By Willem Burgers
4 January 2007
China Daily
Copyright 2007 China Daily Information Company. All rights reserved.
Risk aversion is often talked about in the world of finance, but according to economic prospect theory it is only half the story.
The other half is the other way around when people face the prospect of loss, they display a risk preference in that they hope to avoid the loss. They seek risk; they are willing to pay for risk. In a well-known example, suppose you are offered the following options:
A. Get $30,000 for sure.
B. Take an 80 percent chance on $40,000 with a 20 percent chance of getting nothing.
What do you choose? If you are like most people, you will choose A. We know that, on average, B is the better choice. The value of option B on average is $32,000. But we don't live our lives on average. Averages are not so interesting when you can only choose once. Most of us are willing to give up some potential gain in order to eliminate risk. This is something we all know. Thus, on average we get $30,000. We gladly pay $2,000 to avoid risk.
Now consider the following two options:
A. Lose $30,000 for sure.
B. Take an 80 percent chance of losing $40,000 with a 20 percent chance of losing nothing.
Now what do you do? Faced with this choice, the great majority of people prefer option B.
Thus, on average we lose $32,000. This time around we gladly pay $2,000 for the risk.
These results are useful for marketers. First, if you want someone to buy from you, especially when you are a new supplier or offering a new product, you are asking that person to take a risk. Since people are willing to take risk to avoid loss, do not tell them what they will gain if they accept your offer; instead, tell them what they will lose if they do not accept your offer.
Good car or house sellers love to use this weakness of ours against us. "This is a really nice car for you. But, to tell you the truth, if you don't buy it now, you will lose it for sure." It works even better if the salesperson adds: "I haven't told my boss yet, but I have someone else looking at this car who'll come back tomorrow to buy it." A shared secret of impending shortage "Nobody knows this yet" multiplies persuasive power.
For more about persuasion, you should read Robert Cialdini's fascinating book, Influence: Science and Practice, Allyn and Bacon, 2001, not just to learn how to be successfully persuade others yourself, but also to learn how to avoid unwanted persuasion.
My wife once bought a car and then found out I had to co-sign the loan. Looking at the papers I noticed they had taken her for a ride, adding life insurance on the loan and a maintenance and repair warranty. So I called the dealership and told them I would co-sign provided they removed these extra charges. They called her first, then she called me. "He said I might lose the car because of you." How many cars are there in America 100 million? She didn't lose the car.
In addition, the loss aversion, rather than risk aversion, we all have means we should look for opportunities in our customer relationships to build in elements of loss for the other party in case the relationship breaks down.
We can offer warehouse space, finance, promotional support and so forth. The more things like this we offer, the more the customer stands to lose when the relationship is broken. As a result, we can demand more and more from the relationship. In fact, we will demand rewards that exceed the expense of our generosity.
Customers might obtain a net gain by breaking the relationship, but they might not.
Willem Burgers is a permanent faculty member at the China Europe International Business School in Shanghai.
