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 & 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 saw: 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 the owner of a company, who perceives their possession of the business to be more important that 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 which exemplifies the endowment effect, and has been replicated over and over, starts with a college professor who teaches a class with two sections: one which meets Mondays and Wednesdays and the second which 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.

  1. Endowment Fund

    An investment fund set up by an institution in which regular ...
  2. Accelerative Endowment

    An option in a whole life insurance policy to use accumulated ...
  3. Bias

    Biases are human tendencies that affect our behavior and perspective, ...
  4. Inheritance

    All or part of a person's estate/assets that is given to an heir ...
  5. Section 1035 Exchange

    A tax-free exchange of an existing annuity contract for a new ...
  6. Behavioral Finance

    A field of finance that proposes psychology-based theories to ...
Related Articles
  1. Insights

    Top 5 Largest University Endowments

    The five largest university endowments in the world are Harvard, Yale, University of Texas...
  2. Financial Advisor

    Here's How Schools and Charities Invest Their Endowment

    Each endowment has an investment policy statement, with topics on the mission statement, spending, investment, asset allocation and rebalancing policy.
  3. Insurance

    The Truth About Endowment Life Insurance Policies

    Endowment life insurance is a way to save for your child's college education, but is it as beneficial as the insurance industry wants you to believe?
  4. Tech

    Small Endowment Money: A $100B Opportunity

    A shift to outsourced management among small endowments is providing billions in opportunities to capture assets.
  5. Personal Finance

    A Career In Endowment Management

    The pay may not be as competitive as Wall Street, but the work environment, opportunity and knowing your helping out an educational facility makes this an attractive career.
  6. Investing

    Why Ivy Endowments Are Flunking

    Harvard may have the largest endowment among its Ivy League peers but its investment returns have ebbed. Yale, however, has fared well. Why?
  7. Investing

    What Can We Learn From Harvard’s Investing Mistakes?

    Here's what individual investors can take away from the Harvard endowment's losses.
  8. Managing Wealth

    David Swensen vs. Stephen Blyth: Tale of the Tape (DB, MS)

    Learn about the managers and specifics of the Yale and Harvard University endowments, with a focus on performance and asset allocation.
  9. Financial Advisor

    How to Create a Client Investment Policy Statement

    Investment policy statements are vital for financial advisors and their clients. Here are some tips for creating them.
  10. Investing

    Harvard Endowment Managers Leave to Launch New Funds

    Three managers from Harvard Management Co. are combining efforts to launch two new funds.
  1. How do "factor endowments" impact a country's comparative advantage?

    Find out how factor endowments – namely labor, land and capital – affect a country's comparative advantage and how that advantage ... Read Answer >>
  2. What's the difference between the income effect and the price effect?

    Learn what the price effect is and how it is related to consumer spending. Learn what two components make up the price effect ... Read Answer >>
Hot Definitions
  1. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  2. Standard Deviation

    A measure of the dispersion of a set of data from its mean, calculated as the square root of the variance. The more spread ...
  3. Entrepreneur

    An entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  6. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
Trading Center