Imagine you are desperate to see your country’s team play in the World Cup quarterfinals; the game is sold out, but when you enter a radio contest, you win two tickets to the match. However, when the radio station calls you with the news, they also ask you this question: How much would you be willing to sell the tickets for? The only reference you have is that before running out, they were selling for $800. What do you do?
They say everybody has a price. What they don’t tell us is that sellers and buyers often have very different prices – prices that have little to do with supply and demand, as economic theory would have us believe. Embedded in our behavior are tons of irrational quirks that govern our perceptions and our decision making, and one in particular has been tested in many experiments: how we value and put a price on things. This has incredible relevance in businesses (and in life for that matter) because we are always buying or selling, whether it’s our work, our car, a house, a project, or tickets to a World Cup game.
One of these experiments, reported by Dan Ariely in Predictably Irrational, used a basketball game as the testing ground. They asked 100 ticket-holders and prospective buyers how much they would be willing to sell the tickets for and how much they would pay for them, respectively. Were the figures similar, given that everyone knew more or less what the ticket prices had been? Surprisingly, the prices named were so far apart that no deal could ever be made. How far apart were they? Double? Three times as much? The average price a seller named for his precious tickets was a whopping 14 times as much as the sellers were willing to pay. That’s the equivalent of you selling your World Cup tickets north of $12,000.
Granted, sporting events tend to strike an emotional nerve, thus making us more irrational than usual, but this scenario illustrates a set of behavioral particularities we all share. For example, we fall in love with what we have. Have you ever met a homeowner who sets the price of his house just a little too high? Or have you ever struggled to put a value on that car that has been with your family for so long it feels like a classic by now? Behavioral scientists call this the endowment effect. Once we own something, we attach a higher value to it, which is usually associated to our emotional imprint on the object. This applies to ideas as well. Have you met anybody (not you, of course) who, once he or she has expressed an idea or position publicly, feels too invested to let it go, even when proven wrong?
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Ownership of things or ideas changes our perception of their value, and that usually gets in the way of matching the buyer’s expectations, because of a second irrational quirk: we think others view the transaction from our perspective. While we believe ourselves to be highly rational, we have a hard time understanding that the other party might not share our feelings and memories. Of course those high ceilings and big patio are valuable to you, but all your buyer might see is how small the kitchen is and how the house lacks a second parking space. Our diminished empathy is due in part to the fact to the history we bring to the table. There’s a lot of value that is intangible to others, but crystal clear to us.
In a previous article on the challenges on investing in startups, I mentioned how entrepreneurs inadvertently increase their valuation of their companies to account for all the sleepless nights and time away from their children. You can see the same premium from an investor that knows how hard he had to work for his cash and expects “adequate” compensation for his/her risk. (The term “adequate” and “fair” are, in my experience, among the most relative terms in business language.)
Why are we so worried about compensating ourselves in this way? Because we focus more on what we might lose than on what we might gain. The homeowner is thinking of how she will never set foot in his house again, the entrepreneur is worried about all that equity she is sacrificing, and you are thinking about how you are going to miss your team advancing to the semi-finals for the first time in history. This is called loss aversion, and we all experience it. Inevitably, when looking at a deal, we have different attitudes towards risk depending on whether we are contemplating gains or losses, and this discovery earned Daniel Kahneman a Nobel Prize in Economics some decades ago.
Here’s an example: Let’s say you are contemplating a scenario where you might lose money. You were asked to choose between taking a sure loss of $1,000 to liquidate your business right now or keeping it open for three more months with a 50% chance of losing $3,000. More than 80% of people choose the latter, although is the option where you stand to lose the most ($3,000*0.5=$1,500). The bottom line is: We hate to lose, and in order to avoid it, we will usually make poor decisions.
Overvaluing what we own, whether that is a business, a home, an idea, or tickets to a game, is a basic human bias. So is worrying more about covering losses than about achieving gains. So what can we do about it? One strategy to help your chances of striking a good deal is by using an agent to mediate between different expectations or points of view. While we think of agents most often in the context of industries such as real estate, sports or entertainment, the presence of a third party in any negotiation helps smooth and facilitate the transaction and offsets (somewhat) this behavioral quirks we all fall prey to.
Another is simple self-awareness. In the end, the mere realization that this is something common to all of us can help us adjust our expectations and modify our behavior. Just knowing about these irrational behaviors that affect our decision-making can take us a long way. In business, as in life, we are constantly facing opportunities to create value through negotiating with others, whether our things, work or ideas are on the table. By being more aware of our biases, we can hope to become better dealmakers.
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Randall Trejos works as a business developer, helping startups and medium-sized companies grow. He’s the co-director of the Founder Institute in Costa Rica and a strategy consultant at Grupo Impulso. You can follow his blog La Catapulta or contact him through LinkedIn. Stay tuned for the next edition of “Doing Business,” published twice-monthly.