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At Yahoo: Losses and Endowments


On Feb 10,2011 I wrote about Losses and Endowments:

(Reproduced in full)

Given two choices, which one would you take? You have to walk to me, and

1)      I’ll give you a guaranteed Rs. 500, and if I feel like it, I’ll randomly throw in a Rs. 500 bonus.

2)      I’ll show you Rs. 1,000 but on a whim, randomly, I will take out Rs. 500 before giving the rest to you.

Chances are that the second one looks unattractive, especially if you had to do it over and over again. But your mathematical mind has already realized that if I am truly random in the choices I make, what you make is around the same in both cases. But the second choice makes you believe you have lost Rs. 500, while the first case gives you a feeling of an extra Rs. 500.

(Note: At this point, I will take all the money back. Thank you.)

This is traditionally quoted as an example of “loss aversion” — a theory in behavioural finance. Human behaviour is irrational — we choose the wrong things, supposedly, because it makes us feel slightly better. In one well-understood case, loss-aversion, we take one choice over another even though theoretically, we may be behaving irrationally.

The above experiment was conducted with monkeys who displayed just as much of a risk aversion as humans do. But is this really a behavioural flaw? If you showed me a guy who randomly took out money, versus another who seemed to give a bonus, the voice in my head says, listen, trust the guy who will give you money, not someone who takes it away. In reality, nothing is truly random, and you’re more likely to suffer if you choose someone who your instincts tell you is untrustworthy. The monkeys knew.

Loss aversion, though, manifests itself in investing as well. You don’t want to “book” a loss. So you don’t. The stock has fallen 30%, and you still won’t take it. You stop looking at the stock markets completely because that very thought of a loss hurts. (Oh, don’t we know about that now, when markets seem to have had their carpet pulled off underneath them)

The problem is that you consider the actual transaction of selling what you bought at higher levels a “booked” loss. Losses are losses, whether they are booked or not. You could hold on for longer, but it shouldn’t be in the fervent hope that the stock will recover back to the level where you don’t have ANY loss, and you walk away even.  I write this, and every year, I have at least one moment when I do this to myself; it takes a lot of effort to undo what we’re wired for.

Warren Buffet has two rules: 1) Do not lose money and 2) Don’t forget rule #1. It would be entirely stupid to believe he doesn’t lose money. Rules, after all, are meant to be broken, especially when your choice is to break it and lose money, or to stand by it and lose even more money.

Some will say I’m stupid — you must stand by your convictions and hold on to the trade. Be loyal. Stay firm. Stick with it. And they are sometimes right. The Tata Motors that fell to below 200 is now above 1,000. The Infosys that went to 1,200 is now above 3,000. The DLF that was at 1,000…oh wait. It’s at  240 today, you say, but so what? Let’s be loyal. And not take that loss.

Interest rates are going up and people soon won’t be able to afford the interest payments on those houses that DLF wants to sell. No problem, let’s be loyal. The real estate sector has seriously underperformed everything else on this planet, other than Hosni Mubarak. But let’s be loyal. There is a land bank after all.

The problem is also that we won’t let small things like actual information change our decisions. I could have written that paragraph six months ago, except the Hosni Mubarak part. The stock has fallen 40%. Loss aversion gives rise to another, and more dangerous behavioural pattern: Hallucination. (No, wait, you think, but I’m avoiding the fancy name right now) You will actually value what you own more than if you didn’t own it, and ignore information that proves you wrong.  The fancier name is the endowment effect.

Kahneman, Knetsch and Thaler conducted an experiment , giving a few people a mug each; they were then asked to write what they would sell the mug for. Independently, another set of people were shown the same mugs and asked to write what they would “buy” the mug for. The consensus was $7 for the sellers and $4 for the buyers. Same mug. We tend to value what we own more than otherwise.

Again, not to disprove behavioral finance, but I ask you this: Why would you EVER value something the same if you were selling it versus buying it? If they did this experiment in Sadar Bazaar in Delhi, the sellers would start at Rs. 1000 and the buyers at Rs. 10. (It will sell for Rs. 40, with some green chillies thrown in for free) I mean, this wasn’t as much an example of a behavioural pattern as much as it is for our natural will to succeed at what we’re doing — so we’ll overprice the sales tag and underprice our bids, because our natural instinct is to take the off chance that there is Mr. Stupid-Mug-Collector-At-Any-Price on the other side.

The Endowment Effect could explain why we would absolutely refuse to sell a house for under what we bought it for, even though we know deep inside that the real estate prices are ludicrously high. One you’ve bought it, even that loose door frame has a value.

While you can’t avoid loss aversion or the endowment effect completely, and I’m the first person to say I can’t, you can attempt to recognize when it happens. The idea isn’t to ask if you’ll sell that stock today. It’s to ask if you’ll buy it. And if the answer is no, the next question is: So why are you holding on?

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