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.
What is loss aversion?
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.
Loss aversion refers to the psychological and economic effect in which losses are weighted more heavily than gains.
How does loss aversion work?
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.
Loss aversion illustrated through examples
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 in marketing
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.
Combining loss aversion with the bandwagon effect in marketing is particularly effective. Through the positive example set by the customers who are already convinced, the sales pressure is psychologically “softened” in a manner of speaking.
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.
Additional effects relevant to marketing
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.