Loss Aversion

Be Careful What You Give-You Cannot Take it Back

Last Thursday was “comp day” at one of the premier investment banking firms, Goldman Sachs. This is the day when employees are handed their bonus for their previous year’s performance. Unfortunately, some reportedly received nothing. If you’ve never received a bonus for your work, that’s not a big deal. If you have, it is a big deal. Let’s find out why.

Imagine you’re babysitting a friend’s child, Jimmy, for the day and he’s been happily playing in your yard. The day is growing long and you decide to reward Jimmy’s good behavior. “Hey Jimmy,” you shout, “you’ve been such a good boy today how ‘bout I take you down to the store and get you a new ball?”

“Awesome!” Jimmy replies as he runs to hop in the car. “Can we get a kickball?” he asks as he slides onto the car seat.

“Sure thing,” you reply. “You’ve been really good today, Jimmy, and I want to reward you for that.”

“Works for me, Mr. Leider. Thanks!”

Anxious to give his new ball a try, Jimmy slides out of the car and onto the driveway without even closing the car door. Stepping to the edge, he holds the ball in front, one hand on each side and swings his right leg back. Hesitating for a moment, he then swings his leg forward in a graceful, powerful arc, sending the ball to the other side of the yard and squeals, “Yippee! Thanks Mr. L. This is awesome!” “You’re welcome Jimmy. I’m glad you enjoy it.”

Jimmy kicks the ball back and forth in the yard, enjoying each kick just as much as the one before. But as he tires, Jimmy has some difficulty keeping the ball in the yard. You watch as he winds up for another powerful stroke. The second his leg connects with the ball you see a car speeding down the street, oblivious to the ball hurled into its path. In an instant the ball is under the car, and then POW! Without hesitating, the car speeds on past, either unaware of the damage inflicted or unwilling to face a dejected child deprived of his precious toy.

“Mr. Leider, Mr. Leider!” Jimmy calls. “Awwww.” Tears begin to stream down his face and you rush to console him.
While it is certainly expected that Jimmy would be sad that his ball has been crushed, let’s step back for a moment to analyze this logically. In the first part of this story Jimmy is quite content playing in the yard without a ball. He has a certain reference point in terms of toys to play with and games he is able to play. You introduce a new toy and new modes of play follow. You have changed the reference point, raising the bar, so to speak.

As a leader, every time that you give your team members something you are changing the reference point. If you don’t give as much as before or take something away you generate unhappiness. While this may not be logical, it is a fact of human behavior.

So be careful what you give. While you can take it back—it won’t be pretty.

• Every time you give team members something you generate a new reference point
• As humans, once we have an enjoyable experience we desire to keep it or repeat it

Keywords: leadership, rewards, happiness, endowment effect, loss aversion, reference point

Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1990). Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325-1348.
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). Anomalies: The endowment effect, loss aversion, and status quo bias. The Journal of Economic Perspectives, 5(1), 193–206.
Munger, C. (1995, June). The psychology of human misjudgment. Lecture given at the Harvard University.
Tversky, A., & Kahneman, D. (1991). Loss aversion in riskless choice: A reference-dependent model. The Quarterly Journal of Economics, 106(4), 1039-1061.
Veenhoven, R. (1991). Is happiness relative? Social Indicators Research, 24(1), 1-34.

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Sovereign Debt, Happiness, and Leading with Difficult Conversations

The global financial markets have been on a roller coaster ride for the last several months, primarily due to sovereign debt issues in Greece and Italy. Observations of the leaders and populace in these countries illustrate two important lessons.

The first lesson is to have the courage to initiate the difficult conversations frequently required as a leader. In this case the conversation is about austerity. Greek Prime Minister George Papandreou has failed to clearly communicate to the general public the ramifications of their situation and the sacrifices all parties must take. While we don’t know that improved communication would have prevented the ensuing riots, it wouldn’t have hurt. Instead, Papandreou vacillated from issue to issue and hid behind the idea of a referendum vote to the general population, abdicating his leadership role. In the end his unwillingness to continue leading in a straightforward fashion cost him his job as Prime Minister.

Italy’s long-time, flamboyant Prime Minister, Silvio Berlusconi, has probably spent more time the last several decades defending himself against scandals than leading the country forward or handling Italy’s economic malaise. Similar to Greece, Italy is unable to continue to service its debt. Furthermore, Berlusconi has been unwilling to clearly articulate the country’s current economic situation, the sacrifices all parties must make to move forward, and a path to economic health.

I continually see similar situations inside organizations. The most frequent lapse is the inability or unwillingness for managers to counsel subordinates and give honest, less-than-stellar, performance appraisals. Few of us like to tell someone they are deficient in some way, but it is necessary in order to create a high performance team. Key elements are to be clear and fair. Explain the specific issue, provide a global context, and state specifically what you would like to see and how it will help the team perform better.

The second lesson we can learn from the recent sovereign debt issues is that it is very simple to give something but very difficult to take it away. The riots in Greece are a prime example. Protesters are upset with reduced pensions, lost jobs, and other government cutbacks. Had Greek leaders acted responsibly and provided only what it could afford, the current austerity measures would not have been necessary. The psychology behind this is quite simple, we become happy when we get something, but more unhappy when we lose it than we were at the outset.

• Gather the courage to have the difficult conversations
• You will generate more unhappiness when you take back something you have given

Keywords: leadership, communication, difficult conversations, loss aversion

• Darling, J., & Nurmi, R. (1995). Downsizing the multinational firm: Key variables for excellence. Leadership & Organization Development Journal, 16(5): 22-28.
• Mishra, K. E., Spreitzer, G. M., & Mishra, A. K. (1998). Preserving employee morale during downsizing. Sloan Management Review, 39(2): 83-95.
• Munger, C. (1995, June). The psychology of human misjudgment. Lecture given at Harvard University.
• Tversky, A., & Kahneman, D. (1991). Loss aversion in riskless choice: A reference-dependent model. The Quarterly Journal of Economics, 106(4), 1039-1061.

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