Human Misjudgment : Endowment Effect

Today I discuss the human trait that, despite all its glory, has lead to disastrous consequences for many individuals and societies and specifically in investment world.

 

In fact, if there is one trait which, even though I do frequently observe in successful people in various other human endeavors, is very rare to find in the top strata of investing community.

 

In Munger’s speech, he calls it…

 

Excessive Self-Regard Tendency

Individuals on an average have a tendency to over-appraise their decisions, their possessions and worst of all, themselves.

 

Just do the following experiments:

 

  • Ask a friend to list down few ‘things to improve’ in his (or her) child and then ask him to do the same for his neighbor’s child and observe the difference in the list. With a very high probability, the list is going to be relatively very small for his child. (Just don’t ask the same question for the spouse :-))
  • Take a survey of students in a classroom and ask them how many of them think they are ‘above’ average. We know it can’t be more than 50% but usually the numbers are very high.
  • Next time when you go to purchase something, a television set, a mobile, a car etc., just observe how confident you are before and after the purchase. Chances are that after your purchase you feel much more confident about it and why not? After all, it’s ‘your’ final decision.

 

The tendency in the first example is what psychologists called ‘Endowment effect’, which increases the ‘perceived value’ of one’s possessions.

 

In investing also, this is very frequently observed. One’s level of confidence, expectations and emotional responses to price movements in a stock differs drastically, just moments after the purchase is made.

 

Somehow, the mere act of ‘owning’ the stock changes the scenarios. Unfortunately, stock doesn’t know that!

 

As we have seen in all other psychological biases discussed before in this series on Mental Models, marketers have exploited this behavior also.

 

Most of the ‘money back guarantees’ and ‘buy now, pay later’ tactics are used as a very effective tool to get over the initial resistance.

 

Once the customer purchase the product, the endowment effect ensures that people start liking ‘their’ purchase and very few people actually return the product.

 

Various success stories (and failure stories) have taught that one should bet high when the probabilities are in one’s favor and do the reverse when they are not. Excessive regard of one’s capabilities leads various people to bet heavily on various endeavors on basis of ‘mis-evaluated’ probabilities and lose a lot.

 

In investing, this tendency is displayed by having an extremely concentrated portfolio with one or two stocks having extremely high percentage of allocation. This also leads us to the classic question of diversification v/s concentration but more on that, later.

 

As we saw earlier, one’s decisions are also often overestimated. This bias has been very well utilized by lottery providers where they observed that the play is far lower when the numbers are distributed randomly than when the player is allowed to pick his own number.

 

As Munger explains, this excess of self-regard also leads to very poor hiring decisions where one overestimates his ability to judge a person better after half an hour of interview and base decisions more on that ‘impression’ after the interview than the achievements of the candidate which are mentioned in his past records.

 

This often leads to better ‘presenters’ getting the jobs than the better ‘performers’. This is what happened with HP, according to Munger, when they hired Carly Fiorina.

 

Other outcome of excess self-regard is the tendency for one to like people who are similar. This was demonstrated in a ‘lost wallet’ experiment. In the experiment, the wallet had clues of the identity of the wallet owner and it was observed that the subjects were found to be more likely to return a wallet to a stranger when that stranger resembled the subject.

 

This tendency to like similar people often leads to organizations with very similar kind of people as the people hiring eventually have tendency to like more people like them. This is especially a problem if the influential people in the group have moral and ethical disregard as the problem has the trigger of ‘excessive self regard’ to hire and hence develop an organization of similar nature.

 

For investors, meeting the management may or may not be an answer to knowing a lot about business (depends on investors), but ‘knowing’ few people in senior positions can certainly give a fair estimate of the kind of people organization has.

 

It is definitely not a generalization but can be an effective extrapolation (one of the very few useful extrapolations in my humble opinion)

 

On such organizational level, the antidote, as suggested by Munger, is to have a fair, meritocratic and demanding culture along with severance of the worst offenders…whereas on a personal level one must try his best to be objective especially when thinking about himself, his possessions, his family or his decisions.

 

In my view, keeping oneself humble and reminding that one can be wrong is of utmost importance, especially in investing.

 

This keeps one grounded and also makes one work harder to develop conviction before betting heavily on something.

 

What do you say?

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