Behavioral Investing and Finance

I learned this game from the book Sway by Ori Brafman, who wrote about a Harvard professor, Max Bazerman, who taught a negotiation class. The game is an auction for the $20 bill. At the beginning of the game, you hold up the $20 bill and say, “You are auctioning off this $20 with starting bids at $1, and bids are in $1 increments. The highest bid wins. However, the 2nd highest bid needs to forfeit his bid to me. So if the highest big is $12 by person A and the second highest bid is $11 from person B. Person A wins the $20, but person B needs to pay $11 to me.”

The rational outcome:

The bidding should continue until it reaches a bid slightly under $20 because who in their right mind would bid over $20 for a $20 bill.

The real outcome:

Because the 2nd highest bidder needs to pay, this changes the game. Everyone starts bidding at the beginning until the bidding gets to the $12-$16 range. Then, normally, everyone drops out except the two highest bidders who continue bidding and get locked into their commitment. If one bidder bids $17, the next one who bid $16 doesn’t want to lose $16, so he bids $18, and so on back and forth. No one wants to lose, but as they continue bidding, their losses get large and larger. In the Harvard class, bids have gone over $200 for a $20 bill. After the game, if you make more than your $20, you can keep the money, or you can say you will donate it to your favorite charity.

The reasoning:

Commitment bias is strong as you go up in the bidding. You are also bidding in a public setting, so giving up makes you look weak, so you keep bidding higher and higher. Loss aversion also sets in, and you don’t want to feel the pain of a loss after playing this game. When you get close to $20 in the bids, you know you should not bid higher than $20 because that is a bad rational decision, but some people will do it to win and not feel the pain of a loss and are committed to winning.

The discussion:

After the game, you can discuss how the players felt at three points in bidding; when the bids started at single dollars, at $12-$16, and close to $20? Then ask the two last bidders how they felt? Did they feel like they didn’t want to lose? Did they feel they were committed to this game and needed to win?

The effect on finance and investing:

You probably have heard the term “Throwing good money after bad.” The term means wasting money on something you already spent money on that was no good. Suppose you loved Krispy Kreme (KKD) donuts and saw they were expanding like crazy, and their stock price was going up and up. You started buying their stock regularly for years. Then 2004 came, and low-carb diets became a fad. Donuts are bad. Carbs are bad. Keto diets are good.

You start seeing your KKD stock go down, but because you have so much invested in KKD, you see this as a buying opportunity and buy more. KKD has given you so much profit you are committed to KKD even when the health-conscious public has said they want lower carb foods, and the company is warning of this change. What happened? You lost all your profit and your initial capital as the stock plummeted from highs of $48.92 on Aug 20, 2003, to a low of $4.05 on Oct 27, 2005.

You might say, but you told me to buy on the downturn to cost the average of my stock price. Yes, but that is only if the company’s market did not change and the customer base did not shrink. Krispy Kreme’s customer base shrunk dramatically in 2004 with the low-carb diets.

Personal story:

Have I been so committed that I lost all my capital in a stock? Yes. In my earlier days, I would purchase much riskier stocks, or what you might call penny stocks, and look for bargains. These were rollercoaster rides. I remember a startup biotech stock I purchased at around $5 per share, which went up to $20 per share, and I rode it up. Then they had issues with their Phase 1 trials, and the stock dropped to $9 per share. Because this company only had one product, this Phase 1 issue was huge. I should have taken my $4 in profit per share, but their news and company announcement was very optimistic, so I bought more. In the end, this company’s stock we delisted as it was lower than $1 per share and eventually went bankrupt. I was committed and felt like I knew more than everyone else as I was following the news and announcements from the company, so overconfidence bias also led to this mistake.

Endowment Effect Game

The endowment effect is when people demand more to sell an object than they would be willing to buy.

If you have seen the Wolf of Wall Street movie, you remember the scene where Jordan Belfort is giving a seminar and ask a man in the audience, “Sell me this pen.” This game is about selling a pen.

What you need:

• 6 or more players, the more, the better
• Enough nice pens ($1 or more per pen) for half the players Don’t tell the players how much the pens cost.
• Have everyone bring $5-$10 in one-dollar bills

The game:

Give half of the players a pen that they can keep or sell. Have the pen owners look closely at the pen and its styling, how it writes, the smoothness, or uniqueness.

Ask the other half of the players if they want to buy the pen from the players with the pens. If they want to buy a pen from another player with a pen, they would have to negotiate an acceptable price. Give them 15 minutes to negotiate and do any buying or selling. Pen owners do not have to sell their pens, especially if they are not given a price they want.

The rational outcome:

This is a pen exchange market. If this is an efficient market, you should have about 50% of the people selling their pens, and you will find a clearing price for selling a pen, i.e., an average price they would pay to buy or sell a pen. An efficient market means everyone is acting rationally and in their best interest, and all information is known about the transaction.

The real outcome:

You find that not many pens are traded because the pen owners will demand more than what the buyers are willing to pay. You may also see that the clearing price is higher than the price you purchased the pen for.

The reasoning:

The pen owners do not want to part with the pen because they don’t want to feel the pain of giving up the pen.

The discussion:

After the game, you can discuss how the players felt in the negotiation. Did they feel pain in selling an object they own? Why didn’t the buyers offer more? Was there a difference in how they valued the pen when buying it and if they owned it? Then you can tell the whole group how much you paid for the pens and see their reaction.

The effect on finance and investing:

The endowment effect also causes people to not sell stocks or objects they own because they want to avoid the pain of loss even when, rationally, this is the best path forward. Or they demand a higher price than what the market will bear, i.e., marketing clearing price. You can see this when someone sells a house. The seller demands more than what the buyer is willing to pay due partially to the pain of loss. And if you lived in a house for a long time, there are so many memories that the pain of loss is large.

Personal story:

My son is almost paralyzed by this endowment effect. He will not give up anything you have given him, even for any amount of money, new toys, or games. The pain of giving up a toy, even a baby toy, is too much. I joke he is becoming a hoarder. This is one of the reasons some individuals hoard more than others, due to how much pain they feel from letting go of an object.

---

Fairness Game