Loss Aversion

We hate losses about twice as much as we enjoy gains, meaning we are more likely to act unethically to avoid a “loss” than to secure a “gain.” This phenomenon is known as loss aversion.

Discussion Questions

1. Studies show that people hate losses twice as much as they enjoy gains?  Is that consistent with your experience?

2. Have you ever been caught off guard doing something you probably shouldn’t have been doing (eating the last cookie in the cookie jar, peeking in someone’s diary, touching your mother’s jewelry) and when surprised with the question: “What are you doing?”, quickly and almost automatically (and falsely) said: “Nothing!”

3. Nick Leeson famously almost sank Baring’s Bank when he lost a big chunk of money, but was too embarrassed to admit it and then doubled down trying to make the money back before the loss was discovered.  The losses grew and grew (to more than $2b) as he took increasingly risky bets.  Indeed, this is a famous pattern in financial frauds including those involving Jerome Kerviel (lost $6.3b trading for France’s Societe Generale) and John Rusnak (lost $691m trading for Allfirst Bank).  Does it seem to you that loss aversion plays a role in this dynamic?

4. A recent study found that when people were under time pressure, they were more willing to cheat to avoid losses (“losing the sale”) than to accrue gains (“getting the sale”).  Do you think that is how you would react?

5. Can you think of any situations where you or someone you know may have made decisions affected by loss aversion?

6. Evidence indicates that over-withholding of taxes reduces tax cheating.  Can you explain why?

7. What steps can people take to minimize the chance that loss aversion will help lead them to act unethically?

Case Studies

The Collapse of Barings Bank

Founded in 1762, Barings Bank was a United Kingdom institution with worldwide reach. Even the Queen of England had an account there. In 1989, Nick Leeson was hired at Barings, where he prospered. He was quickly promoted to the trading floor and appointed manager in Singapore where he traded on the Singapore International Monetary Exchange (SIMEX). Leeson was an aggressive trader, making large profits in speculative trading. In 1993, his profits constituted almost 10% of Barings’ total profits. He had developed a reputation for expertise, for near-infallibility, and his superiors in London gave him little supervision.

In July 1992, a new Barings employee suffered a small loss on Leeson’s watch. Leeson did not wish to lose his reputation for infallibility, or his job, so he hid the loss in an error account. Leeson attempted to make back the loss through speculative trading, but this led to even bigger losses, which again were hidden in this account. He kept doubling up his bets in an attempt to get out from under the losses. Leeson later said: “[I] wanted to shout from the rooftops…this is what the situation is, there are massive losses, I want to stop. But for some reason you’re unable to do it. … I had this catastrophic secret which was burning up inside me—yet…I simply couldn’t open my mouth and say, ‘I’ve lost millions and millions of pounds.’”

Leeson took out a short-term, highly leveraged bet on the Nikkei index in Japan. At the same time, a severe earthquake in Kobe, Japan sent the index plummeting, and his loss was so huge that he could no longer hide it. Barings, a 233-year old bank, collapsed overnight and was bought by ING for £1. Leeson fled to Malaysia, Thailand, and finally to Germany, where he was arrested and extradited to Singapore. He plead guilty to two counts of deceiving bank auditors (including forging documents) and cheating the SIMEX. Leeson was sentenced to six and a half years of prison in Singapore, but only served four years due a diagnosis of colon cancer, which he ultimately survived.

Discussion Questions

1. How was loss aversion apparent in Nick Leeson’s conduct? Explain.

2. Judith Rawnsley, who worked for Barings Bank and later wrote a book about the Leeson case, proffered three explanations for Leeson’s behavior once the losses had started to pile up: 1) Leeson’s loss aversion stemmed from his fear of failure and humiliation; 2) his ego and greed were exacerbated by the macho trading environment in which he operated; 3) he suffered from common distortions in thinking patterns that often result from high levels of stress, including overconfidence and denial. Which of these explanations (or all) do you think played a role in this case? Why?

3. Leeson explains that he wanted to stop, but could not. Based on his and Rawnsley’s reflections, where do you think the blame primarily lies and why? With Leeson individually, or with the system within which he operated?

4. If you were in Leeson’s position after the initial loss made by the employee, what would you have done? Why?

5. Do you have trouble owning up to mistakes that you have made? Do others whom you know? Explain with examples.


Teaching Notes

This video introduces the behavioral ethics bias known as loss aversion. We hate losses about twice as much as we enjoy gains, meaning we are more likely to act unethically to avoid a “loss” than to secure a “gain.” This phenomenon is known as loss aversion and must be guarded against.

People can relate to the notion that loss aversion has an impact on tax cheating. People will cheat more to avoid a loss than to secure a gain. So, if they have over-withheld, they are less likely to cheat in order to obtain a larger tax refund (which they view as a gain) than they are to cheat if they have under-withheld and are trying to avoid making a tax payment (which they view as a loss).

Students can usually grasp the idea of loss aversion and relate to it in their everyday lives. A student is more likely to cheat to avoid flunking out of school (a loss) than to move from a B to an A (a gain), unless the student has a 4.0 GPA and views the potential B as a loss.

In life, loss aversion often means that people who have made mistakes and perhaps even violated the law through carelessness or inattention often will, upon realizing that fact, take their first consciously wrongful step in order to attempt to ensure that the mistake is not discovered and they do not lose their job or their reputation. They will lie, they will shred, and they will obstruct justice.

In business, loss aversion also means that firms that are performing well, but not as well as they expected to or as well as others expected them to, may engage in unethical behavior because they frame their act of profiting (but not profiting as much as expected) as a loss rather than a gain.

Loss aversion is related to the behavioral ethics concept of framing because the same situation can often be framed as a potential loss or a potential gain, and the difference in framing can definitely affect people’s decisions. To learn more about this concept, watch Framing.

To learn more about how the ethical dimensions of decisions can fade from view, watch Ethical Fading.

The case study on this page, “The Collapse of Barings Bank,” details an extreme case of loss aversion when investment banker Nick Leeson, faced with growing losses, took big risks in attempt to get out from under the losses with dyer effects. For a related case study about the famed fall of a major energy company due to dubious practices, read “Selling Enron.”

Terms defined in our ethics glossary that are related to the video and case studies include: ethical fading, framing, loss aversion, moral cognition, and moral emotions.

Behavioral ethics draws upon behavioral psychology, cognitive science, evolutionary biology, and related disciplines to determine how and why people make the ethical and unethical decisions that they do. Much behavioral ethics research addresses the question of why good people do bad things. Many behavioral ethics concepts are explored in detail in Concepts Unwrapped, as well as in the video case study In It to Win: The Jack Abramoff Story. Anyone who watches all (or even a good part) of these videos will have a solid introduction to behavioral ethics.

Additional Resources

Kern, Mary C., and Dolly Chugh. 2009. “Bounded Ethicality: The Perils of Loss Framing.” Psychological Science 20 (3): 378-384.

Mishina, Yuri, Bernadine J. Dykes, Emily S. Block, and Timothy G. Pollock. “Why “Good” Firms Do Bad Things: The Effects of High Aspirations, High Expectations, and Prominence on the Incidence of Corporate Illegality.” Academy of Management Journal 53 (4): 701-722.

For resources on teaching behavioral ethics, an article written by Ethics Unwrapped authors Minette Drumwright, Robert Prentice, and Cara Biasucci introduces key concepts in behavioral ethics and approaches to effective ethics instruction—including sample classroom assignments. The article, published in the Decision Sciences Journal of Innovative Education, may be downloaded here: “Behavioral Ethics and Teaching Ethical Decision Making.”

A detailed article by Robert Prentice with extensive resources for teaching behavioral ethics, published in Journal of Legal Studies Education, may be downloaded here: “Teaching Behavioral Ethics.”

An article by Robert Prentice discussing how behavioral ethics can improve the ethicality of human decision-making, published in the Notre Dame Journal of Law, Ethics & Public Policy, may be downloaded here: “Behavioral Ethics: Can It Help Lawyers (And Others) Be their Best Selves?

A dated but still serviceable introductory article about teaching behavioral ethics can be accessed through Google Scholar by searching: Prentice, Robert A. 2004. “Teaching Ethics, Heuristics, and Biases.” Journal of Business Ethics Education 1 (1): 57-74.

Transcript of Narration

Written and Narrated by

Robert Prentice, J.D.
Business, Government & Society Department 
McCombs School of Business
The University of Texas at Austin

“Psychological tendencies and organizational pressures can cause even good people to act unethically.  Consider loss aversion, which is our tendency to prefer avoiding losses to acquiring gains. You probably won’t be surprised to learn that people detest losses about twice as much as they enjoy gains.

Loss aversion is related to prospect theory, developed by Nobel Prize winner Daniel Kahneman and Amos Tversky, which includes the notion that people will take much greater risks to avoid losing what the things have than they would have taken to gain them in the first place.

All this means that people who perhaps inadvertently commit an unethical act will often consciously decide to lie to cover up their inadvertent mistake.  In order to get his coaching job in the first place, former Baylor University basketball coach Dave Bliss probably would not have stooped so low as to try to pin a false drug dealing rap on one of his players who had been murdered.  But in order to avoid the loss of that same job, Bliss did exactly that.

Bernie Madoff’s massive Ponzi scheme may well be explained, in part, by loss aversion.  Madoff has explained that he had made trading errors before, but when it appeared that his entire business model was wrong, he committed fraud not so much to get rich, but to cover up his mistake.  He said: “I refused to accept the fact—could not accept the fact that for once in my life I had failed. I couldn’t admit that failure and that was a tragic mistake.”

A recent study Schrand and Zechman found that companies often unintentionally overstate earnings, perhaps due to over optimism, but this gets them into a situation where in order to avoid having to admit an embarrassing error, they will begin intentionally misleading investors to avoid a hit to their reputation.    Martin Grass, CEO of Rite-Aid Corporation provides an example.  After being sentenced to eight years in jail for accounting fraud, Glass admitted:  “[W]hen things started to go wrong financially, I did some things to try to hide that fact.  Those things were wrong.  They were illegal.  I did not do it to line my own pockets.”

Remember that Martha Stewart didn’t go to jail for insider trading.  She went to jail for obstructing a federal investigation into that insider trading in an attempt to avoid a loss of reputation.  And the accounting firm Arthur Andersen was convicted not of securities fraud but of shredding two tons of documents to try to cover up its errors and avoid potential fines.

To be ethical people, we have to monitor our own actions and motivations constantly.  And we may need to muster the courage to admit to even our most painful mistakes.”