Originally Published on March 16, 2016
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.
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 overvalue 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 culprits proposed for loss aversion, our tendency to hold onto loser stocks regardless of their underlying worth.
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).
The second is the mere ownership effect - merely owning something is enough to increase the perceived value of the object. And the third is a reluctance to trade at any price - some people simply don't want to be parted from their belongings, no matter how tatty or valueless they appear to be to everyone else.
The IKEA effect is clearly related to these effects, but there's also something else going on. For instance, if you expend effort at Build-A-Bear to help your child with the creation of their very own growly playmate, you don't then expect the store to reduce the price of your ursine friend because you've spent your time making it. In fact, you probably pay more, and do so happily, because your added input increases your estimate of the value of the critter.
Prior research suggests that the more effort we put into some activity the more we value the outcome - a behavior known as effort justification. So if you're inclined to do lots and lots of research into stocks before buying, you're likely to end up suffering from both effort justification and the endowment effect.
Now, that doesn't automatically mean your efforts aren't worthwhile; but it would strongly suggest that the more work you put into deciding to buy a stock, the more likely it is that you'll end up biased towards it and against alternate views. We have perhaps all met people who know every single detail of their favorite shares but completely miss the big picture; Polaroid was a great investment all the way up to the point that digital photography took off. You could analyze the company's numbers till the end of time, but you still wouldn't have seen the digital cliff coming.
However, the research into the IKEA effect adds a second factor: the research suggests that the effort expended in all this work has to result in some level of success. A failed attempt to erect a chest of drawers is more likely to cause feelings of regret than an increased level of attachment. It's hard to be happy with yourself if your furniture keeps on collapsing around you.
In "The IKEA effect: When labor leads to love," the researchers Michael Norton, Daniel Mochin and Dan Airely found that:
"Participants saw their amateurish creations as similar in value to experts' creations, and expected others to share their opinions. We show that labor leads to love only when labor results in successful completion of tasks; when participants built and then destroyed their creations, or failed to complete them, the IKEA effect dissipated".
Interestingly, they then go on to show that this isn't simply an effect experienced by novices: experienced do-it-yourselfers also got caught up in the pleasure of admiring their own creations. Effort justification appears to be behind this - the more effort that people put into their successful creations, the more in love with them they became.
Now, because the experiment used pre-packed components from IKEA, they didn't allow for any customization. Every creation was a clone of every other creation. Yet still, participants habitually overvalued their output apparently because of the effort they'd expended in making it.
If this research translates into a more general problem, then the issue for investors is starkly obvious. Overvaluing our investments simply because of the sheer amount of effort we've expended in figuring out that they're worthy of our capital would trigger confirmation bias. We're likely to miss future changes in prospects because we're deliriously happy that all of our research efforts have resulted in a successful investment: we're less likely to acknowledge evidence that points to the fact that things are going wrong, because we can always summon up a battery of figures to show that critics are idiots who haven't done the necessary detailed work.
The idea that less is sometimes more, and that if you actually have to spend weeks of your life analyzing a company in order to determine whether or not to invest in it is probably an indication that you shouldn't, is anathema to some investors. And, to be fair, people who do this for a living should expect to do this level of research and will either be successful or be culled by the invisible hand passing their money to less gullible people.
But for most of us, with limited time and resources, if we have to commit so much time to analysis that we end up suffering from the endowment effect, we're probably looking at the wrong stocks. Building an IKEA wardrobe is fine and well, but equating its value with something created by a craftsman is stupid and biased. And, more importantly, it's a pointless waste of a life.