Lessons from fan appreciation night

Revisiting a behavioral economics classic: Why do people hold on to losing stocks?

Tyler Cowen poses the following question about stocks, and what he says used to be the conventional behavioral economics answer.

Let’s say you bought two stocks last year. One has tanked and looks likely to fall further. One has gone up and you expect it to keep rising. (Hey, it’s not completely impossible.) Which are you more apt to sell?

Behavioral economists used to think they knew the answer: neither. Studies have shown that people tend to value things more – whether shirts, stereos or stocks – once they own them, no matter what has happened to their actual worth. This phenomenon is called the endowment effect. If it were the only psychological factor at work, you’d be reluctant to sell both losers and winners simply because they’re already tucked into your portfolio.

Cowen’s story is incomplete, and therefore unfair, even to old behavioral economists. In the scenario Cowen describes, two biases, each reinforcing the other, would be in effect: The endowment effect and loss aversion. The endowment effects for both stocks (assuming you bought them at the same price) would cancel each other out, but this would not necessarily mean investor paralysis. For more than twenty years, behavioral economists have been citing something called the disposition effect, which is an implication of prospect theory and the component of loss aversion). The status quo purchase price serves a reference point. Gains and losses are perceived relative to some other aspirational level different from the status quo – say, what you thought the stock would rise to. As the winner is closer to this aspiration, you, as the investor, become more risk-averse and therefore more likely to sell it, while holding on to the loser in the hopes of a roaring comeback, even one with a small probability.

But this isn’t the only explanation for identical behavior. An alternative is a commonly mistaken belief among average investors that stocks will revert to their mean. Stocks that have risen will fall; stocks that have fallen will rise. This story also predicts the selling of winners on the expectation that it will fall. Yes, Cowen’s scenarios says you, the ordinary investor, would expect the winning stock to keep rising. Old behavioral economics says you’d be quite extraordinary for believing this. Both of these potential explanations are laid out in Terrance Odean’s classic paper “Are Investors Reluctant to Realize Their Losses?” His data does allow him to distinguish which of the two stories makes more sense.

Addendum: Cowen’s column is actually an appreciation of a paper by Nicholas C. Barberis and Wei Xiong with yet another explanation for why investors sell winners and hold onto losers: That it’s the pleasure of actual (or what stock traders would called realized) gains – the good feeling you get from making a seemingly smart decision – and the pain of actual losses that leads to selling winners. Read the full paper.

The endowment effect starts before the endowment

So reports Live Science:

A new study suggests that just fingering an item on a store shelf can create an attachment that makes you willing to pay more for it.

Previous studies have shown that many people begin to feel ownership of an item – that it “is theirs” – before they even buy it. But this study, conducted by researchers at Ohio State University, is the first to show “mine, mine, mine” feelings can begin in as little as 30 seconds after first touching an object.

In the name of scientific replication, the experimenters follow Richard Thaler’s classic design and used coffee mugs. They set up an auction in which a people could handle the mugs for varying lengths of time.

Participants in the study were shown an inexpensive coffee mug, and were allowed to hold it either for 10 seconds or 30 seconds. They were then allowed to bid for the mug in either a closed (where bids could not be seen) or open (where they could be seen) auction. The participants were told the retail value of the mug before bidding began ($3.95 in the closed auction; $4.95 in the open auction).

The study…found that on average, people who held the mug for longer bid more for it – $3.91 to $2.44 in the case of the open auction and $3.07 to $2.24 in the closed. In fact, people who held the mug for 30 seconds bid more than the retail price four out of seven times.

Behavioral economic theory aside, there are real practical lessons in here for auction choice architects and retailers of all stripes. Bottom line: Let people take the product home.

Full paper is here. Hat tip: Marginal Revolution

Wendy’s cheeseburgers – food for economic thought

Behavioral economics or standard neoclassical economics? The endowment effect or a plain old good deal? You decide.

Evidence of the endowment effect? Thaler, himself.

From an article about the endowment effect in this week’s Economist:

Supposedly rational economists are affected, too. Dr Thaler, who recently had some expensive bottles of wine stolen, observes that he is “now confronted with precisely one of my own experiments: these are bottles I wasn’t planning to sell and now I’m going to get a cheque from an insurance company and most of these bottles I will not buy. I’m a good enough economist to know there’s a bit of an inconsistency there.”

More on chimpanzees and the endowment effect

A follow-up paper by two of the researchers involved in the chimpanzee endowment effect experiment offers an evolutionary explanation for its occurrence. From the abstract:

Drawing on evolutionary biology, this Article provides a new theory of the endowment effect. Briefly, we hypothesize that the endowment effect is an evolved propensity of humans and, further, that the degree to which an item is evolutionarily relevant will affect the strength of the endowment effect. The theory generates a novel combination of three predictions. These are: (1) the effect is likely to be observable in many other species, including close primate relatives; (2) the prevalence of the effect in other species is likely to vary across items; and (3) the prevalence of the endowment effect will increase or decrease, respectively, with the increasing or decreasing evolutionary salience of the item in question.

For humans its mugs and chocolate bars, for anthropoids its frozen fruit juice sticks and peanut butter

One of the seminal findings of behavioral economics is the endowment effect, in which humans show a tendency to value a good they have just come to possess more than the maximum price they would have paid immediately before they obtained it. Turns out the endowment effect may be a simian tendency too. (Ok, that’s all the appropriate synonyms we know, from now it’s chimpanzees.)

Continue reading the post here.