Monday, April 22, 2013

Mediation and the Science of Decision Making Part VI: People Hate Losing More Than They Love Winning. Losses Loom Larger Than Gains.

A third principle of Daniel Kahneman’s work, together with the idea that people evaluate losses and gains relative to their reference points (discussed here) and the idea that people have a diminishing sensitivity to losses and gains (discussed here), is the idea that losses loom larger than gains. Kahneman traces this to the evolutionary need to be alert to danger.

Remember how the body reacts to the idea of financial loss? The idea of financial loss induces the classic fight or flight response because we perceive it as a risk to our well-being. The idea of gain, however, does not induce an equal but opposite visceral reaction.  

To illustrate the idea that losses loom larger than gains, ask yourself whether you would take the following gamble on the toss of a coin: If the coin shows heads, you win $150; if it shows tails, you lose $100. Would you take the bet?  

The simple math shows that this is a good bet. You have a 50% chance of winning $150 and a 50% chance of losing $100, so the expected value of the gamble is $25.  Here are the numbers : (50% x +$150) + (50% x -$100) = $75 - $50 = $25. 

Despite the math, most people would reject this gamble. You probably felt this yourself when you considered the gamble, and it made you feel nervous. In fact, most people require a potential gain of more than two times the potential loss in order to accept the gamble. In other words, I would have to offer you $200 or more to get you to accept a 50% chance of winning $100.  In mixed gambles – that is, situations in which both gains and losses are possible – this imbalance causes people to make extremely risk-averse choices. 

Consider a typical business dispute. Each party is making a claim against the other, so each party faces both the possibility of gain and the possibility of loss. The science suggests that both are likely to be relatively risk averse and make more conservative decisions. 

(As you read this, did you think of a notable business lawsuit in which the parties seemed to show no desire to avoid risk? The Bratz dolls case came to my mind as I wrote it. If you had a similar thought, you likely concluded that the science is wrong on this point about mixed gambles. Your reaction is a function of what Kahneman calls "associative memory," a powerful source of cognitive errors that Kahneman discusses at length, but that will have to wait for another day.) 

In contrast to the typical business law suit, in most employment actions, only the employee has claims against the employer. Further, the law typically allows a successful employer to recover its attorney fees in limited situations, if at all. Because the employee typically does not face this type of potential loss, the typical employment law case is not a mixed gamble, and the employee may feel free to make decisions that entail greater risk. 

However, as we will see next time, even an employee in this type of litigation will be influenced by the risk of loss.