The Endowment Effect, Loss Aversion, and Status Quo Bias Daniel Kahneman, Jack L knetsch, and Richard h thaler (1991)

The Endowment Effect, Loss Aversion, and Status Quo Bias

• Daniel Kahneman, Jack L Knetsch, and Richard H Thaler (1991)

Agenda

• Understanding the terms

• Summary

• Example

• Discussion

• Implications in Markets?

• Further Questions

Understanding the terms

• Endowment Effect: Gain of value of product by just owning it – increases WTA-WTP spread

• Loss Aversion: Regret minimization – in some senses causes the other phenomena.

• Status Quo Bias: Inertially staying in same state – a form of underadjustment .

• Implication? Endowment Effect Status Quo Bias

• Loss Aversion

Terminology

• Omission v Commission – Repenting changing states to find it unfavorable > regret of staying in state.

• Income Effect – People change budget share for certain items based on income.

• Reversibility of Indifference curves – if you have 5 pens and 0 dollars  have to give up 4 pens for 8 dollars  when you have 1 pens and 8 dollars  you should be willing to buy the 4 pens for 8 dollars.

Summary

Summary (2)

Example

• Round 1: Please make a choice between (1) and (2)

Example

• Round 1: Please make a choice between (1) and (2)

• Round 2: Please make a choice between (1) and (2)

Example

• Round 1: Please make a choice between (1) and (2)

• Round 2: Please make a choice between (1) and (2)

• Hypothesis: In simple, controlled repeated choice scenarios, it is difficult and inaccurate to continue these studies – people learn!

Example

• Round 1: Please make a choice between (1) and (2)

• Round 2: Please make a choice between (1) and (2)

• Hypothesis: In simple, controlled repeated choice scenarios, it is difficult and inaccurate to continue these studies – people learn!

• True in this case… but not always !!

• Even now, 80 deg in winter seems warm but in summer seems cool. Trivial but important consideration.

Illustration of problem in decision making

Stocks v Bonds - Effect of Loss Aversion

• “While stocks and bonds provide a reasonably comparable neo-classical economic risk function, stocks have always commanded a higher rates of return than bonds.”

Stocks v Bonds

• “While stocks and bonds provide a reasonably comparable neo-classical economic risk function, stocks have always commanded a higher rates of return than bonds.”

• Loss Aversion explanation?

• Stocks can be bought/sold at will  more chance for profit  even greater chance for loss  require higher compensation for additional “risk”.

Effect on Markets?

• Implementation on portfolio is obvious – long term investment.

• How is it applicable to short-term trading (like day trades)?

• Pitting rational agents with irrational agents – how to model this irrational behavior into market when trying to design a competing automated agent?

Other Anomalies?

• Intertemporal Choice

• Preference Reversals

• Mental accounts……

Is it always a negative effect?

• Apparently .. No!

• The tumbling DOW Jones Index was explained to be “propped up” because of loss averse behavior – people refused to sell losing stock for fear of seeing their paper loss translated into actual “irreversible” loss….

Discussion

• Opportunity cost: Is a GOOD consideration to get out of status quo ?

• Wine collector: Market price assumed – no undervaluation by seller.

• Transaction costs are usually negligible for large trades or money decisions.

• Lack of information or overwhelmed by math… does it explain something?

• Grand Canyon example: Not part with money for social benefit? No private gain?

References

• Why smart people make big money mistakes – Gary Belsky/Thomas Gilovich (book).

• Loss Aversion in repeated games – Jonathan Shalev

• Prospect Theory and Asset Prices – Barberis, Huang and Santos ….