I knew it wasn’t that simple!

Prospect TheoryI’ve recently had that experience: the one where you’ve always thought something is peculiarly wrong about conventional wisdom but couldn’t quite put your finger on why…then you happen to read a book and “aha! That explains it.”

Now, rather than pointing you to the research…or (worse) attempting to rewrite (by which I mean ‘butcher’) it here, I’m going to try and provide a concise post around my ‘aha’ moment:

The topic in question:

I’ve written before about the harm that contingent rewards do, and this has mainly been from the point of view that they distract us and distort our actions (and these remain massive criticisms) …but I’ve always thought that there is more to be said about the emotions people experience when it comes to the annual bonus.

If you’ve worked in an organisation that uses financial incentives, cast you mind back to the joys of bonus time. How much of the following rings true:

  • You’ve got a bonus but you aren’t exactly ecstatic about it…there’s plenty of negative emotions going on
  • You are aware of what you didn’t get
  • You compare with what you got in previous years
  • You were really only ‘arguing over’ a couple of hundred dollars in your performance review…but you still fought hard for this or, if you are introverted, perhaps you did so in your head.
  • …no doubt you can add your own thoughts for the reactions and emotions you experience (or, if you manage people, have to deal with).

This sounds crazy – you should be happy shouldn’t you?…you got a bonus! So what’s going on?

Utility Theory1:

Classical economists have based their thinking around the ‘rational person’ for hundreds of years. In particular they assume that, given a set of options, we make logical comparisons and then make rational choices.

Given that two options may not be directly comparable (say a carrot with a banana), Economists talk about utility as a measure of worth. At its simplest, the measure of utility is your willingness to pay different amounts for different goods (and services).

Further, when there is uncertainty about an outcome, utility theory assumes that we rationally use probabilities in our thinking. i.e. If there’s a 75% chance of earning $1,000 then the utility of this option is $750.

…but it turns out that we aren’t that rational!

Example 1: You are offered the choice between:

  1. a sure gain of $750; or
  2. a 75% chance at winning $1,000 and 25% of winning nothing

What would you do? … please consider and take a few seconds to decide.

Utility Theory expects these choices to be identical (both valued at $750) but, to the vast majority of us, they are not.

It turns out that we overwhelmingly prefer the certainty in the sure gain of $750 (we are risk-avoiding). This probably feels right to you but what’s going on?

‘Behavioural Economists’ to the rescue…

Psychologists consider what people really do (and why), as opposed to what a rational (well reasoned) analysis says they should do.

Some of these psychologists started looking at ‘real’ decisions made by people that contradict what a rational economist would expect. This gave birth to the rather trendy (and I would say fascinating) school of ‘behavioural economics’.

Prospect Theory2:

Two of the early giants of behavioural economics, Amos Tversky and Daniel Kahneman, spent years together considering scenarios where utility theory broke down (i.e. where real people took irrational decisions) and how this can be explained.

They arrived at a new ‘Prospect Theory’ that far better explains3 why we behave as we do. So, now that you have this background knowledge, let’s consider the annual bonus:

That wonderful (?) annual bonus:

So, when ‘Management’ believe that they are offering you a healthy bonus, they likely think you are conforming to Utility Theory. Indeed, much of their (verbal and written) communications around such a bonus suggest this is so.

But such thinking is far too simplistic, and flawed. Tversky and Kahneman identified a number of cognitive features at play. I’ll explain two key features below:

Feature 1 – Reference point:

Do you think that a financial trader should be ecstatic with her mega $2 million bonus?

What now if I told you that this is only half of what she has become accustomed to?

I expect that you would be ‘over the moon’ with such a bonus but you also understand that the trader may not be (however much this might annoy or even disgust you)…you have different reference points.

Why the difference? This is because we don’t just consider the quantity of an outcome; we use a reference point as a comparator, though we may not be conscious of doing so.

Here’s another way of thinking about the importance of reference points: If I told you that two people had been at the (horse) races today and they both came out with $50 you don’t have enough information to predict how they feel…you need a reference point: how much did they start with?

Our reference points have a huge effect on our thinking and this cognitive feature is relevant to the annual bonus scheme:

Scenario: Let’s take Bob who is on a $70,000 salary and is being ‘motivated’ (!) by the chance to earn a 10% bonus.

‘Management’ would like to believe that Bob is thinking about his chance to gain up to $7,000; that he will consider this to be a sizeable amount; and that this is a positive experience for him (translation: it is acting as an ‘effective bribe’ to get more out of him):

i) If this is the first year of the annual bonus scheme, then Bob’s reference point is $70,000 and he is happy when he is awarded, say, a 75% ‘performance’ score equating to a bonus of $5,250 (i.e. 75% of $7,000);

ii) If this is, say, the 3rd year of the scheme and Bob has averaged a 75% performance score on both his previous years, then his reference point has become $75,250. This is what he has come to expect and he will compare any bonus he receives this year against this reference point…which you can see means that the bonus has lost a great deal of value to him. Indeed, it is very likely to be a disappointment.

Annual bonus schemes look great at the start, but cause problems after only a few iterations. There is nothing procedurally that can be done to resolve this – the reference point has moved away from a person’s base salary and to what they now expect.

Kahneman notes that “For financial outcomes, the usual reference point is the status quo, but it can also be the outcome that you expect, or perhaps the outcome to which you feel entitled, for example, the raise or bonus that your colleagues receive. Outcomes that are better than the reference points are gains. Below the reference point they are losses.” …which leads nicely on to:

Feature 2 – Loss Aversion:

So far we have only looked at potentially gaining $$$, but what happens with loses?

Example 2: You are offered the choice between:

  1. a sure loss of $750; or
  2. a 75% chance at losing $1,000 and 25% of losing nothing

What would you do? …please consider and take a few seconds to decide.

This looks very similar to example 1 – it’s the same except that we are looking at a loss rather than a gain…but it turns out that people treat gains and losses differently – we are loss averse.

People really don’t like losing and, as a result, are willing to take a gamble (we become risk seeking). The majority of people would go for the 2nd option in example 2 and take the chance. They might get away with losing nothing and they find this attractive as compared to the unpleasant certainty of losing $750.

Note: If you go back up to the graph used as the picture for this post, the curve represents the logic within Prospect Theory, showing that we feel far more pain from a loss than joy from an equally sized gain.

Tversky and Kahneman’s experimental research on peoples’ real choices identified that our loss-aversion co-efficient* is around 2 in many contexts, and much higher in others (e.g. it can be as high as 50 when it comes to decisions about our health).

* This means that I feel as much emotional pain from a $375 loss as I do joy from a $750 gain. They are asymmetric.

Putting the two together:

So let’s assume that it’s year 4 of the bonus scheme’s operation and Bob has become used to the $75,250 ‘salary plus bonus’ reference point. Let’s now compare and contrast two different outcomes for this performance year:

Outcome 1: Bob’s score delivers an annualised $76,000 pay packet– what does he think?

Feeling: “Yeah, big deal, I got another $750…nothing much to that.

Note: He isn’t thinking too much about $6,000 i.e. the absolute size of the bonus

Outcome 2: Bob’s score delivers an annualised $74,500 pay packet– what does he think?

Feelings: “That’s terrible, I’ve lost $750….I’m really not happy about that!!!”

Note: Worse (from management’s perspective) than not thinking about the $4,500 bonus, Bob actually think of it in terms of a loss and that loss really hurts him (far more than its apparent size).

What’s the point?

Our emotions about our annual bonus award are dealing with far more than the simple bonus number printed on the payslip: There is sooo much more going on in our minds:

  • Reference points: can reduce a seemingly large bonus figure down to a virtual irrelevance; and
  • Loss aversion: can turn us to think in terms of losses, and feel emotionally hurt by them by far more than would appear to be rational.

I always knew it wasn’t as simple as looking at that bonus figure on my payslip – there are lots more emotions going on!

I am reminded of Alfie Kohn’s insight that “within every carrot, there is a hidden stick”.

Annual bonus schemes appear great in their first year (if you subscribe to Theory X thinking )….and then become a major burden.

Some organisations think the answer is to ‘reboot’ them every now and then. I don’t.

Notes

  1. This introduction to Utility Theory is necessarily ‘overly simplistic’ but it makes the necessary point about rationality vs. reality.
  2. You can read an account of this in Kahneman’s mind-bending book ‘Thinking fast and slow’. Their paper on the theory was first published in 1979 and is included as an appendix to the book.
  3. Kahneman recognised that Prospect Theory isn’t perfect. It has since been revised as ‘cumulative prospect theory’.
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