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



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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 ….



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