“Strategic direction is more important today. It's about providing a framework for managers to navigate through the fog of complex chokes. No company can avoid this."

– C.K. Prahalad –

PoS May 2015 | How Endowment Effect, Confirmation Bias & Overconfidence Make a Deadly Cocktail

A friend of mine has been trying unsuccessfully to sell a property for a few years now. She is not satisfied with several offers she has received even though she will make a more than handsome profit if she were to sell. She expects 30% more. Is she being unreasonable, unwise to expect higher than the market price?

Countless experiments have observed we set a higher value on an object we possess compared to the price we are willing to pay to acquire the very same item. This phenomenon, called Endowment Effect, arises from the universal human tendency for loss aversion. When we possess an item the pain of losing it, even if we are selling, is greater than the joy of obtaining it.

Endowment Effect

Endowment Effect explains why shareholders of companies often expect unreasonably high prices for their stock in mergers and acquisitions. But why do acquirers pay? It’s strange but they do and destroy value.

In January 2006 Jet Airways offered Rs. 2300 crores (23 Billion) to acquire Air Sahara in an all cash deal. The market reacted unfavourably and Jets stock price tanked 35% in a few months.

Naresh Goyal, Jet’s boss, renegotiated and concluded the acquisition at Rs. 1450 crores (14.5 Billion). It was still too much for an airline that had been losing money and all whose planes were leased. Besides, the Indian aviation market was changing with emergence of budget airlines.

The market was not impressed. Shares of Jet continued to fall. Consider the closing share prices of Jet Airways on Bombay Stock Exchange.

Jet’s stock has never regained its halcyon days.

Blindsided by bias

A firm usually begins a rational exercise to create value through acquisition. When careful scrutiny and due diligence reveal a target firm to be a good fit, its attractiveness grows. Gradually, assumptions about fit morph into hypotheses, then into belief that the target firm is just right. At this stage the leaders of the acquiring firm tend to develop confirmation bias. Under its influence they look for evidence that supports their belief and actively overlook, even disregard disconfirming data.

Overconfidence about ability to integrate the target firm and extract value combines with confirmation bias to turn belief into conviction that the target is worth acquiring even at exaggerated valuation. Leaders ignore advice and disregard dipping stock price of company as early warning.

When Quaker Oats and America Online ended up with lemons In 1994 Quaker Oats acquired Snapple for $ 1.7 billion in spite of warnings from Wall Street it was paying $ 1billion too much. 27 months later it sold Snapple to a holding company for $ 300 million.


America Online acquired Time Warner for $ 165 billion. Soon after, the dot-com bubble burst resulting in massive erosion of AOL divisions value in the combined entity. In 2002 the merged company declared a loss of $ 99 billion, the largest loss in corporate history.

The failure of the mega merger is attributable to overconfidence and inability to anticipate foreseeable changes in the market.

Leaders must learn to avoid the deadly cocktail of endowment effect, confirmation bias, and overconfidence.

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