You may not have heard of them, but Daniel Kahneman and Amos Tversky are rock stars. Their band name doesn’t have the same ring as say, Hall & Oates, but these men helped develop some of the most influential theories in the history of Behavioral Economics. One of their primary focuses centered around decision making; more specifically how humans can make irrational decisions based on biases and heuristics stemming from a variety of sources. As a result of his work Kahneman received the Nobel Prize in Economic Sciences, and one of the findings that led to that award was his work on Prospect Theory. This article will focus on one of the principle findings made within Prospect Theory called Loss Aversion and will tie the concept of Loss Aversion to the car dealer’s decision-making process related to inventory management.
Overcome Loss Aversion and Make Tough Decisions
Overcome Loss Aversion and Make Tough Decisions
Loss Aversion states that the effect of a loss is more impactful than the effect of a gain. For instance, the pleasure gained from receiving $1000 is not equal to the pain felt from losing $1000; the latter is much more impactful. Tiger Woods offers a golfing analogy that helps expound on the point: “Any time you make big par putts, I think it’s more important to make those than birdie putts,” Woods said. “You don’t ever want to drop a shot. The psychological difference between dropping a shot and making a birdie, I just think it’s bigger to make a par putt.”
Prior to jumping into the article, if you want a quick “Dummies” synopsis to reference, click here
One interesting finding in the analysis is how people, in general, are risk averse when it comes to gains and risk seeking when it comes to losses, something referred to as The Reflection Effect. Here is an example from a 1981 Kahneman and Tversky paper titled “The Framing of Decisions and the Psychology of Choice”
“Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:
If Program A is adopted, 200 people will be saved.
If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved.”
Which would you choose? In a sample of 152 people, 72% of respondents chose Program A. Now let’s see what happens when two new programs are introduced.
“If Program C is adopted 400 people will die.
If Program D is adopted there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die”
Now which would you choose? In a sample of 155 people, only 22% chose Program C, which is the identical outcome to Program A above! Program A = Program C and Program B = Program D in terms of expected outcomes, and simply changing the wording to emphasize gains and losses causes a complete switch of preference. We contradict ourselves based on the phrasing of the same problem.
Luckily in the automotive world we don’t have to make decisions like the one above, but in terms of inventory selection and management we fall victim to Loss Aversion. When our DRIVIN Sales and Trading teams speak to dealer partners, we hear statements like: “I can’t sell that car unless I make $X on it,” “My GM will kill me if I get rid of that VIN without making money on it,” and finally “I’ll hold that car as long as it takes to sell.” When we hear this feedback I can only help but think of Loss Aversion as the culprit, the fear of taking a hit or having a purchase decision looked at as a failure when in reality doing nothing is making the matter exponentially worse.
When dealers source inventory from auctions, trade-ins, or other available means, the emphasis is on maximizing potential profit from the transaction. Using years of experience in the industry, availability of inventory in the market, and forecasted sales and pricing data from various software tools, dealers target specific VINs that hopefully turn quickly and profitably. But in instances where the ideal scenario doesn’t come to fruition the dealer must flip the line of thinking from maximizing profit to minimizing loss.
A compounding factor is that the vehicle value is NOT static. As a vehicle sits on a dealer’s lot, depreciation takes its toll, financing charges add up, consumer behavior shifts, and the used inventory in the market adjusts. Our Analytics team has begun performing a preliminary analysis to find the probability of moving a VIN after stocking it for 90 days and, while the % changes based on market, the national average is about 18% thus far. Loss Aversion clouds better judgement of wholesaling that VIN and targeting something that has a higher propensity to sell.
This decision making framework requires dealers to answer questions such as “What happens if I sell now? What do I lose?” then compare that scenario to “What is the risk of keeping this inventory and incurring additional losses? What do I lose by passing up the opportunity to sell today?” This type of decision needs be objective as it relates to the bottom line and shift away from the biases caused by Loss Aversion. Leadership within the dealership needs to shift its focus away from reprimanding buyers and used car managers for not making money on every vehicle but rather encouraging them to make sound decisions to get out of vehicles that aren’t moving. Arming your team with the best data to stock the right vehicles for your used lot is imperative and will lead to better long term results, but the process is not perfect. Tough decisions will always be required.
When viewing aged inventory on your lot, and consulting a partner such as DRIVIN who calculates market demand and pricing data for our dealer partners, you can make more rational decisions around exiting inventory that carries both real and opportunity costs and sourcing vehicles that fit the needs of your shoppers. Not every vehicle you stock is going to sell quickly and profitability, whether it is due to a lack demand, competitive pricing or just plain bad luck. The lesson is to minimize the negative effect of this loss by getting out of that inventory before it continues to suck money from your bottom line. DRIVIN and our Optimal Lot methodology aims to provide the data and analytical insights to our dealer partners to assist with this process on both ends: targeting inventory in the market that your dealership should be stocking and finding a dealer that would want to purchase a vehicle you are willing to wholesale.