What Is Endowment Effect?
Within the complex world of human psychology, there are distinct behavioral biases that emerge as intriguing idiosyncrasies, exerting an impact on our cognitive processes and judgments. The “Endowment Effect” provides insight into the process by which individuals assign worth to their possessions. It also emphasizes the complex mechanisms through which our cognitive processes may be influenced by outside factors. This blog aims to examine the concept of the Endowment Effect, provide illustrative examples, analyze potential approaches to mitigate its influence, and ultimately present a summary of its wider ramifications.
The Endowment Effect, as theorized by economist Richard Thaler in 1980, refers to the psychological phenomenon in which people display a tendency to assign more worth to belongings only due to their ownership of those belongings. Fundamentally, individuals have a cognitive bias in which they assign an inflated value to an item solely based on their ownership of said item. However, based on rational economic analysis the ownership status of an item should theoretically have no influence on its inherent worth.
What Are Some Examples?
Consider a scenario where you purchases a concert ticket for a much-anticipated event. However, as the concert date draws near, you realize you can no longer attend the show. A close friend knows of this dilemma and expresses an interest in purchasing the ticket at the original price. Would you sell the ticket to the friend at the same price or seek to get a higher price?
According to the Endowment Effect, there would be a certain unwillingness on your part to sell the ticket at its original price due to the emotional attachment you’ve developed towards the ticket. Instead, you would consider the possibility of selling the ticket at a higher price, being persuaded by the belief that its value has increased as a result of your ownership of the ticket.
How does the Endowment Effect play a role in investments?
The Endowment effect leads investors to cling to losing investments, despite all rationality pointing towards cutting their losses. In the context of investing, once we’ve purchased an asset, we become emotionally attached and it can sometimes cloud the investor’s judgment and lead them to make decisions that may not be in their best interest.
As mentioned above, one example that is seen a lot is when investors refuse to sell a stock that is steadily decreasing in value. Despite the clear signs indicating a downward trend, the investor finds it difficult to let go. But why? This emotional attachment can stem from various sources, such as a sentimental connection to the company or a belief that the stock will eventually rebound. While it’s understandable to develop a preference for certain investments, it’s crucial to remember that emotions should not dictate financial decisions.
However, the Endowment Effect can go the other way as well! Instead of overvaluing what the investor owns, they seem to undervalue their holdings. How does this look? An investor owns an asset that has experienced significant gains but is hesitant to sell the investment and realize the gains. Why would the investor want to hold onto the investment?
It could be because it’s a great investment, but many times the hold decision is because of the “fear-of-missing-out” or FOMO. It is a feeling that creeps in when investors believe they have stumbled upon a “winning” investment. This belief can be so strong that they hold onto it long after it has reached its optimal exit point. Instead of objectively assessing the performance of their investment and making a well-informed choice, they become driven by the fear of missing out on additional potential gains.
What Can Be Done?
The Endowment Effect could have real implications in practical settings, resulting in illogical decision-making and possibly hindering economic efficiency. Nevertheless, acknowledging and confronting this bias may aid in reducing its impact. The following are just a few ways to minimize the influence of the Endowment Effect:
- Role Reversal – Imagine yourself in the role of a prospective buyer rather than the owner. This behavioral transformation could encourage a detached evaluation of the item’s/asset’s worth. Considering the potential willingness to pay the requested price if you were the one to assume the counterparty’s position in the transaction can help you view the assets price/value more objectively.
- External Valuation – Seek advice from external sources to assess the fair market value of the item or asset. You could participate in a comparative analysis of price offerings by various merchants or consult with industry experts to get a range of what the item is worth. Doing this will include objective information that could serve as a means of verifying the worth and mitigate the potential bias that may arise from being the owner of the item.
- Deliberate Detachment – Temporarily remove the item from your sight which could potentially diminish the emotional bond that has been established. For financial assets, this could be done by not checking on performance every day.
The Endowment Effect serves as an intriguing example of how cognitive processes can impact deviations from logical decision-making. By recognizing this behavioral bias, individuals may enhance their ability to make well-informed judgments, particularly in the context of evaluating the worth of their belongings. The recognition of the Endowment Effect enables individuals to make decisions based on objective evaluation rather than emotional connection, whether it pertains to concert tickets or to financial assets.