ENDOWMENT EFFECT
After covering Loss Aversion, in this blog, we will cover Endowment Effect.
What is Endowment Effect?
The endowment effect is a cognitive bias which describes how people tend to value items that they own more highly than they would if they did not belong to them. This means that sellers often try to charge more for an item than it would cost elsewhere.1
The sellers (who owned the mugs) placed a significantly higher value on the mugs than the buyers did. They were willing to sell a mug for $7.12 while buyers were only willing to pay $2.87 (median reservation prices).
The endowment effect happens when there’s a gap between a buyer’s willingness to pay and a seller’s willingness to accept a specific price. Sometimes this gap appears because, when trying to decide what a reasonable price for something is, buyers will look to the lowest available price as a reference point, while sellers look at the highest ones.
What causes it?
Research has identified two main psychological reasons as to what causes the endowment effect:
Ownership: Studies have repeatedly shown 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.
The Endowment Effect and Marketing
Many companies strive to exploit the endowment effect for their benefit. For instance, they may devise strategies that attract customers, then leverage the endowment effect knowing it will be difficult for a consumer to leave.
For example, consider how companies can offer free trials to consumers to try their products. When people try a product, they may become attached to it and see it as something they own, making them more likely to purchase it. This same emotion may be felt during limited-time offers, where consumers are faced with a sense of urgency to buy a product, and then forge a relationship with that good.2
The Endowment Effect on Investing
The endowment effect has been demonstrated many times in investing. Time and again, investors have been shown to be reluctant to part with a poorly performing stock that they already own and less inclined to exchange it for ownership of a similar but better-performing stock. This type of behaviour supports the attachment theories put forward to explain the endowment effect.3
Investors think their stock to be PRECIOUSSS…. And so are not willing to sell it.
And worst part can be
Endowment Effect + Loss Aversion + Greed = Sunk Cost Fallacy.
So investors, keep on averaging the stock down and thus fall prey to the sunk cost fallacy.
How to avoid it?
Try to find the Intrinsic Value range of the stock.
Find the intrinsic value of the stock by various available methods and buy that stock only when there is an appropriate margin of Safety. This will help in removing the emotions aka endowment effect from the equation.
Beware of psychological ownership
When you buy a stock, you feel like the owner of it and value it more than what the market believes. So even when that stock falls down in value, due to the endowment effect, the investor refuses to sell it. Don't marry with your stock.
Try to consider opportunity costs
Keeping on holding the stock when it's falling in price has a HUGE opportunity cost. See the image below to know how much gain is required to just cover the loss.
So it's always better to sell the loss-making stock and invest in better available stock. This way you will avoid the Opportunity cost.
And as with the Basic solution for all these biases - develop your own CHECKLIST and apply it diligently before buying the stock itself. And of course, MAINTAIN AN INVESTMENT DIARY to note down all your such behavioural mistakes, so that you can improve upon them in the future.
That’s all for the endowment effect. Please suggest which bias you want me to cover in the next blog.
dr.vikas
1 - https://thedecisionlab.com/biases/endowment-effect
3-https://corporatefinanceinstitute.com/resources/wealth-management/endowment-effect/