Richard Thaler, Daniel Kahneman and Amos Tversky are the pioneers of the field called “behavioural economics”, two of them even won Nobel prizes for their work and the third would have too, if he was alive to receive it. The trio uncovered numerous ways in which people make poor decisions without knowing it. Here’s a short podcast where Thaler tells a number of stories that bring behavioural economics to life. I wanted to talk about some of their findings (again) and apply it to watch collecting in some way.
First, I want to highlight one of the stories that Thaler tells in the podcast about a bottle of wine.
Before you continue, pretend you’re a wine collector, or someone who buys bottles and keeps them around for a while before drinking them. How much would it cost you to drink a bottle of wine that you bought years ago for $10, but is now worth $100? Once you’ve thought about this, make a note of your answer and we can come back to it later.
Here’s the full story in Thaler’s own words:
“One case came from Richard Rosett, the chairman of the economics department and a long-time wine collector. He told me that he had bottles in his cellar that he had purchased long ago for $10 that were now worth over $100. In fact, a local wine merchant named Woody was willing to buy some of Rosett’s older bottles at current prices. Rosett said he occasionally drank one of those bottles on a special occasion, but would never dream of paying $100 to acquire one. He also did not sell any of his bottles to Woody. This is illogical. If he is willing to drink a bottle that he could sell for $100, then drinking it has to be worth more than $100. But then, why wouldn’t he also be willing to buy such a bottle? In fact, why did he refuse to buy any bottle that cost anything close to $100? As an economist, Rosett knew such behaviour was not rational, but he couldn’t help himself.”Richard Thaler
It is worth reminding ourselves of some definitions. A sunk cost is money that you have spent already, and nothing you do now is going to change that. You have to write it off. In this case, the $10 you spent to buy the bottle in the first place is a sunk cost. An opportunity cost is the price of choosing one course of action over another — in this case, choosing to drink the bottle instead of selling it for $100, or even keeping it and selling it for more money in the future.
With this in mind, here’s the experiment which Thaler used in a survey sent out to the annual subscribers of a wine publication called Liquid Assets:
“Suppose you once bought a case of good Bordeaux for $20 a bottle. The wine now sells at auction for about $75. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking the bottle?
- $0. I already paid for it.
- $20, what I paid for it.
- $20 plus interest.
- $75, what I could get if I sold the bottle.
- -$55. I get to drink a bottle that is worth $75 that I only paid $20 for so I save money by drinking this bottle.
What is your answer now? How does it compare to the answer you came up with before? Interestingly, Thaler asked the question again but with a small modification. He posed it like this: “We asked subjects how it would feel if they had dropped and broken the bottle. A majority said they felt that dropping the bottle costs them, $75, what they could get for selling it.” This intuitively makes sense, as we’re quite prone to loss aversion – just ask any insurance company!
Nevertheless – The Wine Test is more than a party trick. Though the correct answer according to economists would be “4: $75, what I could get if I sold the bottle,” only 20% of respondents made that choice. Many people considered drinking the bottle to be free (1: 30%) or even result in a profit (5: 25%). The rest just considered the original price (2: 18%) or included interest (3: 7%).
The bottom line is that we are not purely rational agents who optimise outcomes. Included in a long list of deviations is that we tend to over-react to losses, to overweight near-term versus long-term benefits, and to base decisions based on how they’re worded or “framed.”
The formal theory on this topic can be summarised as follows: Thaler (1980) called this pattern—the fact that people often demand much more to give up an object than they would be willing to pay to acquire it—the endowment effect. The example also illustrates what Samuelson and Zeckhauser (1988) call a status quo bias, a preference for the current state that biases the economist against both buying and selling his wine. These anomalies are a manifestation of an asymmetry of value that Kahneman and Tversky (1984) call loss aversion—the disutility of giving up an object is greater that the utility associated with acquiring it. Here’s an awesome paper that discusses experiments covering all these concepts in more detail.
What does this have to do with watches?
By now you have probably made the connections yourselves; in a time where many desirable watches are trading above their MSRP in the open market, it isn’t difficult to conclude that option 4 is the correct answer in the wine test. The key difference is that the wine is consumable. Does this, however, change the way we perceive ourselves wearing the watch? Let’s say you bought a Nautilus at £25,000 a few years ago, and whilst wearing and enjoying it as you used to all these years, you lose it… do you perceive it as a £25k loss, or closer to £100k? Remember, you didn’t plan to sell it, so the possibility of you realising the £100k market value was non existent. How does this compare with the wine example in your mind? I would imagine that everyone will have different opinions on this, so this is more of a thought experiment than anything else.
My advice on this topic is that one should overweight the value of those extravagances which you get to enjoy frequently. My favourite categories on which to pay over the odds are beds and bedding, shoes and your mobile phone. Sadly, being an avid watch enthusiast, I can safely say it would probably be cheaper and more convenient to be addicted to cocaine, but I take comfort in knowing that this hobby delivers a kind of enjoyment that most other things don’t. A leading academic authority on happiness once justified his Rolex on this basis: ‘Divided by the number of times I look at it, it really isn’t that expensive.’
Perhaps a useful metric for watch collectors could be ‘cost per entertainment hour’ or CpEH. This was first developed in the computer games industry to explain why computer gaming enthusiasts pay excessively high prices for a single game. The answer was simple; Looked at through the lens of time, where a game might entertain you for hundreds of hours, this was cheap entertainment.
Using this formula, living in London is highly disadvantageous… the best performing watches are my Unimatic watches, as I wear them without fear of being robbed – and the worst performing watches are all the Rolex sports models. Go figure!
Hope you enjoyed this topic; Please leave your thoughts and comments in the comments below.