Cartoon Capers

If you get someone to build an IKEA sideboard – you know, one of those flat-pack conundrums that involves trying to work out what a cartoon character is doing with a hammer, a drill and forty three assorted metal dowels – they immediately place a higher value on it than anyone else would, even if it goes on to develop an alarming 45 degree tilt. This is the IKEA effect.

It’s associated, sort of, with a more general behavior that’s been known about for years, the endowment effect, in which possession of an item immediately causes us to value it more highly. Just imagine what the impact might be if you build your own portfolio, no matter how wonky it might be.

Well Endowed

The endowment effect was originally demonstrated in an experiment by Daniel Kahneman, Jack Knetschand Richard Thaler, who gave half of a graduate class a college themed mug and then invited them to trade with the other half. Little trading occurred because the valuations set by the mug-possessors far outstripped those set by the mug-less. Somehow mere possession of a mug was enough to endow it, in the eyes of the possessors, with a value that made no sense to an outsider.

In part this looks like status quo bias – people like to stick with what they know. In combination it’s not hard to see how these issues could cause problems in other sorts of markets. If we over-value items of any kind – stocks say – merely because we possess them then we’re likely to find it difficult to sell them whatever the circumstances. Status quo bias and the endowment effect are among the the culprits proposed for loss aversion, our tendency to hold onto loser stocks regardless of their underlying worth.

Building Bears

There are three underlying, odd, behaviors associated with the endowment effect. The first is the obvious one – that sellers and buyers place radically different valuations on the same thing, an effect that holds even when we adjust for negotiation strategies (i.e. put in a low bid as an anchoring point).