Endowment effect

What Is Endowment Effect?

The endowment effect is a cognitive bias within behavioral finance that describes the tendency for individuals to place a higher value on objects they already own compared to identical objects they do not own. This valuation discrepancy can lead to a situation where the amount a person is willing to accept (WTA) to sell an item they possess is significantly higher than the amount they would be willing to pay (WTP) to acquire the same item if they did not own it. This phenomenon influences decision-making across various economic contexts, deviating from traditional economic models that assume rational valuations.²⁸

History and Origin

While psychologists noted the difference between WTP and WTA as early as the 1960s, the term "endowment effect" was explicitly coined in 1980 by economist Richard Thaler.²⁷ Thaler's conceptualization challenged accepted economic theory, which largely assumed humans make completely rational decisions. He identified this bias as an explanation for loss aversion, a theory outlined by Daniel Kahneman and Amos Tversky in 1979 as part of their broader prospect theory.²⁶

In the early 1990s, Thaler collaborated with Daniel Kahneman and Jack Knetsch to provide empirical evidence for the endowment effect through a series of experiments.²⁵ One of their most famous studies involved Cornell University undergraduates and coffee mugs. Half of the students were given mugs and then offered the chance to sell them, while the other half were offered the chance to buy mugs. They found that participants who owned mugs demanded approximately twice as much compensation to sell them as non-owners were willing to pay to acquire them. This experiment and similar replications have consistently demonstrated that ownership alone can inflate an item's perceived value.²³, ²⁴

Key Takeaways

• The endowment effect is a cognitive bias where people value items they own more than identical items they don't own.
• It often results in sellers demanding a higher price for an item than buyers are willing to pay, leading to a gap between willingness to accept (WTA) and willingness to pay (WTP).
• This bias is closely linked to loss aversion, as the pain of losing something already owned is psychologically greater than the pleasure of gaining an equivalent item.
• The endowment effect impacts various financial and economic behaviors, including investing, real estate, and consumer choices.
• Understanding this bias can help individuals and organizations make more rational financial decisions and design more effective marketing strategies.

Interpreting the Endowment Effect

The endowment effect suggests that an item's perceived worth is not solely based on its objective characteristics or its prevailing market value. Instead, the mere act of ownership or even a feeling of psychological ownership can inflate this perceived value. This leads to a disconnect between a seller's valuation and a buyer's valuation, often making transactions difficult even when they might be economically rational. The effect highlights how emotional attachment and the fear of loss can override purely rational economic calculations related to supply and demand.²²

Hypothetical Example

Consider an individual, Sarah, who received a vintage comic book as a gift several years ago. She has read it many times and enjoyed owning it. A collector offers to buy the comic book from Sarah for $200, which is slightly above its current estimated market value. Despite knowing this, Sarah feels a strong reluctance to sell. She might tell herself the comic is "worth more to her" than $200, perhaps thinking she wouldn't sell it for less than $350.

Now, imagine Sarah sees an identical vintage comic book for sale online for $200. While she might consider buying it, she would likely be hesitant to pay more than $150, reasoning that $200 is a bit too much. This discrepancy—her high willingness to accept ($350) for her own comic versus her lower willingness to pay ($150) for an identical one—illustrates the endowment effect. Her personal utility and perceived value have shifted, creating a different reference point for the item once it became hers.

Practical Applications

The endowment effect has several real-world implications, particularly in finance and commerce:

• Investing and Portfolio Management: Investors often exhibit the endowment effect by holding onto underperforming stocks or assets longer than is financially advisable simply because they own them. Thi²⁰, ²¹s can prevent them from rebalancing their portfolio management or divesting from declining assets, potentially leading to missed opportunities or greater losses. Ove¹⁹rcoming this bias is crucial for developing a sound investment strategy and making objective decisions regarding asset allocation. As Wharton faculty note, this bias can limit trade efficiency in the economy.
• ¹⁸ Real Estate: Homeowners frequently overvalue their properties due to emotional attachment and invested effort, leading them to set asking prices higher than what the market is willing to bear. This can result in homes staying on the market longer or ultimately selling for less than the initial inflated expectation.
• ¹⁷ Marketing and Sales: Companies often exploit the endowment effect to influence consumer behavior. Strategies like free trials for software, test drives for cars, or "satisfaction guaranteed" return policies aim to create a sense of psychological ownership, making it harder for consumers to part with the product once the trial ends. Per¹⁴, ¹⁵, ¹⁶sonalization options, such as designing custom shoes online, also foster a sense of pre-ownership.

##¹³ Limitations and Criticisms

While widely observed, the endowment effect is not universally accepted as solely a function of irrational bias, and its underlying mechanisms are debated. Some critics argue that observed differences between WTP and WTA can be explained by rational economic factors, such as asymmetric information or the availability of close substitutes for the good in question. For¹² example, a seller might have private information about an item's quality that a buyer lacks, justifying a higher asking price.

Furthermore, some research suggests that the endowment effect might be less about loss aversion and more about a general aversion to making a "bad deal" or a distorted perception of market prices. Exp¹⁰, ¹¹eriments have also indicated that the effect can diminish or disappear under certain conditions, such as when participants are experienced traders or when the good in question is a fungible item like money. Res⁹earch published in PubMed Central explores how buyers' and sellers' beliefs about market prices can influence observed discrepancies, suggesting that the endowment effect might not always reflect a pure ownership-induced shift in preference. Des⁸pite these discussions, the endowment effect remains a robust finding in behavioral economics, highlighting the complexities of human valuation. Beh⁷avioral biases, including the endowment effect, are a recognized factor influencing decision-making in corporate governance, too. https://corpgov.law.harvard.edu/2018/06/18/behavioral-biases-in-the-boardroom/

Endowment Effect vs. Status Quo Bias

The endowment effect and status quo bias are closely related cognitive biases, often occurring together and stemming from similar psychological roots, particularly loss aversion. However, they describe distinct aspects of human behavior:

While the endowment effect specifically concerns the increased value placed on owned items, the status quo bias is a broader preference for maintaining one's current state, whether it involves possessions, habits, or policies. The⁶ reluctance to sell an owned item (endowment effect) can be seen as a specific instance of a broader preference for the existing situation (status quo bias) because selling would mean changing the current state of ownership.

##⁴, ⁵ FAQs

Is the endowment effect a rational behavior?

No, the endowment effect is considered an irrational cognitive bias in behavioral finance. Traditional economic theory assumes rational actors would value an object equally whether buying or selling it, based on its objective worth. The endowment effect, however, demonstrates that ownership can lead to an inflated, subjective valuation that deviates from rationality.

How does the endowment effect relate to loss aversion?

The endowment effect is often explained as a direct consequence of loss aversion. People typically feel the pain of a loss more intensely than the pleasure of an equivalent gain. Once an item is owned, giving it up is perceived as a loss, which makes individuals demand more compensation to offset that perceived pain, even if the gain from selling is objectively favorable.

##³# Can the endowment effect be overcome in investing?

While difficult, investors can mitigate the impact of the endowment effect. Strategies include having a clear, predetermined investment strategy with specific criteria for buying and selling assets, focusing on objective financial metrics rather than emotional attachment, and establishing an exit strategy for investments before they are purchased. Diversifying a portfolio management and regularly reviewing asset performance against market benchmarks can also help reduce subjective biases.

Does the endowment effect only apply to physical objects?

No, the endowment effect extends beyond physical objects. It can apply to intangible assets like stocks, ideas, or even job roles, where individuals may overvalue their current position or holdings simply because they "own" them or have a sense of psychological attachment. Thi¹, ²s can impact decisions related to career changes, business sales, or even the adoption of new technologies.