Loss aversion: The value of this effect in marketing

Losses tend to be weighted more heavily than gains of equal value. The cognitive dis­tor­tion, referred to as loss aversion, is one of the great psy­cho­log­i­cal dis­cov­er­ies in be­hav­ioral economics. The ir­ra­tional tendency to avoid losses in uncertain cir­cum­stances is also based on evo­lu­tion­ary psy­chol­o­gy and probably dates back to the time of hunter-gatherers.

In the following sections, you will learn what the phe­nom­e­non of loss aversion is and why this psy­cho­log­i­cal effect plays such an important role in marketing.

Both companies and customers have to fight against cognitive dis­tor­tion every day. It can influence, distort, and alter our per­cep­tion, memory and judgment. One such distorted per­spec­tive is loss aversion, which makes dealing with gains and losses un­nec­es­sar­i­ly com­pli­cat­ed for us humans. Loss aversion is char­ac­ter­ized by the phe­nom­e­non in which losses tend to be weighted more heavily than gains. For example, the feeling of frus­tra­tion over losing 100 dollars is generally much more intense than the feeling of happiness one would have over gaining the same amount.

This is why loss aversion also plays an important role in marketing. To achieve maximum success in marketing, it is important to present customers with op­por­tu­ni­ties to gain something while keeping costs, oblig­a­tions, and so on out of the limelight.

Loss aversion is a key part of “prospect theory”, which was developed in 1979 by Daniel Kahneman and Amos Tversky, who were both psy­chol­o­gists and econ­o­mists. The two fellow re­searchers were awarded the Nobel Prize in 2002 for their overall work. However, this was after Tversky had passed away.

The de­f­i­n­i­tion of loss aversion makes one thing crystal clear: this type of cognitive dis­tor­tion has an enormous impact on marketing and related areas. The key term in this situation is “ir­ra­tional­i­ty.” In economics, it was long believed that the eco­nom­i­cal­ly-minded person (i.e. Homo eco­nom­i­cus) acts ra­tio­nal­ly and pursues their ends optimally. However, the phe­nom­e­non of loss aversion has shown that people behave ir­ra­tional­ly when making decisions, es­pe­cial­ly when un­cer­tain­ty plays a role.

Un­cer­tain­ty increases the like­li­hood that potential losses will be weighted more heavily than potential gains. From the per­spec­tive of the decision-maker, losses are weighted about twice as heavily as gains of the exact same value. Kahneman and Tversky provided an ex­pla­na­tion for loss aversion: People do not value an in­vest­ment (e.g., houses, stocks, products) based on the end result. Instead, the valuation is completed based on a reference point. The reference point is usually the time of purchase.

A classic example il­lus­trat­ing loss aversion is the taxi driver example put forth by the American economist Colin F. Camerer. Through his empirical study conducted in 1990, he further proved Kahneman and Tversky’s loss aversion hy­poth­e­sis. He observed taxi drivers in New York’s highly com­pet­i­tive market and examined their fluc­tu­at­ing incomes and working hours.

In doing so, he dis­cov­ered that pro­fes­sion­als such as taxi drivers also behave eco­nom­i­cal­ly ir­ra­tional­ly because they are “loss averse.” The drivers should have worked longer on days with high demand to make up for any days with low demand. However, the exact opposite ended up being true. The taxi drivers set them­selves a fixed income goal for each day and instead worked par­tic­u­lar­ly long hours on days with low demand in order to reach their goal.

Another well-known example of loss aversion is the endowment effect, which is closely related. This effect states that if we own something, it is worth more to us. The Endowment Effect is si­mul­ta­ne­ous­ly further proof that loss aversion exists. Ac­cord­ing­ly, the endowment effect can either be used alone or in con­junc­tion with loss aversion.

Loss aversion plays a par­tic­u­lar­ly large role in pricing and promotion and even affects product de­vel­op­ment. The im­por­tance of this type of cognitive dis­tor­tion is equally high in areas such as marketing and sales psy­chol­o­gy. The following are marketing methods that use loss aversion:

• discounts, coupons and rewards
• free trials and product samples
• pre-ordering options for new products
• exclusive mailing lists for specific products
• social proof and “fear of missing out”
• com­mu­ni­cat­ing urgency or scarcity (actual or implied)
• following up on customers with in­com­plete shopping carts or orders

The wording is crucial. For example, “save $100 now” is more elegant than “gain $100 by pur­chas­ing this product”.

Due to loss aversion being so broadly ap­plic­a­ble and involving so many aspects, it has been used quite ag­gres­sive­ly since its discovery. For example, it is used in the following common marketing slogans:

• “Only available today.”
• “Only X products left in stock!”
• “Don’t miss out. Buy now.”

The use of short windows of avail­abil­i­ty, product shortages, urgent calls to action, count­downs, and deadlines are all effective marketing prin­ci­ples related to loss aversion. However, as these measures are short term, so is their effect. Therefore, playing with a customer’s loss aversion can sometimes be a useful tactic, but it is far from being a so­phis­ti­cat­ed marketing strategy. Nev­er­the­less, the use of loss aversion in marketing has its place and is important in marketing processes. However, it should not be too blatant. The longer and more intensely customers are con­front­ed with shortages and time pressure, the more likely they are to become numb to it.

You can even leverage loss aversion for marketing in freemium business models or any form of upgrade. During the trial phase or when using the product, the company activates an ad­di­tion­al function for the customer that is valuable and useful. If the customer wants to avoid any losses afterward (e.g., product quality or ownership), they will have to make a purchase with such models.

The ir­ra­tional behavior of people in uncertain sit­u­a­tions, which describes loss aversion so ac­cu­rate­ly, can thus be put to good use by marketers. By combining this with knowledge of other cognitive dis­tor­tion phenomena such as the anchoring effect, the halo effect and the IKEA effect in marketing, you can optimize the success of your marketing campaigns over the long term rel­a­tive­ly easily.