You are on page 1of 8

“‘Markets do very weird things because they react to how people behave, and sometimes people

are a little screwy’ (Alan Greenspan). Indicate ONE way in which psychologists have found that
people act irrationally or differently from what might be expected, discuss why this might be the
case and indicate how behaviour of this type might cause a financial market to react.”

Introduction

The vast majority of finance models have human rationality as an underlying assumption.
However, there is an increasing amount of evidence in behavioural finance suggesting otherwise.
Dellavigna (2009) found that individuals deviate from the classic assumption of rationality in
three different ways: non-standard preferences, non-standard beliefs and decision making. This
paper is concerned with the latter, more specifically with the framing effects that lead people to
make irrational decisions. According to the axioms of utility theory, a different formulation of
the problem should have no influence whatsoever on the final decision. However, it has been
proven by scholars such as Kahneman and Tversky (1984), Donovan and Jalleh (2000), Thaler
(1980) and others that this is not the case. Those violations of rationality due to a different
wording of the problem at hand are known as framing effects. A specific case of a framing effect
is the endowment effect, which states that people tend to overprice goods they are trying to sell
and underprice goods they are attempting to buy (Hardman, 2009). This contradicts the
assumption of economic theory that making abstraction of the income effect, a person’s
willingness to pay a certain amount for a good should be almost similar to the amount they are
willing to accept for the same good (Willig, 1976).

Further, it will be explained why investors might act irrationally under the endowment effect
framework and its potential implication on financial markets’ liquidity, because of reduced
volume trading will be discussed, by analyzing experiments conducted in this regard both on
ordinary people and traders.

Endowment effect literature review

Hardman (2009) suggests that the endowment effect ultimately draws from loss aversion. This
can be illustrated by conducting a contingency valuation survey in which participants are asked
how much they would pay for protecting the environment and what sum they are willing to
accept so as to allow for damage to happen. The willingness to pay (WTP) and willingness to
accept (WTA) should be identical in theory, but as demonstrated by the endowment effect they
are not equal in reality. Because of loss aversion considerations, WTA has recorded much higher
prices than WTP, since WTA is the equivalent of a loss, which causes a high valuation for the
good, while WTP is seen as a gain and consequently brings lower utility. People’s fear of losses
can therefore lead to framing effect biases. This is thoroughly captured by Tversky’s and

Kahneman’s (1981) classic experiment of the “The Asian Disease Problem”, which illustrates

how participants readily choose the “sure” option over the “risky” one even though they are the
same. Thus, one particular framing effect resulting from loss aversions is the endowment effect.
Essentially the way in which buying or selling decisions are perceived under this bias makes
people feel more impact from a loss. Supporting this view, Kahneman and Tversky (1979)
described the endowment effect as a direct manifestation of loss aversion and its impact on
markets is going to be analysed in the following paragraphs.

Furthermore, I believe that the reason why the endowment effect is a special case of framing
effect is best observed by Peters et al. (2003) in their study of WTP and WTA for lottery tickets.
Participants were provided with a lottery ticket and had either a 5% chance to win $10 or a 50%
chance to win $100. Participants who were sellers were asked for how much they would be
willing to sell their ticket (WTA) and buyers were asked how much they would pay for a ticket
(WTP). On average, the WTA value was almost double the WTP.

An interesting conclusion drawn from this study is that buyers base their decision on the
probability of winning or losing, while sellers focus on the final result. Therefore, the same
information framed differently for participants depending on their position lead to different
evaluations, which subsequently results in different decisions on the market causing unexpected
events due to individual perception.

Conclusively, in the particular case described in this paper, the reason why people act against
rationality is simply given by a fear of losing one’s valuable assets. Loss aversion can easily lead
people to price things differently so as to minimize their losses, even if only as a justification
mechanism. Ways in which markets could react to this bias are tackled bellow, with emphasis on
the liquidity shortage issues that endowment effect is prone to cause on financial markets.

Behavioural implications on the market

Kahneman et al. (1990) tested weather the endowment effect can cause under-trading when
exchanging money and goods. The test was performed several times in order to exclude the
possibility that experience in the market can affect results. A control condition using induced-
value tokens was used for comparison. Tokens are free of any endowment effect as buyers and
sellers simply value them at the amount that was assigned to them (Plott, 1982). In the control
market situation participants were divided in buyers or sellers and for different prices they were
asked if they would trade at that given level. Finally, the forms were collected and the market
clearing price was announced.

Next, the good exchanged was a mug. The participants had to decide whether they were willing
to buy or sell at certain prices in four different markets. The experiment was conducted
identically four more times with various objects.

The results for the induced-value token market and consumption goods market were entirely
different. In the former, the ratio of actual traded volume to predicted trading volume (V/V*)
was 1, while the same ratio in the mug market was 0.20. The average selling prices in those two
markets were more than double the buying prices. It can be easily observed that for the goods
without a predetermined price the endowment effect was conspicuous as subjects wanted to sell
the products at higher prices creating a shortage of fair supply.

The same experiment was conducted again in a different university, with the only difference that
instead of surveys, subjects were asked to provide minimum and maximum trading prices.

Conclusively, the control induced-value markets had an almost perfectly efficient V/V* ratio of
0.91. On the other hand, the goods market had a ratio of 0.31 on average, while the selling price
remained constant almost double the buying price.

A key conclusion that can be drawn from this experiment was the fact that transaction costs and
market experience did not seem to have an impact on traded volume. V/V* was consistently high
in tokens market and low in the other markets. A possible implication of this phenomenon on
financial markets is a decrease in liquidity. Put into the context of a financial crisis, the
endowment effect could aggravate the liquidity risk, similarly to what happened in the Global
Financial Crisis.

Alternatively, Knetsch (1989) conducted a similar experiment with three groups of participants:
students in the first group were given a mug in the beginning of the experiment and at the end
they were presented with the choice of switching it for a bar of chocolate; students in the second
group were given the chocolate at the start and the last group was presented with the choice
between chocolate and a mug from the very beginning. The mug was chosen by 89% of the
students from the first group, 56% by the third group and only 10% by the second. This
experiment concluded that that the endowment effect is still present even when there is no
financial gain to be received and that prices do not converge to equilibrium with repeated trials.

Conversely, Brookshire et al. (1987) and Coursey et al. (1987) have argued that the endowment
effect disappears when subjects trade for longer periods of time and get used to the market
mechanism. Regardless, this view is being contradicted by the previous two experiments, since
the market situations were repeated multiple times for each sample and the bid-ask spread was
still large, displaying a significant endowment effect. This observation is critical to infer that the
behavioural bias influences captured by those experiments can be safely applied to real markets,
implying that reduced traded volume can occur regardless of transaction costs or experience.

In order to further demonstrate the applicability of those empirical studies to the financial
markets, Weber’s et al. (1999) experiments conducted on individuals trading risky financial
assets on a double auction market will be analyzed.

The first experiment required the participants to trade two simple lotteries which pay either a
fixed amount of money or nothing. The participants were dividend in two control groups. The
first group started out with a long position, having cash and a few valuable assets (positive
frame), while the second group started out with a short position, more cash, but also liabilities
(negative frame). Initially, total wealth was identical for both groups, only the description of the
position was different. The hypothesis of this experiment was that negatively framed
endowments would display a higher level of overpricing compared to positively framed
endowments. After running six trading sessions, the hypothesis was confirmed and the results
were in accordance with a similar experiment run by Rietz (1993). The presence of overpricing is
yet again an indicator of possible illiquidity. If sellers in a market ask for prices well above the
buyers’ budgets, then the bid-ask spread will consistently increase, while supply will not meet
demand.

The second experiment was based on a similar methodology, but aimed to investigate traders’
behaviour when their starting position was positive, negative or neutral. Therefore, the second
hypothesis was that prices of assets in positive or neutral endowments would be smaller than
their expected value and vice-versa. The hypothesis was rejected, as it was observed that positive
and neutral endowments had similar prices which were slightly larger than the expected value of
the asset. Only negative endowments experienced prices higher than the expected value by
approximately 50%. On average, overpricing was constantly present throughout the trading
sessions, even in the positively framed contexts to a smaller extent. This result thoroughly
supports the previous statements that overpricing can lead to market illiquidity.

Conclusions

In summary, one of the main limitations of the empirical evidence used in this argument is that
the majority of experiments were conducted on people with little financial background, which
could affect the accuracy of the results. However, it can be asserted that Kahneman’s et al.
(1990) experiment is still relevant despite that, as the majority of subjects who participated were
Economics students. Another aspect that reduced the possibility of biased results was the use of
objects that had no sentimental value to the participants and eliminated the possibility of the
endowment effect being present only due to subjective feelings associated with trading personal
objects as formulated by Reb and Connolly (2007).

Having asserted the relevance of the evidence at hand, I believe that it is crucial to note how this
behavioural bias could affect financial markets by restricting trading volume. The resulting
reduced liquidity is manifested in a large bid-ask spread given by sellers’ overpricing as
described in Weber’s et al (1999) experiment and a decline in investors’ ability to execute a fixed
trade amount within a certain period of time without incurring a loss (Cohen-Setton, 2015). On
its own, this effect may not be powerful enough to cause severe liquidity shortage, but combined
with another type of behavioural bias such as herding for instance, it could gain the power to
make investors’ irrational decisions impact upon market stability. Shifts in liquidity are only one
of the ways in which cognitive biases have the power to affect markets. As discussed above, the
endowment effect along with loss aversion can lead to shrinkage of liquidity on the stock market,
but biases like overconfidence, illusion of control or herding can cause significant overreaction,
which in turn can lead to a bubble like the 1998-2002 Dotcom bubble or the Global Financial
Crisis. The underlying origin of the endowment effect and other such biases is non-other than
human nature and behaviour, which can result in irrational decision making due to people’s
fears, beliefs or preferences for risk.
References:

1. Brookshire, D. and Coursey, D. (1987). Measuring the Value of a Public Good: An


Empirical Comparison of Elicitation Procedures. The American Economics Review,
77(4), pp. 554-566.
2. Cohen-Setton, J. (2015). The decline in market liquidity. [online] Bruegel. Available at:
http://bruegel.org/2015/08/the-decline-in-market-liquidity/ [Accessed 05 Dec. 2017].
3. DellaVigna, S. (2009). Psychology and Economics: Evidence from the Field. Journal of
Economic Literature, 47(2), pp. 315-372.
4. Coursey, D., Hovis, J. and Schulze, W. (1987). The Disparity between Willingness to
Accept and Willingness to Pay Measures of Value. The Quarterly Journal of Economics,
102, pp. 679-690.
5. Donovan, R. and Jalleh, G. (2000). Positive versus negative framing of a hypothetical
infant immunization: the influence of involvement. Health Education & Behaviour,
27(1), pp. 82-95.
6. Hardman, D. (2009). Judgment and decision making: Psychological perspectives.
Chichester: Psychological Society and Blackwell Publishing, pp.84-85.
7. Kahneman, D., Knetsch, J. and Thaler, R. (1990). Experimental Tests of the Endowment
Effect and the Coase Theorem. The Journal of Political Economy, 98(6), pp. 1325-1348.
8. Kahneman, D. and Tversky, A. (1979). Prospect theory: An analysis of decision making
under risk. Econometrica, 47, pp.263-291.
9. Kahneman, D. and Tversky, A. (1984). Choices, values and frames. American
Psychologist, 39(4), pp. 341-350.
10. Knetsch, J. (1989). The Endowment Effect and Evidence of Nonreversible Indifferences
curves. The American Economics Review, 79(5), pp. 1277-1284.
11. Peters, E., Slovic, P. and Gregory, R. (2003). The role of affect in the WTA/WTP
disparity. Journal of behavioural decision making, 16(4), pp. 309-330.
12. Plott, C. (1982). Industrial Organization Theory and Experimental Economics. Journal of
Economic Literature, 20(4), pp. 1485-1527.
13. Reb, J. and Connolly, T. (2007). Possession, Feelings of ownership and the endowment
effect. Judgement and decision making, 2(2), pp. 107-114.
14. Rietz, T. (1993). Arbitrage asset prices and risk allocation in experimental markets.
Kellog School of Management Northwestern University Working Paper No.109.
15. Tversky, A. and Kahneman, D. (1981). The framing of decisions and the psychology of
choice. Science, 211(4481), pp.453-458.
16. Thaler, R. (1980). Toward a positive theory of consumer choice. Journal of Economic
Behaviour & Organization, 1(1), pp.39-60.
17. Weber, M., Keppe, H. and Meyer-Delius, G. (1999). The impact on endowment framing
on market prices – an experimental analysis. Journal of Economic
Behaviour&Organization, 41 (2000), pp. 159-176.
18. Willig, R. (1976). Consumer’s surplus without apology. The American Economic Review,
66(4), pp. 589-597.

Word count: 2,000

You might also like