The Greater Good: Relative Value and the Endowment Effect

Mr. Market finished higher this week, despite the best efforts of reality to sway his opinion. The Dow, S&P and NASDAQ all posted modest gains, even as the nation’s economic firmament continued to weaken like the good intentions of a boozed-up quarterback on prom night.

How did this jovial market mood come to pass? Did the jobs situation improve? Nope. Housing prices go up? No way. Did the debt load of the United States suddenly start to shrink? You’ve got to be kidding. How about a change in policy…a move toward austerity…public denouncement of the idiots that got us into this mess? What? Have you lost your mind?

For years behavioral economists have been busy erecting a body of evidence to substantiate what we already know: that human beings cannot be trusted. Or, more correctly, that they can be trusted…but only to make stupid decisions. [This is not to say that we would infringe on their right to do so; only that it helps to know why so we might avoid making similar mistakes ourselves.] The reasons for this are many and varied. We are plagued with biases and tendencies that lead us to feel comfortable getting things wrong.

The endowment effect, for example, illustrates how people demand more money to replace an object than the thing cost in the first place. When presented with a wager where the subject stands a 50% chance at losing $100, most people will settle for nothing less than the potential of a $200 gain in order to take the bet. Obviously, any potential gain over $100 ought to be a mathematically sufficient enticement (depending, of course, on how much of your total wealth $100 represents).

In the words of psychologist Daniel Kahneman, “a good is worth more when it is considered as something that could be lost or given up than when it is evaluated as a potential gain.” We might better recognize this as a bird in the hand being worth two in the bush.

While it is not difficult to see how evolution has selected for precisely this kind of risk aversion, we wonder about the associated opportunity cost and how, knowing this tendency of ours, politicians might skew their rhetoric to play exactly to this weakness. Consider the ranting and raving that invariably precedes each new round of market intervention by the feds.

“If we don’t sign this check, we may not have a market on Monday.”

“If we don’t pass this bill, unemployment could reach…”

“We are standing on the edge of the abyss.”

Notice how before each new round of meddlesome intervention, voters were lulled into taking the bet on pain of losing something dear to them…the market, their jobs…even their gravitational reality. Given our propensity to guard what we have, even at an expense greater than the value of what we may stand to gain, it is little wonder people go in for such nonsense.

Instead, we might think to ask ourselves what US taxpayers might have done with their own cash, for example, had the government not mopped the streets of Midtown Manhattan with it on their behalf? Might they have opened a little corner store, a bakery, or a barbershop? Might they have spent it at their friend’s new corner store, bakery, or barbershop? Perhaps. Perhaps not. The only thing we can be sure of is that now we’ll never know.

And what of these so-called “too big to fail” institutions themselves? Might other companies, those that were more prudent during the bubble era, have swooped down to feast on the carrion? Might the market have found, for example, a fifty cents- (or twenty cents-…or one cent-) on-the-dollar clearing price for AIG’s cluttered basement of mark-to-model junk? And wouldn’t that have been better than watching the government – in either a pitiful display of negotiating ineptitude or a criminal act of collusion – absorb it, unquestioningly, at face value? Again, we’ll never know. Investors and voters were spooked with apocalyptic stories of what might be lost – a gazillion jobs, access to fresh water, the cat – if they didn’t acquiesce to the plans of the all-knowing, all-seeing state.

Of course, the endowment effect is but one of many predictable tendencies we carry around with us, for better or for worse, both in life and in the markets. Consider our apparent eagerness to engage in herd mentality and to judge our successes or failures relative to the rest of the mob.

It’s somehow easier to stomach a quarterly loss if we know the market, as a whole, is down too. And it’s easier still if we know our next-door neighbor has performed even worse. Presumably, therefore, there should exist no greater thrill for a man who’s real estate portfolio is in the red than to watch every other house on his street enter into foreclosure. That may be of some comfort to Floridians and Californians, where foreclosure notices are more or less issued at point of sale, but it’s hardly a recipe for progress.

To add insult to mental injury, the list of our irrational biases is as long as it is disturbing. There’s the “denomination effect” – the tendency to spend more money when it is denominated in small amounts than when we have a pocket “full of Benjamins.” There’s “normalcy bias,” defined as a refusal to plan for, or react to, a disaster that has never happened before. We must also contend with “irrational escalation,” the tendency to justify increased investment in a decision based on our cumulative prior investment, despite new evidence suggesting that the decision was probably wrong. And, one of our personal favorites/weaknesses, the phenomenon of “reactance,” an urge to do the opposite of what we are told to because of a need to resist a perceived attempt to constrain our freedom of choice.

Even if we do manage to curb these behaviors, who is to say the guy next to us will do so, or the guy next to him? And what does this say about politics, for example, when representatives are chosen by majority vote? The inimitable H. L. Mencken was probably onto something when he once described democracy as “the pathetic belief in the collective wisdom of individual ignorance.”

This could also explain why markets tend to act irrationally, overshooting to the upside before overcorrecting in the opposite direction. They are merely representing, magnifying even, the irrational biases of the myriad participants within them. We’ve been saying for a while that we’re due for another big pullback, but what do we know? Everywhere we look we see signs of an impending implosion: a textbook case of confirmation bias.

Joel Bowman
for The Daily Reckoning