The endowment effect can make us overvalue something we already own. Photo: Piscine26 / Shutterstock
What is the endowment effect?
The endowment effect, also known as the divestiture aversion, is a type of emotional bias that leads people to consider something they own to be worth more than it actually is.
The effect often involves items that have an emotional or symbolic connection with their owners, leading them to place more value in said item than they would if they didn’t own it.
The effect can have an impact on people from all walks of life, so let’s take a look at it and also examine how it could have an impact on your trading psychology.
The endowment effect is a type of emotional bias that leads people to consider items to be more valuable than they are, when they have a connection with them.
This can impact traders, as they could refuse to accept a reasonable offer for an item they are selling, mistakenly believing it is unfair.
Critics of the theory, however, believe there is little empirical evidence to support the endowment effect.
Understanding the endowment effect
An example of the endowment effect came from psychologists Daniel Kahnemank, Jack L. Knetsch and Richard H. Thaler, who wrote a paper in 1991, describing:
“A wine-loving economist we know [who] purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only $10 when purchased would now fetch $200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price.”
“Thaler (1980) called this pattern—the fact that people often demand much more to give up an object than they would be willing to pay to acquire it—the endowment effect.”
It could be argued that the endowment effect is a byproduct of loss aversion. For many the fear of making a loss may be stronger than the allure of making a gain. As a result, they might try to avoid losing out by keeping things as they are. This develops into the status quo – whether it is in terms of possessions or assets – being assigned a higher value.
People also tend to underestimate the opportunity costs of a transaction, not thinking about the non-monetary elements of any sort of deal. This could lead them to putting too high a monetary value on an item, especially if it is something they own.
What impact could the endowment effect have on trading?
The endowment effect could have a negative impact on people for a number of reasons.
If a seller values an asset more highly than is realistic, they might not accept what could be a reasonable price for it.
It could prevent a transaction from happening. If a seller’s valuation of an asset is too high, it could be hard for the buyer and seller to come to an agreement.
It could lead to people buying things they don’t need. A big part of the endowment effect is the idea of psychological ownership. If, for instance, someone offers a customer a free trial, on a psychological level it could feel like they already own the product so they will spend money on it, even if they don’t really need or want it.
The endowment effect could have an impact on your trading, but you can learn how to recognise it. Photo: Piscine26 / Shutterstock
Endowment effect aversion
There are a number of measures that could potentially lessen the impact of the endowment effect:
Base prices on market value. When selling something, it could be useful to keep in mind the price it usually goes for, not what you would like it to go for. This may allow for a better chance of a deal that benefits both parties.
Investment strategy. If you are investing, consider having a clear idea of what your goals are and how you intend to reach those goals. Doing so could help provide focus and clarity, as well as potentially helping prevent attachment to individual investments.
Portfolio review. Having a varied portfolio could help prevent falling victim to the endowment effect. A wider range of assets may lessen the likelihood of becoming attached to one of them or overvaluing one’s price.
Think. Consider this – would you buy something you already owned? If you wouldn’t but also would not sell that item, you may have fallen victim to the endowment effect. Recognising that could be the first step in overcoming the effect.
Criticisms and limitations of the endowment effect
There are, however, some criticisms of the endowment-effect theory. For instance, a study by the UCLA Law Review found that there was little empirical evidence for the theory, and that, under laboratory conditions, “mere ownership does not affect willingness to trade or exchange”.
The paper said that educating test subjects or otherwise changing the conditions meant that the value people placed on things they owned did not necessarily rise just because they owned them.
While in a perfect world we could know the precise optimal value of everything we owned and were willing to sell, this cannot always be the case. Understanding that the endowment effect exists could potentially help guard against it.
The endowment effect is the psychological phenomenon of placing a higher value on something we own than we otherwise would. This could be a problem for traders, as it could prevent them from selling an asset for a good price while they hold out for a price that never comes, or can prevent deals altogether if a seller’s valuation is too high.
Even if we could eliminate the endowment effect altogether, trading would still carry a high amount of risk. Markets can move in an unwanted direction at any time, so it is important to do your own research and never trade with more money than you can afford to lose.
What is the opposite of the endowment effect?
The opposite of the endowment effect is, perhaps unsurprisingly, called the reversed endowment effect. This suggests that when someone has something that is undesirable, they seek to swap it for another undesirable item.
Is the endowment effect a cognitive bias?
The endowment effect is a cognitive bias, because it is a disposition or inclination in human thinking and reasoning that often does not comply with the tenets of logic.
How does the endowment effect affect buyers?
The endowment effect can affect buyers because it may lead to buyers and sellers becoming unable to come to an agreement, and can also cause people to buy things they may not need.
What is an example of the endowment effect?
An example of the endowment effect would be if someone bought something and then did not sell it when it rose in price, purely because they owned it.