Would You Buy $20 for $204? How Loss Aversion Works
Professor Max Bazerman always starts the first day of his Harvard MBA class the same way. He holds up a 20-dollar bill and offers it up for auction to the class. He has two rules for this auction:
- Rule number 1: bids must be made in $1 increments.
- Rule number 2: the runner-up must honor their bid, meaning that, although the winner will take the 20-dollar bill, the second place finisher too must pay the last bid he or she made, but receive nothing in return.
This is a classic case where coming second means you lose all.
“The pattern is always the same,” he explains. “The bidding starts out fast and furious until it reaches the $12 to $16 range.” This is the point when those with weaker wills start to drop out. Meanwhile, like moths to a candle, the last two students get locked in. One bidder has bid $16 and the other $17; the $16 bidder must now bid $18 or suffer a $16 dollar loss. Neither student wants to be the fool who paid good money for nothing.
In Bazerman’s Harvard MBA class, students will continue bidding: $21, $22, $50, $100, up to a record of one auction that closed at $204, for a $20 bill! Indeed, in all the years Bazerman has been teaching, he has never lost a penny of that 20-dollar bill, but he does donate all the proceeds to charity.
Numerous experiments show that people behave irrationally when they begin losing money. Initially, all students feel that they have the opportunity to get easy money. They are not fools and will not pay more than twenty bucks for a twenty bill. However, as soon as the bidding reaches $ 12 – $ 16, the second person understands that he faces a serious loss, so he starts bidding more than he intended, until the auction reaches $ 21. At this stage, both parties will lose money. But someone has to lose only a dollar and the other twenty. To minimize losses, everyone tries to become a winner. However, this race leads only to the fact that both participants in the auction are losing more and more money until the loss is less than that amount, to dig a hole deeper that just does not make sense.
Thus, the desire to get easy twenty dollars fails. Most interestingly, there are lots of cases especially in the stock market and in the casino which shows the Bazerman phenomenon in action. When person begins to lose money, he hopes to win back a loss rather than fix the loss and almost always loses even more money. This is called the “loss aversion principle”, one of the many ways we act irrationally.
So remember the lesson here – the fear of loss leads to greater losses. Fix losses until they are minimal.
This story is from Sway: The Irresistible Pull of Irrational Behavior
