Wednesday, June 11, 2008

Why It's So Hard to Let Go (Hint: It's all in your head)

Another brilliant new study from the SPAN lab at Stanford elegantly describes the neural predictors of the endowment effect. If you recall from some of our past blog posts, the Endowment effect describes the tendency for people to overvalue what they own, and value less what they don't.

A classic example of the Endowment Effect is playing out in the housing market. In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value (per Hersh Shefrin on NPR, March 30, 2008).

So what could drive people to cling to what they own and demand a higher price for it? It turns out that we are hardwired for "scarcity," and we don't want to let go of something we already have.

It even appears that we fear losing something we think we are going to get, and we'll chase it with a higher price at an auction (such as Ebay). This is seen in an insightful study by James Heyman, Yesim Orhun, & Dan Ariely called : AUCTION FEVER: THE EFFECT OF OPPONENTS AND QUASI-ENDOWMENT ON PRODUCT VALUATIONS).

Brian Knutson, Elliott Wimmer, Scott Rick, Nick G. Hollon, Drazen Prelec, and George Loewenstein demonstrated in a study published by Neuron tomorrow, called Neural Antecedents of the Endowment Effect, that activation in the anterior insula (appearing in the top image), predicts the strength of the Endowment Effect.

Importantly, there are "individual differences" in the intensity of the Endowment Effect. That is, the activation in any one person's right anterior insula predicted how much value they assigned (and how much money they would demand from a bidder) for a consumer product. Each individual is different in this regard. And I imagine (though I have not seen it shown experimentally) our own propensity to the endowment effect changes over time depending on recent events in our lives.

Remember, the anterior insula often activates when someone is afraid of losing something, when they are in physical (and imagined) pain, and when they are experiencing disgust. So the idea of giving up a product is actually painful, and so we assign a higher value to it - to avoid the pain of loss.

Maybe that's another reason why it's so hard to let go of a sagging stock, especially one with a great story that is a former high-flyer. It's actually painful! More on this study and its implications later...

Happy Investing!


1 comment:

Rahul said...

This endowment effect seems to link in quite well with behavioral finanace. people do actually tend to attach a higher value to something they have and also are biased about their own opinions..