Much Too Good for Children: The Endowment Effect
Episode #6 of the course How cognitive biases are messing up your decisions by Abasi Latcham
Welcome back! Today, you’ll learn about the endowment effect.
What Is It?
The endowment effect makes you value things more than they are actually worth just because you own them. It’s linked with loss aversion and prospect theory, which we discussed previously. Recall that loss aversion is the notion that people prefer to avoid a loss than acquire an equivalent gain (i.e. it is better to not lose $20 than it is to gain $20), and that prospect theory suggests people base decisions on the magnitude of the series of gains and losses (instead of the expected final outcome). The endowment effect builds on these hypotheses, as well as elements from developmental psychology (whereby an item is incorporated in the “self-concept of the owner, becoming part of their identity”) to suggest why we overvalue our own belongings.
Imagine you are selling something to me. Let’s say that it’s a table. Because of how loss aversion affects your brain, each of us will focus on the the thing we are giving up. So, you’ll focus on the loss of the table, and I’ll focus on the loss of the money. And because you are focusing on the loss of the good, you’ll want more money as compensation. And because I’m focusing on the money, I’ll want to part with less of it. What’s more, the psychological connections between ownership and identity increase the pain of the loss, further exacerbating the value differential.
Now this doesn’t mean that no one will ever be able to sell or buy anything ever. Because each person has slightly different value functions, transactions will occur. But it suggests that there are fewer transactions that might be expected from a purely rational, classical economic perspective.
However, humans aren’t alone in this behavior; chimps have also demonstrated an endowment effect. Given a choice of peanut butter or juice, 60% of the subjected chimps preferred peanut butter. But when they were endowed with peanut butter, 80% kept it instead of swapping it for juice: “It was as if the peanut butter became more valuable as soon as it was possessed.” And if the chimps were endowed with juice? Well, they preferred juice.
Where you find the endowment effect, you will likely be able to spot prospect theory, loss aversion, and even the status quo bias (i.e. our preference for the current state of affairs).
• Marketplaces: From online markets (e.g. eBay, Gumtree, or Craigslist) to old-school markets (e.g. garage sales), you’ll see the endowment effect, even in the share market. Next time you see an overpriced item, think of the endowment effect.
• Gollum’s “precious”: He really overvalued that ring.
• Test uses: Test drives, free samples, trying clothes on, playing on tech products in-store, “try it and if you don’t love it, return it for free” deals—these activities make you feel like the thing is yours, planting the seed of the endowment effect.
• Airplane seating: You know the psychological pain you feel when someone tries to sneak some armrest or reclines into your space? Endowment effect.
• Relationships: Research shows that the endowment effect exists in relationships: “Once a partner has been chosen, he or she is valued more highly relative to other possible partners simply because the relationship exists.”
• Antiques Roadshow: This is a show where people bring old objects to antiques appraisers for valuation. Both the “winners” and “losers” of Antiques Roadshow likely exhibit this bias. According to Summit Advisors, because of the endowment effect, “these objects are worth more in the minds of the owners than any price someone is willing to buy them for (either more [for ‘winners’] or less [for ‘losers’] than originally projected).”
The endowment effect is part of our psychology, so it is hard to avoid (but easy to detect in others). Summit Advisors suggests striving for objectivity in every financial decision you make: “The best advice may be to seek advice from your trusted advisors such as independent financial planners, tax advisor, attorney or competent peers.”
Tomorrow, we’re going to look at how we make many decisions based on relative instead of absolute differences by discussing how decoys can affect our perceptions (technically, the simply-named asymmetric dominance effect).
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