When Should You Cut Your Losses?

Deciding whether to shut down is one of the toughest decisions any entrepreneur will ever make. It helps if you dial down the emotion

Written by Wayne Vanwyck

Here’s a quick little test. If you had to choose between the following two options, which would you pick?

  1. A 100% chance of losing $90,000; or
  2. A 90% chance of losing $100,000.

When faced with this choice, the majority of entrepreneurs will choose the second option. If there is a chance of not losing—even if it is slim—most of us prefer that risk over the sure thing of having it all slip away.

Here’s another test. What would you choose out of these options?

  1. A 100% chance of winning $90,000; or
  2. A 90% chance of winning $100,000.

You’d probably choose option 1. Even though the risk/reward percentages are mathematically the same in each test, most people will choose the risk of losing more if there is a chance of not losing, while most people will be risk-averse in the choice between two wins.

These, and many other decision-making scenarios, are shared in Daniel Kahneman’s book Thinking, Fast and Slow, a fascinating guide to understanding how we think. Reflecting on decisions I’ve made—and have since come to regret—there are important lessons in understanding this thought process in real-life situations.

For most people, the psychological aversion to loss is much stronger than the attraction to win. Once we have something, we don’t like to let it go and will go to great lengths to hang on to it. So, taking a dispassionate view of the actual odds could in fact save you from making a big mistake. And that can be very useful in making one of the toughest decisions any entrepreneur has to face: when to cut your losses.

Read: What Failure Taught 3 Leading Entrepreneurs

Imagine this scenario: in spite of the bad economy, your business has enjoyed a particularly good year. Others around you are bemoaning the tough time they’ve had just to survive while you have money in the bank. You’re feeling a little smug. Then something happens. Your market softens, a couple of key customers that represent a disproportionate amount of your overall sales starts to cut back and, eventually, people stop buying altogether. You lose a few key people in your company. Suddenly, monthly reports are showing big red numbers, not black. This goes on for several months. What do you do? How long do you allow this to continue before you decide not to proceed any longer.

Your next steps probably depend on a number of factors, including:

  • Your age. How many times have you seen this before? How many years do you have left to recover? How much energy can you put into solving the problem?
  • The age of your company. Is this a new phenomenon? Do you have a “war chest” to see you through a difficult period?
  • Your personal financial status. How will this situation affect your family, your home and your retirement options?
  • The size of the losses relative to the depth of your pockets. Large public companies can lose millions of dollars per month and, in some cases, still turn things around. For smaller businesses, however, losing even $5,000 per month can be a lot.
  • Your management team. Is everyone on board and committed to do whatever is necessary to turn red to black? Even if they want to, are they capable? Do they have the right skills? Can they rally your employees?
  • The market. What is the market telling you? Are you beating a dead horse? Have you lost to the competition? Have you missed the timing to reinvent your business?
  • The true cost difference between staying the course and abandoning it. Is it just 10%? Or is it really 30% or 40%—or even more?
  • Your self-confidence and optimism. Do you see this as simply a temporary annoyance, a challenge to be overcome or a serious problem?
  • The tangible or intangible effects. What effects would a negative decision could have on your reputation, your employees, suppliers and customers?

All these factors (perhaps more) will swim around in your head as you consider your options during a particularly difficult turn of events. And yet, as the tests at the top of this article demonstrate, you’re likely to make an emotional choice first and then try to justify it with logic. And so, a number of months with losses may go by while you do what you can to turn it around. You may be able to make it work. You may not.

Read: What If You Regret the Sale of Your Business?

In Thinking, Fast and Slow, Kahneman doesn’t give us the answer for making the right decisions. He can’t. These things are not black and white. But by revealing our natural tendency to avoid losses at the risk of even more losses, Kahneman’s book holds a light up to the problem, encouraging a more logical and analytic approach to how far you go before accepting the inevitable and cutting your losses.

Wayne Vanwyck is the founder and CEO of The Achievement Centre International in London, Ont. He is the creator of The Business Transition Coach Forum and the author of the best-selling books, Pure Selling and The Business Transition Crisis. He has been training and coaching business owners for the past 30 years.

More columns by Wayne Vanwyck.

Originally appeared on PROFITguide.com