What Loss Aversion and Behavioral Economics Teach us About HR Best Practices

behavioral economics loss aversion

Consider people's natural risk-averse behaviors when crafting HR policy.

Behavioral economics is the study of how human behavior and financial factors intersect. People may seem largely irrational in the choices they make, but as individuals, humans are biologically, socially and psychologically programmed to act and respond in certain ways.

For HR leaders, a clear understanding of the underlying principles of behavioral economics can provide the basis for more effective management, program design and talent retention. One concept that's particularly powerful is loss aversion. Here's a closer look at what loss aversion is and how HR leaders can use this idea to create more effective management policies.

Loss Aversion and the Human Psyche

Loss aversion is "the idea that losses generally have a much larger psychological impact than gains of the same size," says the Scientific American. The potential impact of loss may be twice as powerful psychologically as theoretical gains. Studies such as the one referenced in Scientific American typically show that people will accept a bet or take a risk when the upside is much higher than the risk. For HR leaders, there are clear implications around issues such as compensation, attracting new talent and incentivizing participation in workplace programs.

This principle plays into the way organizations make decisions and help guide their employees toward choices. As the Harvard Business Review notes, "To achieve true transformational change, CEOs must have more than a strategic plan. To effect actual change, they need to understand how biases — their own, and their employees' — can shape behaviors and decisions, and prevent them from achieving what they set out to achieve."

During times of change or when taking steps to drive specific actions on the part of employees, recognizing loss aversion and finding creative ways to leverage that can lead to better outcomes.

Choice Architecture: Loss Aversion in Action

Jordan Birnbaum, ADP's chief behavioral economist, describes loss aversion in terms that are directly applicable to the workplace. He writes in HR Technologist, "Loss aversion describes the human tendency to be twice as motivated to avoid a loss as to secure a gain of equal value." The way people make choices, though, are complex.

As Birnbaum has noted, people have a limited amount of mental energy and are constantly switching between automatic and reflective thinking. With automatic thinking, your brain takes over and you use less mental energy. This is how you operate when you're running a report that just requires clicking a button or listening to a conference call that doesn't necessarily have information that's vital to you. Reflective thinking is when you're engaged; you're actively working on a critical project or driving a new route for the first time, for example.

In many cases, loss aversion is an innate bias. It's a mindset people default to when they're relying on automatic thinking. Getting your employees to think about issues differently or react in new ways, such as overcoming loss aversion during change management, may require strategic engagement that helps employees tackle these issues reflectively.

How HR Leaders can Work With Loss Aversion

Be aware of the influence of loss aversion in change management: The Harvard Business Review notes loss aversion has a powerful impact on human behavior during times of change. They report, "This tendency to prefer avoiding losses over achieving equivalent gains drives powerful risk-averse behaviors that can hold us in place like gravity, leading us to prefer the status quo even when change is very much in our best interest."

Shift the way you incentivize growth: Birnbaum offers a powerful example of loss aversion at work. Imagine your firm is launching a management and leadership growth program. You're working hard to get your best people to participate, but it's taking some convincing. Maybe the program involves extra work or will require activities after hours or on weekends. The standard approach many HR leaders would take to increase participation is to say, "Think about all the opportunities you'll gain." In fact, it may be more effective to say, "Think about all the promotions and raises you'll miss out on if you don't participate."

Recognize loss aversion dynamics in hiring and retention: Loss aversion also plays a role when hiring and retaining top talent. For example, envision a recruiting scenario where you're trying to lure a key employee away from a competitor or just get a top player to accept your offer. Many recruiters will determine a prospect's current salary and make an offer that's just a bit over what they're currently making. Loss aversion suggests that the candidate is assuming a lot of risk for minimal reward, assuming they're currently employed or neutral about their current employer. Higher compensation — or clarity on the future raises, promotions and growth they'll miss out on if they turn down your offer — can be an essential part of overcoming this risk aversion.

Understand why changes where employees lose out are particularly harmful: Issues come up in the workplace where HR leaders need to make changes, where employees lose out or are perceived to lose out. Benefits is an area where HR has seen this trend in recent years. An organization that's struggling might need to reduce employer match for retirement or switch to a less expensive health insurance plan. These may be essential decisions, but particularly challenging to navigate due to loss aversion. An HR leader that has to save money might use this insight to choose a path to savings that doesn't take something away from an employee. They may also frame discussions in a way that helps employees look at changes in terms of how they might be impacted negatively if these changes weren't made.

Loss aversion guides how your workers look at situations and make decisions. For HR leaders, this important insight can help develop more effective messaging, frameworks and employee interactions. From anticipating the way loss aversion causes people to look at the larger picture to shaping the way they make career decisions, understanding these dynamics is essential to shaping a workplace where today's top talent thrives.