Posted by Robert on October 25, 2010
One of the benefits of living in a market-based economy is the ability to freely negotiate purchases and sales at a price that’s impartial. I can choose to sell at whatever price I choose, but buyers can also choose to buy only at a price that’s acceptable to them. However, human beings aren’t necessarily wired for functioning in this way.
People tend to place a higher value on an object that they own than on an identical object that they do not own. Behavioral economists call this the endowment effect. To demonstrate this, a study was done with a coffee mug. A researcher approached a number of people and asked them to estimate the value of his coffee mug. The answers were what you would expect: $2, $3 or even $5. With a separate group, he gave each person a coffee mug. He then asked them what the value of their coffee mug is. The answers were higher this time: $5, $6 or even higher.
Just knowing about the endowment effect doesn’t make a person immune from it. I’m currently trying to sell my house. I think that it’s worth quite a lot. To me, it’s a home, it’s very comfortable and well-maintained. To a potential buyer, however, it’s unfamiliar and in unknown condition. The buyer is not willing to pay for it what I would like to receive for it, except in an especially strong real estate market. Being aware of this, I accepted an offer that was even lower than I was originally willing to consider. However, the buyer still continued tried to find excuses to lower the price. In the end, they didn’t honour their offer.
The same thing happens with shares in a publicly-traded company. All day long, investors enter buy and sell orders and only if those orders happen to match do shares trade. If you have access to Level II reporting from the TSX, you can view all the current orders in the market. You will see that buyers are willing to pay a variety of prices below the market price. You can also see that sellers are willing to accept prices somewhat higher prices than market. However, the majority of those shares won’t trade until either the market moves, or a very large order is entered, in which case the price will move until all the shares are bought or sold.
Being able to negotiate a price that is acceptable for both sides is a skill that makes transactions smoother. In the stock market, there is little negotiating power. Offering a set price, especially with a large order, ensures that the buyer won’t pay more than he or she is willing. Dealers hold presentations to convince brokers of the value of a company, and brokers tell the story to their clients, in order to create an impression of value. With the sale of a house, there are more variables that can be negotiated and more opportunity to have a conversation around the perceived value.
Knowing that people perceive value differently, we can approach transactions, prepared to negotiate. When investing, specifically, it may be helpful to remember that if we’re not rushed to buy or sell, we may be able to get a slightly better price, especially if offering large volume.
Have you had an experience buying or selling something where the price was difficult to agree on? Have you developed negotiating skills that have helped you financially?