The Endowment Effect, Loss Aversion, and Status Quo BiasAgendaUnderstanding the termsTerminologySummarySummary (2)ExampleExampleSlide 9Slide 10Illustration of problem in decision makingStocks v Bonds - Effect of Loss AversionStocks v BondsEffect on Markets?Other Anomalies?Is it always a negative effect?DiscussionReferencesThe Endowment Effect, Loss Aversion, and Status Quo Bias Daniel Kahneman, Jack L Knetsch, and Richard H Thaler (1991) Harish K Subramanian (11/18/03)Agenda •Understanding the terms•Summary•Example•Discussion•Implications in Markets?•Further QuestionsUnderstanding 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 AversionTerminology•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.SummaryValue function replaces traditional utility function (which predicts linear fit).Reference points make a difference !Summary (2)Indifference curves do not cross. This is a consequence of the assumption that they are reversible.Standard Assumption:Kahneman says:The curves intersect because with endowment, the curves are no longer reversible.Indifference is between 5 pens and $0 / 8 pens and $1!Example Round 1: Please make a choice between (1) and (2)ExampleRound 1: Please make a choice between (1) and (2)Round 2: Please make a choice between (1) and (2)ExampleRound 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!ExampleRound 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 makingStocks 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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