Relativity Of The World And Why We Hate Losing Money
How would you feel if I offered you a salary increase of 5,000 dollars? Would you be happy? Or would you shrug and be indifferent? It depends. It depends on your attitude toward wealth, and more importantly, it depends on your current salary. If you are making 10,000 dollars, you would be ecstatic with the 50% increase. If you are making 100,000 dollars, you may not even register that you got an additional 5,000, as it would be only a 5% increase.
This is why companies often talk in percentages rather than the actual dollar value. When we speak in terms of percentual increase, it feels equitable. Everyone gets a 10% increase. It seems fair. No matter it means hundred dollars for one and ten thousand dollars for another. The perceived utility for each of the two people will be the same.
Utility theory
Nicolaus Bernoulli, a Swiss mathematician living in the 17th century, developed the utility theory and the first application of marginal utility. The theory nicely explains why poor people buy insurance, and wealthy people sell it. If you have a thousand dollars and there is a risk of losing 900 of them, you are happy to pay a small fee to transfer that risk to someone else. If you have a hundred thousand dollars, you are happy to own that risk of losing 900 dollars for a small fee.
It is a nice theory that explains how people approach money and make decisions. And it is wrong, or at least it is not complete. Imagine that you and I both have one million dollars. Do you think we feel equally happy? Once again, it depends. Aside from our general attitude towards money and our needs, it depends on how much we had last week. If I had nothing and you had ten million, I’m sure that while I will be excited, you will be depressed. It is not only the utility of wealth but also the recent change in what we have.
This is even more exacerbated by the fact that we care more when we lose something that was already ours versus gaining something we didn’t own yet. If I tell you that you have a fifty percent chance of winning thousand dollars, you will feel less anxious than if I give you thousand dollars and then tell you there is a fifty percent chance of you losing it. You have precisely the same chance of ending up with the same amount of money, yet you are much more worried about losing. This loss aversion has evolutionary roots as it is beneficial for survival to prioritize threats over opportunities.
Endowment effect
In Thinking, Fast and Slow, Daniel Kahneman describes the so-called endowment effect first described by Richard Thaler. Imagine you get a ticket for a concert by your favorite band. You paid fifty dollars for it, and in fact, you were willing to pay even a hundred. The show is sold out, and you get approached by other fans who offer you a hundred dollars. Will you sell? Very unlikely. The value of that ticket, at least in your head, is now higher than a hundred. While you were not willing to pay for it more than a hundred, you are not going to sell it for less than significantly more than that.
“Pain and pleasure have different values. The pain of giving up something usually has a higher value than the pleasure of gaining it. Loss aversion is in our nature.”
The item may have a specific utility value, but whether you buy or sell depends not only on the utility but also on whether you own it or not. If you own it, you need to consider the pain of losing it. If you don’t own it, you need to consider the pleasure of getting it. Pain and pleasure have different values. The pain of giving up something usually has a higher value than the pleasure of gaining it. Have you ever seen a small child fighting fiercely for a toy that it just got its hands on? It couldn’t care less about it a minute ago, but once the little boy or girl got possession of it, it won’t let go. Loss aversion is in our nature.
The endowment effect doesn’t exhibit the same way for impoverished people. For them, both loss and gain are actually losses. If there are certain goods that you genuinely need to survive, like food, but can’t afford, you don’t see a gift of a meal as a gain. It just lowers your losses. You need three meals a day, and one meal doesn’t solve your problem. You are still losing, even though the loss got a bit smaller.
What does this mean for you?
This asymmetry between the opportunity to gain and loss aversion makes any agreement about possessing things rather difficult to achieve. When transferring ownership, the value of my gain differs from that of your loss. That is why negotiations about price are often so complicated. It is not about the actual utility value of the item but about our emotions connected to it. Consider this the next time you negotiate. It may give you a more realistic idea about the true value of the thing you are selling or buying and may lead to a better agreement.
What is your take on the topic? Have you observed that the pain of losing something tends to be bigger than the pleasure of getting it? Do you have things in your possession that have sentimental value? What tricks do you use to look at the world through logic and throw away the things you don’t need?
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Originally posted on my blog about management, leadership, communication, coaching, introversion, software development, and career The Geeky Leader or follow me on Facebook and Twitter: @GeekyLeader
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