How To Overcome An Aversion To Loss: Lessons learned through the effectuation principle of affordable loss.

August 19, 2018

In business, most people would rather know what the future holds before committing to starting a business venture. This makes sense.  Common knowledge informs us that business venturing can be risky. Because we have a propensity to go to great lengths to avoid incurring loss, aka loss aversion (read the Tversky and Kahneman publication, Choices, Values, and Frames.), many people are fearful of acting on a business idea, for fear of failing and losing whatever resources were allocated. In other words, better not to try, and avoid failure, then to try, and experience loss. The future is certainly unknown, and no matter how hard we try to predict it, there is always risk in nearly everything we elect to do, especially in business enterprising. Effectuation helps us understand how expert entrepreneurs deal with this complex issue of risk and loss aversion, but still manage to start a business venture. Inexperienced entrepreneurs typically think about how successful and big their business idea will evolve into before they begin. Another way of looking at the mindset of an inexperienced entrepreneur is to understand that their primary focus is on expected returns.  Their energy, enthusiasm, and optimism fuels them into the world of the unknown, because after all, their mom told them their idea was brilliant. It is only after experiencing the pain of business failure that inexperienced entrepreneurs begin to develop greater entrepreneurial competency and figure out how best to avoid experiencing the pain of business failure.

 

Research done by Dr. Saras Sarasvathy and others about effectuation teaches us that expert entrepreneurs focus on what she calls affordable loss, instead of expected returns.  So, what is affordable loss? As Saras explains; “[Effectual entrepreneurs] decide what they are willing to lose rather than what they expect to make. Instead of calculating upfront how much money they will need to launch their project and investing time, effort, and energy in raising that money, the effectual entrepreneur tries to estimate the downside and examines what she is willing to lose.“ This mindset shift forces the experienced entrepreneur to think about the question of what do I do if the cost of starting this business is greater than what I am prepared to lose?

 

For example, lets assume a business requires $10,000 in cash and four months of unpaid full-time work to launch the business. The experienced entrepreneur calculates their affordable loss and determines that they are willing to lose $5,000 and two months of unpaid full-time work. Of course, this is not to say that the experienced entrepreneur would be happy if they lose $5,000, and two months of unpaid labor, but they feel comfortable with that level of risk. Obviously, this level of resources is not enough to start the business, so what do you do? Well, one option is to say, my affordable loss is deficient, therefore, I am not going to start this business. An alternative might be to put off your entrepreneurial aspiration until you are able to amass more resources and feel comfortable with losing $10,000 and four months of unpaid work. These first two choices aren’t horrible, but they’re not great, because both put off taking action. In these instances what invariably happens is the entrepreneur moves on, doesn’t ever act on the idea, watches Shark Tank years later, sees their idea being pitched, and thinks to themselves, I had that idea back in the day.

 

Research done on effectuation, and how experienced entrepreneurs behave, reveals a third option. Find two other people that are willing to invest $2,500 each ($5,000 total) and one month of full time unpaid labor (two months total), and you can launch the business sooner rather than later. You will then have the $10,000 needed, and the four months of unpaid full-time labor required. Of course, your ownership in the business will fall to 50%, while your new partners will each own 25%. But effectual entrepreneurs know that it is better to own 50% of something, then 100% of nothing. By thinking about what you are willing to lose, rather than what you think you will make, allows you to distribute the risk you are unwilling to take, and consequently act quickly. As Mark Twain said, the secret to getting ahead is getting started.

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