Loss Aversion: The Shortsightedness of “Playing Not to Lose”

We experience the pain of a loss much more acutely than we experience the pleasure of a gain. One result is that we overreact to price increases.

Asymmetrical reaction to price fluctuations

Imagine you’re at the supermarket, about to buy your favorite brand of peanut butter. If you see that the price has dropped, you’re mildly pleased. But if you see the price has increased by the same amount, you get that awful sinking feeling. Disappointed, you put it back on the shelf and go without.

But it’s not just the potential loss of money that we overreact to. It can be the loss of time, prestige… or a game of football.

The best explanation of loss aversion I’ve ever read appears the book, Sway: The Irresistible Pull of Irrational Behavior. Authors Ori and Rom Brafman give some great examples of how loss aversion can lead us to make the most irrational, self-defeating decisions. Below are two real-world examples from Sway:

1.  A pilot’s obsession with getting back on schedule

In the 1970’s, Captain Jacob van Zanten was KLM’s most esteemed pilot. He was their chief flight instructor and even appeared in KLM advertising.

On a flight to the Canary Islands in March of 1977, van Zanten’s 747 was diverted to a smaller, nearby airport. After several frustrating delays, van Zanten — driven by an obsession to get back on schedule — started to take off in thick fog without full takeoff clearance. What he didn’t know was that a fully loaded Pan Am 747 was sitting on the runway, directly in his path.

The KLM jumbo smashed into the Pam Am plane. Everyone on board the KLM flight was killed, as were most of those on the Pan Am flight. There were 584 fatalities – the worst air disaster ever. And it was caused mainly by the KLM pilot’s obsession with living up to KLM’s claim of being “the people who made punctuality possible”. In other words, avoiding a loss.

2.  Playing not to lose

When Steve Spurrier took over as coach for the University of Florida Gators in 1990, he spotted a weakness in his opponents’ strategy. The other teams in his conference all played very conservative, defensive games. In other words, they were playing not to lose.

Spurrier exploited his opponents’ obsession over avoiding losses. He had his team take some chances, pass more often, play more aggressively, and try to score. The strategy was a huge success and it illustrates the opportunities that exist when we recognize irrational behavior for what it is.

You’d think the opposing coaches, seeing what was happening, would have changed strategy and played more aggressively. But they simply couldn’t. They had become so committed to the goal of avoiding a loss that for years they continued their losing strategy.

http://www.cardinalpath.com/loss-aversion-the-shortsightedness-of-%E2%80%9Cplaying-not-to-lose%E2%80%9D/

Loss Aversion

"losses loom larger than corresponding gains"

"In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful as gains. Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman."

"The principle of loss aversion was first introduced by Kahneman and Tversky (1979)"

Tversky and Kahneman (1991) "The central assumption of the theory is that losses and disadvantages have greater impact on preferences than gains and advantages."

"Numerous studies have shown that people feel losses more deeply than gains of the same value (Kahneman and Tversky 1979, Tversky and Kahneman 1991)."
Goldberg and von Nitzsch (1999) pages 97-98

"Both the status quo bias and the endowment effect are part of a more general issue known as loss aversion." (Montier 2007, p. 32)

Loss aversion - Wikipedia

The Psychology Of Loss Aversion (And How It Applies To Venture Capital)

Rob Go|August 17, 2010

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I’ve been reading the book “The Black Swan” recently on the recommendation of my two partners.  I had heard about the book for years, but it never made it off my “to-read” list until now.

One of the concepts that the book discusses is the way we think of risk differently when we are generating profits vs. when we are minimizing losses.  The simple illustration goes something like this:

If someone gave you the offer of $100, no strings attached, vs. flipping a coin for the chance of winning $200, what would you choose?  Although both options are mathematically equivalent, most folks would choose the $100.

On the flip side, if things were reversed, and you could either lose $100 for sure, or have a 50% chance of losing $200 or nothing, what would you choose?  Most people in this situation tend to prefer the possibility of losing nothing, even though there is the 50% chance of a larger loss.  

This illustrates a simple point that we tend to be irrationally risk tolerant in protecting capital.  Social scientists call this loss aversion.

This has major implications for the venture business in the realm of follow-on investment decisions.  It’s a part of the business that doesn’t get much attention, but consider this:  I think it’s safe to say that well over 50% of a typical venture firm’s capital actually comes in after the initial investment round of financing for a company.  So even if a fund is supposed to be “early stage” focused, the reality is that the bulk of their capital is going into the follow-on investments in the B, C, D and later rounds. 

I didn’t realize this before I went into VC, but most VC firms are lifecycle investors, meaning that they have large reserves and expect to participate in most of the follow on rounds for companies that are doing reasonably well.  One would think that the follow-on investing decision for VC’s would be an easy one.  After all, no one has more information on a company than the existing investors and board directors.  Therefore, they should be very well equipped in figuring out which companies deserve follow-on capital, and which ones don’t.  Even though the follow-on capital is usually at a higher cost base than the earlier investments, this should be concentrated in the “best” companies, and should perform very well from a risk adjusted basis (even before considering the protection from being higher up in the preference stack).

Case closed right? Wrong.  There are a lot of reasons why follow-on financings might happen when they shouldn’t, causing VC’s  to “pour in good money after bad”.   

• Loss Aversion.  As discussed above, the uber-reason this happens is that one is irrationally risk tolerant when trying to preserve capital.  Or put another way, once you have a vested interest (time or money) into a company, you are willing to take irrational risks to protect your investment.   

• Delayed Gratification.  No investor wants to see a “zero” on their track record, and no investor wants to report “zeros” to LP’s.  This is true even though a small -100% return today might be much much better than a big -80% return in 5 years.  The pressure of needing to raise a future fund, looking good in front of your partners, trying to get promoted, trying to look like a clever guy in the twitterverse, etc leads to unnecessary risk-taking in follow-on financing decisions.  Even though almost every firm says they evaluate follow-on rounds like “new deals”,  I think this is actually far from reality.

• The Signaling Death Spiral.  Let’s take the hypothetical case of a company raising a series B that is doing ok, but not great.  The existing investors will often say they will support the company but have an outside lead price the round.  The new investor will ask the existing investors if they are “in” for their pro rata as a signal that it’s worth investing.  If an outside lead is willing to price and lead a round, it’s very very hard for the existing investor to say “you know what, I don’t believe in this.  I’m going to pass on this investment and risk that the whole deal blows up” (note that this is different than the follow-on dynamics of VC led seeds, where the investor will have a much smaller % of capital at risk and knows that they are buying 5 options to make 1 true investment.)  So in this scenario, a follow-on round gets done, and both parties are heavily influenced by the fact that the other is investing.  Puzzling no?

• Confirmation Bias.  This is the tendency for people to favor information that confirms their preconceptions regardless of whether that information is true or complete.  When layered in with Loss Aversion, it creates a deadly combination.  Because an investor is averse to losses, he/she is biased against any data that suggests that the initial investment decision was a mistake and will gravitate towards information that supports a follow-on investment.  

• The Bridge to Nowhere.  Even if a company is really struggling, the following logic is very appealing: wouldn’t you be willing to spend $2M to save the last $8M?  Because investors usually buy preferred stock, they get paid first and so they only need the company to sell for the value of the preferred stock to get their money back.  As a result, you often see struggling companies raise inside rounds under this logic (often crushing the employee’s equity in the process).  But many times, this round of “bridge” financing ends up being a bridge to nowhere.

So, follow-on investing ends up being a much more complicated endeavor than it would first appear.  Clearly, there are some firms out there that have a great deal of discipline about follow-on financing and have been very successful.  But I think that this is a very very easy way to falter as an investor because it’s so natural to fall prey to these pitfalls.  As some super-angel funds increase in size, it will be interesting to see how they deal with these hurdles as well.  It’s easy to say that one will “pile in on their winners”, but the ability to do so will cut both ways.

Read more: http://articles.businessinsider.com/2010-08-17/strategy/30074026_1_venture-capital-investors-loss-aversion#ixzz1vzJKzpZV