ENDOWMENT EFFECT,

WINNERS CURSE &

HINDSIGHT,

DISPOSITION EFFECT

ENDOWMENT

EFFECT

ENDOWMENT EFFECT

• In behavioural finance, the endowment effect describes a circumstance in

which an individual values something which they already own more than

something which they do not yet own. Sometimes referred to as divestiture

aversion, the perceived greater value occurs merely because the individual

possesses the object in question.

• Investors, therefore, tend to stick with certain assets because of familiarity &

comfort, even if they are inappropriate or become unprofitable. The

endowment effect is an example of an emotional bias.

• Studies have shown repeatedly that people will value something that they

already own more than a similar item they do not own. According to the old

saw: a bird in the hand is worth two in the bush. It doesn't matter if the

object in question was purchased or received as a gift, the effect still holds.

• People who receive shares of stock from deceased relatives exhibit the

endowment effect by refusing to divest those shares even if they do not fit

with that individual's risk tolerance or investment goals, and may negatively

impact a portfolio's diversification.

• In line with prospect theory changes that are framed as

losses are weighed more heavily than are the changes

framed as gains.

• An individual owning "A" amount of a good, asked

how much he/she would be willing to pay to acquire

"B', would be willing to pay a value (B-A) that is lower

than the value that he/she would be willing to accept to

sell (C-A) units; the value function for perceived gains

is not as steep as the value function for perceived

losses.

EXAMPLE OF ENDOWMENT EFFECT

• One of the most famous examples of the endowment effect in the literature

is from a study by Daniel Kahneman, & Richard Thaler, in which

participants were given a mug and then offered the chance to sell it or trade

it for an equally valued alternative (pens). They found that the amount

participants required as compensation for the mug once their ownership of

the mug had been established was approximately twice as high as the amount

they were willing to pay to acquire the mug.

WINNERS CURSE &

HINDSIGHT

Winners’ curse

Sometimes winning comes at too high a cost. In such cases, it is the winners that

are the real losers. The phenomenon is known as the “winner’s curse” and it

affects a wide variety of situations.

The winners curse is a concept from Game Theory . It states that , in (common

value) auctions where there is incomplete information, The winner will tend to

overpay.

The severity of the winner's curse increases with the number of bidders. The

winner's curse can be experience by both financial or strategic buyers.

Curse

• Each potential buyer in an auction will individually estimate the value of

the firm before bidding. Buyers, in effect, are pre-paying for uncertain

future revenues and cost synergies. In an urge to beat competing bidders,

the winners tend to overpay. This overpayment is known as winner's curse

or hubris.

Before the auction begins, nobody knows the item’s market value.

Instead , every participant independently estimates the value before

the bidding starts . Once the auction is finished , the winner of the

auction will be the person who bid the highest price. If we assume

that the avg. bid price is close to the actual value of the price (the

vertical red line) , then winner will have paid more than this actual

value (e.g. the black arrow).

Winning the auction is actually a bad news for the winner, because

it suggest that avg. value that the other bidders assign to the item is

lower than what the winner paid. The more bidders ,the more likely

it is that some participants overestimates the value of the object and

the higher the eventual price paid by the winner .

One way of avoiding the winners curse is by bidding the value

below the value we think the item is worth (i.e. our estimate) .By

downward adjusting our bid we will probably be closer to the avg

value, and thus avoid paying too much.

HINDSIGHT

• It's often said that "seeing is believing". While this is often the case, in certain situations what you perceive is not necessarily a true representation of reality. This is not to say that there is something wrong with your senses, but rather that our minds have a tendency to introduce biases in processing certain kinds of information and events.

Another common perception bias is hindsight bias, which tends to occur in situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.

• For example, many people now claim that signs of the technology bubble of the

late 1990s and early 2000s (or any bubble from history, such as the Tulip bubble

from the 1630s or the South Sea bubble of 1711) were very obvious. This is a

clear example of hindsight bias: If the formation of a bubble had been obvious at

the time, it probably wouldn't have escalated and eventually burst.

HERD BEHAVIOUR

• One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn't the first time that events like this have happened in the markets.

• How could something so catastrophic be allowed to happen over and over again?

The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice.

There are a couple of reasons why herd

behavior happens

The first is the social pressure of conformity. You probably know from experience that this can be a powerful force. This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very little experience.

Avoiding the Herd Mentality

While it's tempting to follow the newest investment trends, an investor is generally

better off steering clear of the herd. Just because everyone is jumping on a certain

investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore,

the soundest advice is to always do your homework before following any trend.

Just remember that particular investments favored by the herd can easily become

overvalued because the investment's high values are usually based on optimism and

not on the underlying fundamentals.

DISPOSITION EFFECT

Introduction

• For over thirty years individual decision makers have not behaved in accordance with the expected utility theory

• The tendency to sell winners too early and ride losers too long is referred to as the ‘disposition effect’

Disposition Effect

• The ‘disposition effect’ has four major elements

1. The prospect theory

2. Mental accounting

3. Regret aversion

4. Self-control

Prospect Theory

• According to the Prospect theory the investor goes through 2 stages of decision making

1. The ‘editing stage’ frames all choices in terms of potential gains and/or losses relative to a fixed reference point.

2. The ‘evaluation stage’ in which the decision maker employs an S-shaped valuation function (meaning a utility function on the domain of gains and/or losses) which is concave in the gains region and convex on the loss region.

Prospect Theory

• Consider an investor who purchased a stock for $50 one month ago and the stock now is selling at $40

-There are 2 outcomes to this situation-

1. Sell the stock now and realize a loss of $10

OR

2. Hold the stock for one more period, with a 50-50 odds between losing an additional $10 or “breaking even”

Mental Accounting

• There are 2 kinds of tax on stock returns.

1. Short-term gains (less than a month) is taxed like

income

2. Long-term gains is taxed lower

• Lets consider an investor who experienced a price

decline in his stock. Then this investor will only sell to

exploit the difference between short and long term tax.

Mental Accounting

• The IRS requires that thirty days pass before a stock can be repurchased, if the investor wants to get a tax advantage stemming from its sale.

• Wash sale regulations can be neutralized through a “swap” by replacing a stock sold for tax purposes with a stock that has identical return distribution.

• The main point here is that the swap reduces the investors tax liability leaving him with an equal gamble.

Self-Control

• Self-control is portrayed as a conflict between a rational part (planner) and a more primitive and emotional individual action (agent).

• Planner may not be strong enough to prevent the (emotional) reactions of the agent from interfering with rational decision making.

• An example, traders clearly aware that riding losers was not rational, but could not exhibit enough self-control to close the position at a loss, thus limiting loss.

Self-Control (December Trading)

• The month of December seems to have abnormal trading

volume. The trading constitutes tax loss selling which

reflects self control.

• This occurs because many investors want to benefit

from the tax rebate and this is considered a rational act

by many investors.

• So we can perceive that self motivation is easier in the

month of December than any other month because of

its deadline characteristic.

DEEPANSHU VERMA SHAKTI YADAV DEEPAK SINGH

BY: