Primer | How the Ikea effect affects your return on investment
It was only a few months back that Ikea opened its first store in India. Flaunting one of the biggest stores globally and a 1000-seater eatery – the biggest Ikea eatery in the world, it was a grand affair. However, in an attempt to customize to India, a characteristic Ikea component has been watered down – self-assembly. Globally, Ikea stores sell furniture parts along with detailed instruction booklets. The customer is supposed to assemble the furniture himself. An obvious benefit as labor-costs are removed from the equation is that Ikea furniture is much lighter on the pockets. However, a subliminal benefit that tends to fly under the radar is that as the customers spend their sweat, blood, and tears to assemble the furniture, they fall in love with it! Never mind the squeaks and wobbliness of amateurish furniture, for the builder, it becomes a symbol of accomplishment and a source of pride.
The Ikea effect
This is the Ikea effect – when you have spent time and effort in successfully building something, be it a cake or furniture or even a portfolio of stocks, you start “crushing” over it. It becomes a reflection of your competence – imagine the personal hurt you would feel if someone were to point out the loose hinges in your beloved creation. And Ikea has used this to its benefit – self-assembly doesn’t just reduce costs, it gives the customer the experience of falling in love with the product of their labour, and that makes him come back for more. No wonder Ikea has become a 40 billion Euro company with a competitive position worth envy.
Now, what rational reason is there to like something that makes you work hard? Assuming we could afford it, wouldn’t we rather pay more for convenience? Rationally, we would. But, the human brain is anything but rational, and the Ikea effect is one of the irrational behavioral biases it exhibits. The oldest anecdote explaining this bias is that of an instant-cake-mix seller – they were struggling with muted sales when a tiny tweak helped them make a miraculous recovery. They replaced the egg powder in their cake-mix with an additional instruction for the consumer – add an egg. This almost unbelievably simple adjustment transformed the cake-mix to “real cooking” by making the process “difficult enough”.
Falling in love with your investments
While this adorably named behavioral bias seems like all fun and games when we see it in terms of assembling furniture or baking cakes, if exhibited in your investment decisions, the Ikea effect is severe enough to snafu your financial goals. You can see its ugly head poke out in almost all aspects of investing – we prefer to build our own portfolio instead of hiring a professional or investing in mutual funds because of the kick we get out of cherry-picking stocks on our own even if we don’t have the financial knowledge or experience to pull it off; we fail to book profits on our winning stocks because we feel so proud of having bought them in the first place; and we hold on to losing stocks like we hold on to wobbly self-assembled furniture. What’s worse is that even if you did hire a professional money manager, that manager is susceptible to Ikea effect too – he may hold on to his winning stocks too long, and fail to offload his losing stocks because he has gotten attached to the portfolio he has built and has started to see it as a reflection of himself. In fact, for professional fund managers, with the amount of scrutiny that their portfolios undergo – internally by the management, and externally by clients–it is simply natural for them to get defensive of their portfolios and justify their investment decisions… even when they are wrong.
The attractions of quantitative investing
So, what’s the solution? Regular readers of this series must already know the answer to this question that I invariably pose at the end of every article. For benefit of the others, quantitative approach to investing is the one-stop-shop for all problems relating to behavioral biases in investment. Speaking specifically to Ikea effect, as quantitative investing is driven entirely by numbers, it leaves little room for falling in love with your portfolios.
Quantitative investing operates in two distinct phases – the research phase, and the ongoing phase. During the research phase, the investment philosophy is back-tested to check how it would have performed historically in different market scenarios. If the strategy shows promise in the back-test, it is refined further and locked down once all foreseeable market scenarios have been tackled. In the ongoing phase, the finalized strategy is implemented using the latest data. Say, after back-testing, we settled on a strategy which selects the top 30 stocks which have reported the highest profit growth in the last 3 quarters. Now, in the ongoing phase, every time a company in the investment universe reports its quarterly results, it is automatically fed into the system, which spits out the latest list of high-growth stocks. This is one of the simpler quantitative investment strategies.
Because quantitative investment is backed by computational technology, your strategy can be as complicated as you want it to be – from selecting top stocks by a parameter to layered neural networks for return and risk prediction. This versatility of Quantitative Fund Management, along with its numbers-driven approach makes it the perfect fit for all classes of investors who wish to have an objective investment philosophy free of any and all behavioral biases.
(The author is an associate portfolio manager with Reliance Capital. Views expressed are personal. She tweets at @anayaroycfa.)