Sharemarket investors and the endowment effect

I cover the endowment effect as part of the Behavioural Economics course that I teach. The example that I use was aired on the PBS TV channel and was an experiment at the University of Chicago where students are told to work out how much they would be prepared to pay for a travel mug – they offered an average price of US$6 per mug. Then some of the students were given the same mug for nothing and an hour later, asked how much they’d be willing to sell it for. In rational economics, the price should be exactly the same but when asked they now wanted US$9 for the mug. The emotional pleasure of owning something for just an hour pushed the price up by 50 percent. It’s an unexpected outcome, suggesting we are unaware of the emotions that drive this behaviour.

Endowment effect in the Indian stockmarket

Recent research (Endowment effects in the field: Evidence from IPO lotteries in India Santosh Anagol, Vimal Balasubramaniam, Tarun Ramadorai – 2016) use a real life experiment in the Indian stockmarket to study the endowment effect. It focuses on the floatation of new companies on the Indian stockmarket referred to as initial public offerings (IPOs). When the Indian IPO’s are oversubscribed issuers use a lottery to ensure that winners received a fixed number of shares of the IPO stock whilst the losers in the lottery receive zero shares.

  • Winning investors are allocated shares on the floatation of the company
  • Losing investors can buy only after the issue of the IPO’s start trading.

The researchers tracked the behaviour of 1.5 million winners and losers in the lottery following the random endowment of the stock in lotteries in 54 IPOs occurring between 2007 and 2012. What they are tracking is the propensity of winners and losers to hold IPO stock following random allocation. The randomisation ensures that winners and losers are (based on forecasts) identical in terms of their information sets, beliefs, and preferences. Moreover, they have equal opportunities to trade once the stock is listed in the market. If endowment effects do not exist in this setting, holdings of the randomly allocated stock amongst winners and losers should converge rapidly over time.



The authors also find that the estimated endowment effect has little relationship with listing gains on the first day – the average IPO increase in price is 52% suggesting among other things that these effects are not driven by a wealth effect accruing to lottery winners. However, after 12 months the IPO price falls by 54% so you would expect lottery winners to off load their shares after the first day’s trading and for the losers to buy stock which is much cheaper.

Another finding is that when IPO returns are substantially greater than a winner’s previously experienced returns they are more likely to sell the IPO stock, and losers are more likely to buy the stock. That is to say, the endowment effect reduces considerably when past personally experienced returns are taken into account, suggesting that experience-based learning plays an important role in individual decision-making.

Inertia effect?

The Economist has suggested that the inertia effect could be present as investors are too busy to make time to buy or sell shares once they have been successful or unsuccessful with the lottery issue. However the authors shows that the endowment effect is still present when they study investors who make more than 20 other stockmarket trades in the month of the IPO floatation. The research also looked at those experienced investors who have taken part in 30 IPOs and found there was still a significant endowment effect with winners being four times more likely than losers to hold shares at the end of the first month of trading.

Winning the lottery seems to make investors more likely to hold onto shares regardless of profit or loss.

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