What is the Endowment Effect?
The endowment effect refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value.
- In behavioral finance, endowment effect describes a circumstance in which an individual places a higher value on an object that they already own than the value they would place on that same object if they did not own it.
- Endowment effect can be clearly seen with items that have an emotional or symbolic significance to the individual.
- Research has identified "ownership" and "loss aversion" as the two main psychological reasons causing the endowment effect.
Understanding the Endowment Effect
In behavioral finance, the endowment effect describes a circumstance in which an individual places a higher value on an object that they already own than the value they would place on that same object if they did not own it. Endowment effect can be clearly seen with items that have an emotional or symbolic significance to the individual. Sometimes referred to as divestiture aversion, the perceived greater value occurs merely because the individual possesses the object in question.
For example, an individual may have obtained a case of wine that was relatively modest in terms of price. If an offer were made at a later date to acquire that wine for it's current market value, which is marginally higher than the price that the individual paid for it, the endowment effect might compel the owner to refuse this offer, despite the monetary gains that would be realized by accepting the offer.
So, rather than take payment for the wine, the owner may choose to wait for an offer that meets their expectation or drink it themselves. The actual ownership has resulted in the individual overvaluing the wine. 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.
Research has identified two main psychological reasons as to what causes the endowment effect:
- Ownership: Studies have shown repeatedly that people will value something that they already own more than a similar item they do not own, much in line with the 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.
- Loss aversion: This is the main reason that investors tend to stick with certain unprofitable assets, or trades, as the prospect of divesting at the prevailing market value does not meet their perceptions of its value.
Endowment Effect Impact
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 negative outcomes.
The endowment effect bias applies outside of finance as well. A well-known study that exemplifies the endowment effect (and has been duplicated successfully) 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 later, the professor asks all of the 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, the mug receiving students quote was consistently, and significantly, higher than the quote from the students who did not receive a mug.