The Endowment Effect: Is All That Glitters Gold?

Economics usually assumes that we humans optimize our economic decisions rationally (“Introduction to Public Policy”, Fulbright University Vietnam).

In reality, though, can we always make our own decisions based on careful, independent consideration? And how do we explain our tendency to follow the crowd?

Research in behavioral economics shows that we do not make economic decisions in a purely rational way; we also rely on rules of thumb for solving problems (heuristics), in short, we act on experience.

We assign value to an object not only through reasoned calculation (that is, rationally) but also through feelings. Our decisions can easily be swayed by emotions, our surroundings and so on.

One classic example of irrational human behaviour is called the “endowment effect”. So what is the endowment effect, when and why does it happen, and how can we limit it? This article covers all of that.

What is the endowment effect?

In most cases, the endowment effect refers to an emotional bias that leads a person to value an asset they own more highly than, and often unreasonably above, its market value. 

Put another way, the term describes the common phenomenon of people assigning higher value to things they already own than to things they have not yet bought.

In other words, people often refuse to sell what they own for more than they would have been willing to pay for it in the first place. As a result, the price at which they would sell an item is higher than the price at which they would buy it. 

The most famous experiment testing the endowment effect was conducted by  Thaler at Cornell University in 1990, and went as follows:

Four students in a class were given coffee mugs that sold for USD 6 in the campus store. The other students in the class were asked to make bids, while the four students who owned the mugs were asked to accept or reject the offers.

In fact, very few mugs were sold. The reason was that the average price at which sellers were willing to sell was USD 5.25, while the average bid was only USD 2.25–2.75. 

In another experiment, by Jack Knetsch and John Sinden, half of the participants were given USD 3 and the rest received a lottery ticket (with a possible prize of USD 50). Those without a lottery ticket could buy one from the others for USD 3.

Both groups were asked: “Would you rather have the lottery ticket or USD 3 in cash?” The results showed that 82% of those with a lottery ticket chose to keep it, while 62% of those with cash did not buy a ticket. 

This evidence shows that we value what we have more than what we do not have, and that we will take on more risk than necessary to keep what we have, a risk that may even be greater than the risk of buying something new. 

When does the endowment effect usually occur?

The endowment effect affects investors in many different situations and across different investments. Some typical examples include:

Inherited securities

Most wealth managers observe that some of their clients do not want to sell inherited securities, because selling them feels like a violation of ownership.

Their hesitation to sell also shows that they have not yet worked out what to do with the inherited securities, or how to handle the related estate tax issues.

Purchased securities

The endowment effect has a significant impact on securities that people buy. For example, someone has cash and wants to invest in a high-yield real estate bond. Conversely, suppose someone already owns the bond in question: at what price would he sell it?

Many rational economic theories predict that the seller’s willingness to accept and the buyer’s willingness to pay for a bond should be about the same.

In practice, however, this is unlikely, because once investors own a bond they demand a price above its original price or market value, while buyers want a lower price, so supply and demand fail to meet.

Retail

Many retailers and salespeople exploit this effect through various techniques, such as letting customers try products, offering limited-time deals, free trial periods and so on.

What these offers have in common is that they let buyers try the product and give them a sense of ownership, which makes buyers more willing to pay extra to keep using it.

Why does the endowment effect happen?

The root of the endowment effect is “loss aversion”,  which makes people weigh losses more heavily than gains. As a result, buyers and sellers become biased toward the status quo, holding on to an inflated value for a security or product instead of recognizing its fair value. 

We usually feel the pain of losing money more than the pleasure of making it, just as American tennis player Jimmy Connors famously said: “I hate to lose more than I love to win.” It is much like the Vietnamese saying “the fish that got away is always the biggest”.

Or take the case of Paul Samuelson (Nobel Prize in Economics, 1970), who invited his colleague, economic historian E. Carey Brown, to bet on a coin toss. If Carey won, he would get USD 200; if he lost, he would lose USD 100. In the end, E. Carey Brown chose not to play, replying: “I won’t bet because I would feel the USD 100 loss more than the USD 200 gain.” 

Reference price theory

The endowment effect can be explained from the perspective of reference price theory. In any given transaction, to avoid being disadvantaged, both buyer and seller try to set the exchange price in their own favour.

Because buyer and seller approach the reference price from opposite directions, if the buyer will not pay more than the reference price while the seller will not sell below it, the trade is unlikely to happen.

Ownership effect

The endowment effect often arises because sellers associate ownership with the product they are selling. For example, when we feel that a seller is a positive person, we also tend to judge the product they sell as being of fairly good quality. Sellers recognize this and price their product above its true value.

Psychological ownership

Retailers often try to create a sense of ownership in customers in order to sell their products. By spending a few minutes trying an item and getting a feel for it, buyers start to regard the product as theirs. They tend to overlook the price and become willing to buy.

How can you minimize the endowment effect?

The easiest way to escape the endowment effect is to be aware of it and not invest emotionally in a product. Beyond that, we can minimize the endowment effect in a few specific ways:

Do not get too attached to the idea of owning

A sense of ownership arises very easily when a salesperson encourages us to test-drive a car. This tactic works in the salesperson’s favour by fostering a sense of ownership in the buyer.

You need to be aware of such sales tactics and remind yourself that interacting with a product for a short time does not make it a good choice or better than other products.

Value opportunity cost over the selling price

Sellers may be tempted to sell a product at a price that reflects the value they attach to it. However, sellers should remember that the selling price should not exceed the market value or the price buyers are willing to pay.

Asking too high a price will make the seller miss out on sales, because an unreasonably high price will not attract buyers.

Stay close to market value

You should avoid getting carried away by the endowment effect and try to set a price close to the product’s market value. If many similar products are on sale in the market, you should keep your price close to market value.

In short, cognitive biases such as the endowment effect have a major impact on all sellers and on their decisions in many ways. Having learned about it, you may now be rethinking some of your past decisions, especially the times when you could not find the real reason behind a decision that failed. 

We hope this article has helped you understand one of the psychological effects that play out every day in the stock market, as well as in our lives.

Happy trading! 

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