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Thinking, Fast and Slow by Daniel Kahneman (2011)
Behavioural economics: Buying, selling and the endowment effect
The CBOE Volatility Index had two spikes above 36 in 2018, one in February and one in late December –roughly double the long-term average. Canadian investors had positive flows into money market funds, a departure from previous years.
Money market fund flows in Canada, 2018: $2.44 billion1
Average annual money market fund flows, 2015-2017: -$381 million2
We have a sense that loss aversion is important in many areas of life, especially investing. This is the tendency to overweight losses, psychologically. As documented by Nobel laureate Daniel Kahneman in his 2011 bestseller, Thinking, Fast and Slow, in experiments, subjects experienced around twice as much emotional pain from loss as they experienced joy from an equivalent gain.
Here are some questions that tie to loss aversion, which are more thought-starters than prescriptions:
- How might loss aversion affect investor behaviour during and after periods of market volatility, and what is the role of the advisor?
- Is loss aversion necessarily a negative thing?
- Are there investment strategies that seek to minimize the sting of loss aversion but leave room for potential growth? What is the role of guaranteed products? Asset class diversification? Low-volatility strategies?
- How might Clients react to a service they had previously enjoyed being removed?
Fellow Nobel laureate Richard Thaler related loss aversion to the endowment effect, where people often “demand much more to give up an object than they would be willing to pay to acquire it.3” The basic interpretation of the endowment effect is that once we own something, we have a hard time parting with it. In Thinking, Fast and Slow, Kahneman points out cases where the endowment effect isn’t universal. For example, compare these two situations:
- A professor purchased several bottles of wine for $10 that had risen in value to $100. She was unwilling to sell one of her bottles for $100, yet she would not consider buying more bottles for herself for $100.
- A shoe store owner had no problem selling his last pair of a popular line of shoes.
The difference between the two situations is that the professor owned goods that were held for use, while the shopkeeper had goods that were held for exchange. This is an important difference, and has implications in various transactional settings. Here are some thought-starters related to the endowment effect:
- The same financial holdings can be seen differently, depending on the person’s vantage point. For example, an employee participating in ABCD Company’s share purchase plan may be reluctant to sell any of their company shares, even though diversifying proceeds into other investments may improve their risk-adjusted returns. A second investor who has experience buying and selling shares also holds ABCD. They have no qualms about selling. Is it possible to reframe the first situation so the share purchase plan member thinks like a trader?
- A house owner recently purchased a condominium. Their house is up for sale but they “can’t sell” because offers are coming in below the house’s peak value of a year ago. How is the endowment effect making it difficult to sell, even though they need the money?
When interviewed, Kahneman is humble about the success rate in applying behavioural research insights to produce actual behavioural change. There have been wins, but they often come from building guardrails around predictable errors rather than eliminating them through logic or willpower. Advisors who go back to Kahneman’s bestseller today will be in a better position to understand Clients’ varied, human responses to financial situations.
In our previous behavioural finance article below, we reviewed System 1 and System 2 ways of thinking.
1 Strategic Insights, Investor Economics, January 2019, p. 19.
3 Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias by Daniel Kahneman, Jack L. Knetsch, Richard H. Thaler The Journal of Economic Perspectives, 5(1), pp. 193-206, Winter 1991.
Behavioural economics: Interesting, but what do you do with it?
Behavioural economics has inspired several good books over the past two decades, and people keep buying them. Thinking, Fast and Slow, Blink, Predictably Irrational, Nudge, The Undoing Project, The Power of Habit, Freakonomics and Outliers are all bestsellers. So, the secret is out: research shows that we often stray from the model of homo economicus, which assumes we make rational assessments to maximize utility. The question is, what are we doing with that knowledge?
System 1 and System 2
The old saying, “You can’t judge a book by its cover,” needs a postscript: “But you will anyway.”
Psychologist and Nobel laureate Daniel Kahneman, author of Thinking, Fast and Slow, spent five decades studying the way we interpret events and make decisions. His conclusion: people can be trained to make more thoughtful decisions but, ultimately, we are biased to making quick, intuitive judgments. Our more reflective processes, in many cases, align to support these judgments.
Through measurements of brain activity, researchers have evidence of fundamentally different processes at work, which Kahneman calls System 1 and System 2. System 1 is uncontrolled, effortless, associative, unconscious and skilled. It comes into play when we respond automatically to a photo of an angry person’s face. Similarly, tasks that have been practiced over and over can become a System 1 response. System 2, by contrast, is controlled, effortful, deductive and slow. It goes to work when people are asked, “What is 17 times 14?”
System 1 responses are powerful. From an evolutionary perspective, this makes sense. Snap judgments help us keep out of harm’s way and they conserve energy. Unfortunately, System 1 responses are also error-prone. This combination, of making errors but being powerful, means we have cognitive biases.
One of the most common patterns is that we substitute an easy question for a hard one. When asked what we think of a politician, we substitute the question “Does he look like a leader?” System 1 comes up with a quick answer: “He’s too young/old!” System 2 would entail time-consuming analysis to provide a more accurate answer: “What are his policies? How do they compare to the other candidate’s?” Since System 2 consumes energy, System 1 substitution takes place, and then System 2’s supporting points are brought in after the fact.
Practical tidbit: Have you ever walked out of a client meeting and thought, “Wow, we didn’t even get to (name the important issue)!” The “halo effect” in meetings is one example of System 1 taking over: issues that are introduced first and most forcefully tend to dominate the entire proceedings. One way to lessen this effect is to have meeting participants write down their ideas before anyone speaks.
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