Mine is pricier than yours

Here is a question which may take a bit of soul-searching. You and your neighbour posses identical watches which have been maintained in pristine condition and are of a ‘limited-edition' batch.

One day a stranger knocks on the door and asks you how much would it take to part with the watch. He then asks you if you lost your watch, would you offer your neighbour the exact amount you just quoted for his watch? Behavioural economists hold that chances are you won't. Your watch, even if identical to your neighbours, is worth a lot more to you than you would be willing to pay for an identical one. This controversial effect has been labelled the ‘ endowment effect' by behavioural economists. This bunch holds that humans are an emotional lot whose transactions are swayed as much or more by emotions than by pure profit maximising reason.  

EVOLUTION DISTORTS

The endowment effect comes with several riders. For a start, there has been a continuous debate over why we exhibit the tendency. Could it be that in a historic lawless society it paid to quote a high price when transacting with strangers? This gave you a buffer against a possibly dubious transaction.

The evolutionary tendency to clam up and be distrustful of transactions has been exhibited with experiments on apes and humans. A popular experiment dealt with nearly identical priced coffee mugs and chocolates. Participants given the two items showed a greater reluctance to part with either object than probabilities would suggest. Similar results were noted on apes when tested on preference for two food objects.

The take-away from these experiments is that risk-aversion or inertia is deep-rooted. It is heightened by inexperience. This tendency to hold out for a higher price or believe that their ownership of the asset makes it more valuable can often work to their detriment.

EXPERIENCE PAYS

Neo-classical economists struck back by arguing that humans can keep emotions at bay and let logic seek and maximise profits. Experienced traders and investors have shown the ability to part with their ‘assets' at a quoted price. They do this without any delusions over their ownership making the assets more valuable.  

In a simple yet powerful piece of research, John List tested both relatively inexperienced and experienced ‘dealers' in sports memorabilia. While not as liquid as equity markets, these markets do tend to hold the same levels of subjective interpretation which equity markets exhibit.   When presented with various memorabilia of differing and similar values, more experienced traders were more efficient and dispassionate at making choices. The author observed the difference between the price at which an identical asset was bought and sold was far narrower for more experienced dealers than for less frequent (experienced) dealers.     

TAKE-AWAYS

It is easy to surmise that one should transact more frequently to get better at the markets. But that would leave you far more susceptible to losses stemming from over-confidence and other deficiencies inherent with frequent trading! So what do you do to shield from the endowment effect?

You are hardwired to be sceptical about the price on offer. But don't let that keep you from selling or buying until reason backs a decision. Valuation and facts should always trump the emotional urge to not accept a mistake.

Revisit your investments systematically. Analyse; assess why you bought something and what is the price you would pay for it if you did not own it. If your buy-price is significantly different from the market price, consult to find out why that is the case.

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