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Endowment effect helps explain investor behaviour during bear markets
In one of the early experiments on behavioural finance, American economist and behavioural scientist Richard Thaler documented the now famous endowment effect. People attach a higher value to the goods they own, compared to the price they would be willing to pay for acquiring something similar. The price we are willing to accept is higher than the one we are willing to pay. The bear markets test this behavioural bias that investors suffer from.
When our investments do not perform as expected and the prices begin to correct in the initial stages of the bear market, we suffer from the endowment effect. We refuse to sell a loss-making share we bought, or book a loss in a mutual fund we hold. We are still biased by the memories of the bull market prices. While our willingness to pay a high price has dropped, the willingness to accept a lower price for what we hold is absent.
After a prolonged period of pain, when the prices continue to drop, we suffer from a sense of regret. Regret reduces, and eventually nullifies, the endowment effect.
Behavioural economists point out that decision-making is tough when it is associated with regret. However, a prolonged fall in prices in the financial markets leads us towards the inevitable need to regret the excesses of the past, and admit that we may have made a mistake. We are then willing to sell, or accept a selling price that is equal to the price at which we may be willing to buy. The endowment effect is gone since the ownership of a losing stock is not associated with the pride that creates a mental premium.
When regret turns to disappointment, the endowment effect actually reverses completely. Psychologists define disappointment as involving five elements. The outcome is uncertain; we expect a positive outcome; we believe we deserve a positive outcome; the negative outcome surprises us; and we are unable to control the outcome with our actions. Most investors are currently disappointed with their investment decisions. At this stage, they are willing to sell in distress and accept a price that is even lower than the one they may be willing to pay.
The seeds of reversal in the downmarket cycle lie in this turning around of the endowment effect. Consider the other side of the fence, where sit those who want the investors' money. The businesses that were set up in the boom cycle would have been optimistic about outcomes. Not all of them would have the merit of becoming successful, but would have attracted capital from optimistic investors all the same.
When the cycle of opportunity begins to change, these business owners also suffer from the endowment effect. How many business leaders would have told investors that they may have made a mistake? DLF continued to hold that its sales would pick up; Suzlon was confident about managing its debt; the Future group was still expanding its retail footprint; Kingfisher felt that all it needed was some foreign capital; and Educomp had reinvented the K-12 markets for education. None of these business owners gave the impression that they were holding a losing business.
Over the period that the economic downturn has played out, we have seen regret leading to closure of outlets, branches and units. When regret has converted to disappointment, we have seen distress sales, closures, search for strategic buyers, and prices and valuations that are too distant from the optimism of the past. The willingness to give up what was once owned and considered precious is the known outcome of disappointment. From divorces and break-ups to job changes and business closures, the ability to give up what is not working marks the end of the cycle which began with the craving for ownership.
In the financial markets, this reversal leads to creative destruction. The money that is lost in the ventures that have not been working is written off. Money no longer flows into bad business proposals. The need for careful selection returns. Businesses and investors are too cynical to take on risky projects with unknown outcomes. The distress, arising from the unwillingness on the part of both businesses and people to invest, turns into cynicism. In an environment where even the best business propositions look shaky, the scope for a poor quality project to come in reduces. The audacity of throwing money in businesses without due diligence turns into vigilance about every rupee being invested.
Tomorrow's winning businesses emerge from this churn. Investors are tuned to looking at the past and are dismayed by the loss of value in what they owned yesterday.
Businesses learn to let go of the past and begin to give up what was once precious. When the evidence of the latter action starts to become visible to the investors, the cycle would have turned.
Investors now suffer like the jilted lover. Seething with disappointment, angry about the way things have turned out, and cynical about relationships. The normal response is to sulk, find fault, remain depressed, and be unwilling to act. Psychologists counsel the disappointed, asking them to not blame themselves, but try to find new friends to be with, and new activities to pursue. To those like investors, who cannot look beyond their love for markets, humour is the prescribed medicine. Lectures such as these, about cycles, are indeed cruel and run the risk of being shrugged off. Perhaps it's time to bring those cartoonists in.
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