DEFINITION of 'Endowment Effect'

The endowment effect, in behavioral finance, describes a circumstance in which an individual values something that they already own more than something that they do not yet own. Sometimes referred to as divestiture aversion, the perceived greater value occurs merely because the individual possesses the object in question. Investors, therefore, tend to stick with certain assets because of familiarity and comfort, even if they are inappropriate or become unprofitable. The endowment effect is an example of an emotional bias.

BREAKING DOWN 'Endowment Effect'

Studies have shown repeatedly that people will value something that they already own more than a similar item they do not own. According to the old adage, "A bird in the hand is worth two in the bush." It does not matter if the object in question was purchased or received as a gift, the effect still holds.

For example, an individual may have obtained a case of wine that, at the time, was of relatively low cost. If an offer were made at a later date to acquire that wine for multiples of the original price, the endowment effect might compel the owner to refuse any and all offers, despite the potential monetary gains. There is a sense of personal welfare over actual wealth that is believed to drive such sentiment. So rather than take payment for the wine, the owner may choose to drink it themselves.

Similar reactions, driven by the endowment effect, can influence the owners of collectible items or even companies who perceive their possession to be more important than any market valuation.

People who inherit shares of stock from deceased relatives exhibit the endowment effect by refusing to divest those shares, even if they do not fit with that individual's risk tolerance or investment goals and may negatively impact a portfolio's diversification. Determining whether or not the addition of these shares negatively impacts the overall asset allocation is appropriate to reduce poor outcomes.

Impact of the Endowment Effect

Such bias applies outside of finance as well. A well-known study that exemplifies the endowment effect (and has been replicated over and over) starts with a college professor who teaches a class with two sections: one that meets Mondays and Wednesdays and another that meets Tuesdays and Thursdays. The professor hands out a brand new coffee mug with the university's logo emblazoned on it to the Monday/Wednesday section for free as a gift, not making much of a big deal out of it. The Tuesday/Thursday section receives nothing.

A week or two later, the professor asks her students to value the mug. The students who received the mug, on average, put a greater price tag on the mug than those who did not. When asked what would be the lowest selling price of the mug, it consistently averaged significantly higher than where the students who did not receive a mug would pay for it.

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