I recently had a discussion with a client about paving material choices for a large, old property with many beautiful existing gardens (it is now a non-profit enterprise) that receives overnight guests. This situation is an example of why we shouldn’t just keep going in a direction that feels wrong at the time.
Several years ago, a gazebo with an orange roof was added to the garden in the woods. The landscaper at the time recommended and installed a paver path with an orange* border. This is not at all in keeping with the rest of the gardens, which were bluestone and concrete in this 80+ year old property. Regardless, the path was installed.
Now, in preparation for new paths, the question was whether we should continue to use the pavers (including the orange!) as one of the selections for the new overall scheme. Shouldn’t we try for repetition? This, even though no one really liked the effect. But we had sunk costs in that direction!
Have you ever heard of Loss Aversion? This is a behavioral economics theory that tells us it is human nature to care more (twice as much) about avoiding loss than about gaining. People will continue to invest money in something they don’t like or know to be a good choice. Once they’ve made the investment, they become committed to avoiding a loss. We use a “sunk cost” fallacy – we’ve already invested in orange-edged paths, so we must continue our commitment to them.
From the website: www.BehavioralEconomics.com
Loss aversion is an important concept associated with prospect theory and is encapsulated in the expression “losses loom larger than gains” (Kahneman & Tversky, 1979). It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. (Emphasis added)
Individuals commit the sunk cost fallacy when they continue a behavior or endeavor as a result of previously invested resources (time, money or effort) (Arkes & Blumer, 1985). This fallacy, which is related to loss aversion and status quo bias, can also be viewed as bias resulting from an ongoing commitment. (Emphasis added)
The impact of this theory in buying and selling companies, not firing bad performers, not making a business decision because you may lose money (rather than you might gain money) is clear. How do you avoid it?
- First, make sure you know the theory exists and remind yourself to check your bias. It’s helpful to have someone other than yourself ask the question too.
- Second, spend the time to evaluate choices on a stand-alone basis.
You may find that the decision to break with the “sunk costs” is ultimately far more satisfying. Giving yourself permission to treat an orange-edged paver path as a “one-off” in the woods can be a relief!
If you’d like to further discuss whether you have biases in your current thinking about buying, selling or exiting your business, let’s have a conversation. In addition, we can help you determine your readiness for sale, selling or buying a company, or help with an existing acquisition. I can be reached anytime via email: [email protected] or phone at: 224-688-8838.
We’re here to help you Harvest Your Potential!
*Don’t get me wrong, Harvesters Love Orange!