Third, go through all the gifts that you have received and you’ve never liked or used. Put them in a big bag and just get them out of the house. Yes… corporate gifts included (those are in fact the most useless ones). Do this all at once since the “per unit loss pain” decreases with the number of units. In other words if you throw away one object each week the cumulated “loss pain” will be higher than the “loss pain” of throwing them away all at once. If you still feel bad about losing the investment your friend made, know this: Your relationship and good feelings about your friend don’t reside in an uninspired gift. Even better: after throwing the useless gifts away, call your friends and organize a “get together”. That is what friends and relationships are about. OK… there is one exception to this rule. If your mother in law is very easy irritated by your (imagined) disrespect, don’t throw away the kitsch vase she gave you as a wedding present.  

Fourth, Give your junk to charity. I have to tell you that not all you give to charity is actually used by less fortunate people. For some things the charity is only “one more stop” on the way to the landfill. At the same time, a lot of things find a “new life” in second hand stores (the very table and chair I am using to write this are second hand). Even better, some of your old useless stuff will make happy many less fortunate people in your country or abroad. The benefit (good feeling) of “doing something good” or being altruistic will help attenuate the “loss pain”.

Fifth, enjoy your new comfort in your own house. Less stuff, more space; more space, more comfort and new opportunities.

It is hard to say “Good Bye” but in many cases it is very Useful and Relieving…

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