Investor's Psychology

Endowment Effect: All that Glitters is not Gold

Created on 12 Aug 2022

Wraps up in 5 Min

Read by 655 people

Updated on 12 Sep 2022

Everyone would have met the iconic Kachra Seth from Phir Hera Pheri. In one of the scenes of the movie, one can see him selling a suit at ₹4000 to Raju, the same suit that Kachra bought from Raju for ₹1000. On asking, he narrates various reasons for the increase in price that indicate a sense of ownership towards the suit. 

Similarly, let's take one of the other endowment effects examples when Raju comes to sell his shoes. Kachra quoted ₹150 for both shoes, but Raju felt the price should be double as he has invested a lot in them. In both these scenarios, one can see a common bias working unconsciously. Both characters think their product deserves higher value because they have owned it and are emotionally invested in it. Yet, they were not willing to pay the same price as buyers.

Why does this bias occur? Can this prevent them from potential gains? It is because of the endowment effect! Read ahead to know more about it! 

What is the Endowment Effect?

In most cases, the endowment effect can be encapsulated as a mental bias that exhibits itself when a person values an asset more than its worth when they hold ownership. 

A quote by Jonathan Swift fits best for this scenario "A wise man should have money in his head, but not in his heart." 

Let's understand this with an example related to a study based on coffee mugs by J. L. Knetsch. So, according to the studies, two sets of people were given coffee mugs. One group was asked to determine the value of the coffee mugs as a seller, and others were asked to do the same thing as a buyer.

The study showed eye-opening results as the average buying value was $3, while the average selling value was $7. It showed an active role in the endowment effect among the people with such a vast variation. 

Where does this Endowment Effect occur?

"If out-of-pocket costs are viewed as losses, and opportunity costs are viewed as foregone gains, the former will be more heavily weighted" - Richard Thaler. 

The endowment effect affects investors in different cases and for different investments. Let's understand these effects based on various studies in the following pointers:

1. Inherited Securities

Most wealth management practitioners have remarked that some clients are reluctant to sell their securities passed down as a legacy. These investors showcase feelings of disloyalty while selling such securities. Furthermore, they show general uncertainty in determining "the right thing to do" for the inherited securities and face property tax issues. 

2. Purchased Securities

The endowment effect has a considerable effect on purchased securities. Let's take an example. Imagine a scenario where a person needs money, and a municipal bond is available that pays triple the person's pretax income. How much would a buyer pay for it? Keeping this price level in mind now, think of another scenario where one has already bought it. What price would the owner of the same bond demand when selling it?

According to rational economic theories' predictions, the Willingness to Accept (WTA) compensation would be the same as the Willingness to Pay (WTP) for the bond. However, this would not be the case in reality, as once the investor owns the bond, they will demand a price exceeding the original price or market value. 

3. Endowment Effect on Retail

Many retailers and salespersons take advantage of this effect through different techniques, like letting the customers try the products, giving limited-time offers, free trial periods, etc. The point of these offers is to try and make the buyer feel a sense of ownership over the offering, which will drive the buyer to pay extra for the same product. 

Why does the Endowment Effect happen?

The root problem of the endowment effect is loss aversion, which makes one dislike losing and find enjoyment in gaining. The result is buyers and sellers become biased toward maintaining the status quo by holding an inflated value for the security or product instead of realising its fair value. 

1. Reference Price Theory

Many researchers have conveyed that the effect occurs to avoid getting suckered into a bad deal. This view is conveyed as buyers and sellers have different approaches to the same transaction. Buyers do not feel like paying more than the item's actual worth. On the other hand, the sellers don't want to sell the item for anything lesser than the market price. 

2. Ownership Effect

The endowment effect is often committed because a seller associates ownership with the item. Just as people view themselves positively, this appearance of self-positivity is also extended to a person's possessions. As a result, the owner sets the price higher than the product's actual value.

The way one sees themselves in a positive light to see whether or not they are biased, the same view of self-positivity is extended towards the items as a mere ownership effect. Through this, the seller starts attributing that the product they own is of a higher ranking. 

3. Psychological Ownership

Retailers try to create psychological ownership to sell their products. Buyers already start considering the product as theirs by spending a couple of minutes trying and feeling the item. They tend to ignore the price and are ready to buy the item. 

Professor Richard Thaler, a Nobel Prize Winner from the University of Chicago, was the first to coin the term "endowment effect."

How can you reduce the Endowment Effect?

The easiest way of escaping the endowment effect is to be aware and not invest oneself emotionally in the product. One can make themselves resistant to the endowment effect in the following ways:

1. Don't fall prey to psychological ownership

Let's understand psychological ownership through this example where the salesperson encourages their buyers to have test drives. This tactic provides an advantage to the salesperson by pushing the buyer to develop psychological ownership of the product. 

One needs to be aware of such tactics and try telling oneself that brief interaction with the product would not make it a good choice or superior to other products. 

2. Weigh the opportunity higher than the selling cost

One might be attracted to sell their product at a price that reflects the value they attach to the same. However, sellers should remember that the value should not exceed the market value or price buyers are willing to pay. It will prevent the sellers from missing a sale opportunity as an unnecessarily high value will not attract buyers. 

3. Try to stay close to the market value

One should avoid falling prey to the endowment effect and try to set the price near the market value of the product. If there is a vast range of prices at which the product is sold in the market, then it is advised to keep the price near the market value. 

The Bottom Line

Cognitive biases like endowment bias have a higher impact on all the sellers and their decisions in many ways. After learning about it, you are probably rethinking your past decisions, especially in those places where you could not find the actual reason behind the failure of the decision.

Through this article, we hope you understand one of the many everyday biases that occur in the market. Moreover, learning from others' experiences is always eye-opening, so let us know some of your encounters with the endowment effect in the comments.

An Article By -

Deb P Samaddar

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Deb is a keen learner and eager to learn about the finance world. He is that person who would never stop talking, but my oh my, the words he uses, are not something a normal human would in a regular conversation. While the conversations are well, interesting, the write-ups are faultless. With an increased proclivity towards tech and language, he aims to capitalise on his interests as a content writer at Finology.

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