saush

Why it is difficult to accept the realities of a downturn

Posted in general by sausheong on April 7, 2009

I bought a 17″ Sony Flatron monitor for $535 in 1999, one of my prized possessions that accompanied me during the few years which I hopped from rented room to rented room. It weighed almost 20kg and was a tremendous monster to lug around, maybe 20% of the total weight of my other stuff put together. I retired it (still working) when I got my Samsung 19″ LCD monitor ($220) about 2 years ago and my wife persuaded me to sell it off. However, I baulked when I was offered $50 by the karung guni man, after all, it was still working. So I refused to sell it.

The next time I mentioned it to a karung guni man, he wouldn’t even want to take it and wanted to charge me $5 to take it off my hands. Naturally I didn’t pay.

All these brought me to the couple of conversations I had with Winston and with Simon. Conversations that somehow drifted to talking about our lifestyles in the current state of the economy. Perhaps this was on my mind during our lunchtime chatter, since we talked about completely different things to begin with. Winston talked about how he struggled through his startup days to achieve where he is today. Simon and I talked about how people upgraded their lifestyles over the few good years before the current crisis, and having done so found it extremely hard to accept that they need to lower their expectations now. Stories of people who lost their jobs and cannot accept that their new jobs now pay 20% – 25% lower than their previous one. People who just bought their 42″ LCD TVs, high-end electronic gadgets, cars and even apartments, depended entirely on their salaries to pay for the installments and lost their jobs. People with shiny promising lives ahead of them during the prosperous times but now facing bleak, burgeoning loans and unable to come to terms with the new realities of a recession.

Which led me to think — what makes it so difficult for us to accept the realities of an economic downturn?

My guess is a combination of these three hypotheses:

Endowment effect
This simply means that people place a higher value on objects they own than objects that they do not. An experiment conducted in Duke University by Ziv Carmon and Dan Ariely showed how surprisingly irrational yet humanly plausible this is.

Duke University has a small basketball stadium which doesn’t have enough seats for all its fans so it designed an elaborate lottery system to allocate tickets instead. The experiment involved fans who has won tickets to an NCAA Final Four basketball tournament and fans who had not, 93 respondents in all. Each respondent was asked, one day prior to the match, to indicate their selling or buying price for a ticket to the match. The buying price question asked for the highest price he or she would pay for the ticket and the selling price question asked for the lowest price he or she would agree to sell. In addition, the would-be buyers would be asked to think of other items or experiences that would be equivalent in value to the tickets. The test was to find out how much the buyer value the experience as compared to an equivalent experience and how much the seller value losing that experience. In other words, it was an experiment to determine the existence of the endowment effect.

When the experiment ended, the 10% trimmed mean selling price was about $2,400 while the 10% trimmed mean buying price was about $170. That’s a difference by a factor of 14! Rationally speaking, the would-be buyer and the would-be seller should think of the experience in the same way since they were randomly picked fans. The only difference was that some of the respondents won a lottery for the ticket and others didn’t. It’s pretty hard to explain the differences between the selling price and the buying price but at the same time it is strangely familiar and human.

This is why it’s particularly bitter for us in this downturn — we have already owned our new lifestyle, and it has gained particularly high value. If we have not owned that brand new Honda Civic it wouldn’t have mattered so much, but now that we have it, losing it is much more painful, even though we had lived happily in the past without it.

Loss aversion
This again should be familiar to most of us. It refers to the tendency for people to prefer avoiding losses than to acquiring gains of similar value. For example, it is more painful to lose $1000 than it is pleasurable to gain $1000. Given a choice people would prefer the chance not to lose $1000 than the chance that they might gain $1000. In a 1981 paper by Amos Tversky and Daniel Kahneman, researchers described an experiment conducted at the University of Stanford and the University of British Columbia where 2 groups of students (152 and 155 respectively) were asked to answer this brief questionnaire in a classroom setting:

Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 60 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:

If Program A is adopted, 200 people will be saved.

If Program B is adopted, there is a 1/3 probability that 600 people will be saved and 2/3 probability that no on will be saved.

Which of the two programs would you favor?

As it turns out 72% of the respondents chose Program A and 28% chose Program B. However, when the questions were phrased like this:

If Program C is adopted 400 people will die.

If Program D is adopted, there is a 1/3 probability that nobody will die and 2/3 probability that 600 people will die.

Which of the two programs would you favor?

the reverse happens i.e. 78% of the respondents chose Program D and 22% chose Program C! As you can see Program A and C are essentially the same, as with Program B and D. The difference was how the questions were worded. Whereas Program A describes people being saved (a gain) while Program C describes people dying (a loss). Intuitively it seems right, but it is still pretty startling that mere words could affect us this way.

Cognitive dissonance
Cognitive dissonance is one of the most influential and extensively studied theories in social psychology. It is the uncomfortable feeling when we have two contradictory ideas at the same time. The theory is that in such situations we would be driven to change or justify our attitude or behavior. For example, if you believe that you are a careful driver and an accident happens, you would normally either blame it on the other driver or some external factor that doesn’t contradict with your self-belief that you’re a careful driver.

In this economic downturn, the self-belief that we are worth this much (in terms of salary or other compensation) contradicts with the reality that we have been offered a job that is paying less. The cognitive dissonance then drives us to angrily reject the offer as being unreasonable, the employer is trying to take advantage of the downturn or some other justification that doesn’t take away that self-belief.

So?
So what can we learn from this? Loss aversion tells us that looking at it in a different perspective makes things less painful for us. It’s not losing a job, it’s galvanizing us to try out the other stuff we’ve always been too busy with. What we learn from the endowment effect is that losing our stuff is painful. That will not go away. However we can make things less painful not only by spending only we can afford, but also spending a few levels less than what we can afford in order to buffer for this pain. I can afford that Honda Civic if I have my job and current salary, but shouldn’t I buy a cheaper car such that I can afford it even if I lose 50% of my salary? Finally, cognitive dissonance is part of human nature but what we can’t change, we should adapt. Recognizing that our self-worth is not measured in terms of our salaries but other things our families and friends, that salaries and jobs, like most things in the world goes through cycles should give us better sanity in dealing with a rapidly changing economic crisis.

Having knowledge of what makes is hurt so much in this downturn doesn’t really help us get back our jobs or salaries. But knowing that it is human to feel this way, and that everyone is feeling the same way probably helps us face it better.

I still have that 17″ Sony Flatron monitor lying somewhere. One of these days I will need to overcome the endowment effect and dump it.

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  1. […] Original post by saush.com […]

  2. […] saush.com placed an observative post today on Why it is difficult to accept the realities of a downturnHere’s a quick excerptI bought a 17? Sony Flatron monitor for $535 in 1999, one of my prized possessions that accompanied me during the few years which I hopped from rented room to rented room. It weighed almost 20kg and was a tremendous monster to lug around, maybe 20% of the total weight of my other stuff put together. I retired it (still working) when I got my Samsung 19? LCD monitor ($220) about 2 years ago and my wife persuaded me to sell it off. However, I baulked when I was offered $50 by the karung guni man […]

  3. […] saush.com > Why it is difficult to accept the realities of a downturn Money Quote: Having knowledge of what makes is hurt so much in this downturn doesn’t really help us get back our jobs or salaries. But knowing that it is human to feel this way, and that everyone is feeling the same way probably helps us face it better. […]

  4. Nani said, on June 22, 2009 at 7:10 pm

    Great post, Sau Sheong… at least partly explains why I hung on to two used cars for a couple of years and continued to pay insurance on them, even though I’d relocated to a different country! :P

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