Our “loss aversion” tendency creates inertia and thwarts innovation.
This is not something that is a one-off though. When you assess some of our innovations that have been delayed, you probably can see similar attempts at playing “devil’s advocate” coming in the way.
Research has shown that people and organisations possess a negative bias. Simply stated, our fear of losing is more than the joys of winning. It is called loss aversion.
I am very pleased that Anita has written this week’s message on this important topic. Anita, as you know, leads our global innovation cell. He has also built up our global exports function.
Please read on…
What is loss aversion?
All of us have been through the often gruelling process of school and college education. Here the chase for ‘grades’ starts early and competition is tough and painstaking. The gradation determines the level of joy or pain. Ever wondered why the pain in our minds for a friend failing is far less than the pain if the same friend comes out with flying colours?
For some of us the chase for ‘grades’ slowly gave way to the chase for ‘timelines’ and ‘targets’. Overcoming challenges and over-delivering becomes a burning desire. Top grades give way to top bonus earnings. The joy of a rising bonus index turns to pure elation for some maybe at a 3 index. But have you ever wondered why the pain in our minds for others getting a 4 index is far higher than the pleasure of us having earned a 3 index?
As George Harrison put it, ‘It’s all in the mind’. Losses are twice as powerful, psychologically, than gains. Turns out that most of us don’t like losing. In fact, it’s what the academics call loss aversion. We notice and react to angry faces in a crowd more readily than we do happy faces. We feel the pain of loss more acutely than we feel the pleasure of gain. In other words, we may like to win, but we hate to lose.
In 1979, two Israeli psychologists, Daniel Kahneman and Amos Tversky, published a paper titled “Prospect Theory” demonstrating our aversion to loss through a simple game (also plays out in the 20 questions of the famous British realty show ‘Who wants to be a millionaire’ or its Indian version “Kaun Banega Crorepati”).
Imagine I just gave you $100,000 with the following two choices: I will either guarantee you an additional $50,000, or I will allow you to flip a coin. If you choose to take the coin flip, if the coin comes up heads, you can win another $100,000. But if the coin lands on tails, you get nothing more.
Which option would you choose: the $50,000 guaranteed additional amount or the possibility of either an additional $100,000 or nothing more? Most people choose to take the certainty and walk away with $150,000.
But suppose instead I gave you $200,000, with the following two choices: I will either guarantee you lose $50,000 of the $200,000, or you can flip a coin. If the coin comes up heads, you will lose $100,000; if the coin comes up tails, you lose nothing.
Now which option do you choose? Most people choose to flip the coin.
In 2002 Daniel Kahneman shared the Nobel Prize for Economics but unfortunately Amos Tversky had passed away by that time.
Loss aversion and innovation
We see this aversion to loss play out in the lives of many of us when we try to make smart decisions, especially when it’s time to make a change or innovate. It almost doesn’t matter what change we need to make. We hesitate to change from the current situation because it means having an opinion and making a decision. And with a decision comes the very real possibility that we’ll make the wrong one. Sticking with the status quo feels much better even if we know it’s costing us money. At an organisational level, this tendency increases exponentially. The compounding effect of risk-averse behaviours across thousands of individuals — each preferring known working patterns over the perceived risk introduced by change — generates overwhelming organisational inertia. The end result: we don’t change, innovate and the organisation suffers.
Loss aversion is the single biggest detractor to innovative ideas. You’ve had a creative idea that you believe could become a breakthrough innovation. You’ve researched and modelled the idea’s potential and believe it could generate substantially more revenues for your company. You share and are devastated when rejected as being too expensive, too risky and probably something your customers would not like.
Your mistake was selling your idea on its benefits. You would have done better to sell it by emphasising the consequences of not implementing your idea.
Start-up companies are almost synonymous with innovation, whereas well established companies are usually perceived as being risk averse and much less innovative. An established business in normal times (i.e., not during an economic recession) usually generates a continuous and most likely slow increasing income. Thus, when faced with diverting resources to implement an innovative idea, the manager is faced with a choice of a guaranteed gain, versus a gamble on the possibility of winning a greater amount but under the threat of getting nothing. Not surprisingly, most managers opt for the guaranteed option.
A typical start-up company, on the other hand, begins its existence losing money. Capital is invested in salaries, equipment, raw materials, etc. But from the moment the start-up begins operations, money starts disappearing. Usually it takes one or more years before a start-up generates more income than it losses. Not implementing the idea will result in a continued and predictable loss of income and thus innovation is a desired choice.
There are two main loss aversion factors that make meaningful investment in innovation harder to manage than other corporate activities. First, innovation is fraught with uncertainties. It deals with the future, requiring assumptions about future market needs, market trends, dominating technologies and many other factors. The outcomes of innovation projects are therefore, highly uncertain. Research suggests that 40 to 90 percent of new product developments eventually fail.
Second, there is a tension between the short term and the long term. Innovation may be crucial for a company’s long-term wellbeing, but it requires investment in capacities and resources without immediate cash flows. This makes innovation activities vulnerable to short-term pressures to allocate capital to more pressing matters, making rational decisions hard to come by. Faced with high levels of uncertainty and tangible near-term needs, many companies forego a promising investment in growth for the more present concerns of value preservation and cost savings.
The traps of loss aversion
These loss aversion factors play upon four behavioural traps which impair investments for innovation decisions: underinvestment, choosing by not choosing, focusing on the trees and ignoring the forest and sticking with the familiar. How does one get around these aversion traps?
Companies sometimes shield their innovation budgets and commit to a certain level of R&D spending in the future, irrespective of the current business situation (e.g. R&D expenses relative to sales). Where disruptive innovation is a risk for companies, they also set aside a separate bucket to fund radical innovations.
Recent empirical research of 1,200 companies from 39 countries suggests that companies with R&D spending significantly above the industry standard enjoy higher market capitalisation.
2. Choosing by not choosing – (set default choice or not choosing at all)
While innovation itself cannot be automated, innovation incentives and contexts can become institutionalised. Companies often make innovation an integral part of workplace routines, internal and external stakeholder expectations and corporate culture. Thus innovative behaviour in a company becomes the default option.
Consider Red Bull, a producer of energy drinks. Founded in the mid-1980s, Red Bull had within a short timeframe become the leader in a strongly growing market that the company itself created. A big part of this rise rested on the institutionalisation of permanent innovations in its marketing approach. Associating the brand with edgy sports and relying on non-traditional marketing, Red Bull created unorthodox events such as the flugtag, or “flight day,” where homemade flying machines vie to stay in the air as long as possible; breakdance competitions; cliff diving events; and soapbox and air races. The latest and possibly most spectacular was the Stratos project, the world-record jump from the edge of space to the earth, which was watched by 8 million YouTube users. The default option, in the case of Red Bull’s marketing, was to create novel events and experiences in a clearly defined area of focus. This raises the bar for future marketing activities, sets internal and external expectations, and establishes a clear reference point against which new projects must compete.
3. Focusing on the trees and ignoring the forest
Understanding innovation projects as a portfolio rather than an individual project is important. Thus, innovation and performance metrics is applied to an innovation portfolio as a whole, rather than governing individual projects. Given the inherent uncertainty of innovation, it is safe to expect that some projects will fail, and others will succeed. The critical goal is to ensure that the overall innovation portfolio performs well. A conscious effort to classify innovation projects according to their risk/return profile and manage the resulting portfolio according to pre-defined goals shifts the focus away from individual projects in favour of the portfolio level.
4. Sticking with the familiar
In the realm of innovation, the familiarity bias corresponds to the not-invented-here syndrome. Instincts suggest that the ideas generated internally are superior or more feasible than those coming from external sources. The other consideration pertains to which sources feed an innovation portfolio and which ideas enter an innovation portfolio.
The problem of Nokia, after all, seems frustratingly similar to those of many large companies such as Microsoft or Sony who could not develop high quality innovative products fast enough to match their rising competitors. The fear of losing internal momentum and external sales in the short term prompted them to emphasise the quality of Nokia’s products and internal developments and downplay somewhat, the competitive threats from other companies like Apple and Google to larger internal and external audiences. CEO Kallasvuo noted that somehow the sense of urgency to innovate had waned and managers of the successful company were more intent on defending and preserving existing successes than attacking competitors by developing radically new products and incurring the risk of failure. He admits that the culture of “Not Invented Here” had become entrenched.
To avoid the familiarity bias, innovators tend to diversify their sources of ideation in the same way investors need to diversify their investments. Companies integrate external experts to access new perspectives and lateral thinkers. The company maintains close relationships with universities, intensively cooperates with university chairs and research projects, and regularly discusses trends that are important to the company in trend forums or during tech days with clients, experts, and industry participants. This external ecosystem and the constant external feedback in every phase of the innovation process help the company to have diversified sources of ideation and to steer the innovation process in a market-oriented manner.
Finally not everyone is loss averse. Imagine when we are queuing up to check out and the queue is long, if there is a new cash counter opening, some people will rush to that counter but some will stay at the queue. For those people who stay at the queue, it is a kind of loss aversion but the others have made a choice. Sometime when people are being loss averse, the situation they are in has the probability to benefit them. While the ‘Insurance’ industry uses this psychology to its advantage, ‘free trials’ also successfully target loss aversion as people are inherently afraid of loss and free is a powerful motivator because we don’t like to miss out on a bargain. Pokemon Go and Netflix have used this to successfully create loyalty.
Many thanks to Anita for sharing this very insightful message.
We are at an exciting stage in our growth journey. We have transformed significantly over the last few years – and we are fortunate to have some incredible, much–loved brands and a great team. The possibilities ahead are tremendous. We have the opportunity now to grow even faster. Despite the ongoing macroeconomic challenges, there is significant potential in the geographies and categories where we are present, just as there is scope for us to become truly world class in our outlook and processes.
But to be able to tap into all of this, we must get much better at challenging the status quo and seeing the opportunity in uncertainty. We cannot let inertia set in. We have to be willing to experiment, take calculated risks and be okay with making some mistakes.
That’s the only way we will be able to innovate faster and better and delight our consumers.
We need think much harder about how loss averse we are and what the impact is on the decisions and tradeoffs that we are making. How often do we fall into the traps that Anirban has mentioned? What is triggering it? And what can we do to pull ourselves out of them? If we want to foster a culture of innovation at Godrej, then it can’t be piecemeal. Each of us needs to commit very strongly to driving it.
Do write in with your thoughts and suggestions. I look forward to hearing from you.