Ever heard of the endowment effect? Endowment is an emotional bias causing humans to place higher value on assets we already own than we would if we did not yet possess those assets. From coffee cups and candy bars to municipal bonds, Lirio Chief Operations Officer Miranda Carr explains the endowment bias through real-life and economic examples. Find out how endowment can affect investors, and the one simple question advisors can ask to help clients combat the bias.
NOTE: This podcast was recorded prior to the rebrand of Finworx as Lirio Finance.
(* Indicates language updated to reflect current brand and position.)
I’m Miranda Carr, COO of Lirio,* and I want to talk about the endowment effect. This is an emotional bias that causes people to act as if owning an asset increases the asset’s value. In other words, someone may value an asset more when they possess it and are faced with losing it, than when they don’t possess it and have the potential to gain it.
The endowment bias was coined by Richard Thaler in his 1980 paper titled “Toward a Positive Theory of Consumer Choice.” He starts out by giving three scenarios that show evidence that the endowment effect exists:
- In the first scenario, Mr. R bought a case of good wine in the late ’50s for about $5 a bottle. A few years later, his wine merchant offered to buy the wine back for $100 a bottle. He refused, although he has never paid more than $35 for a bottle of wine.
- In the second example, Mr. H mows his own lawn. His neighbor’s son would mow it for $8. Mr. H wouldn’t mow his neighbor’s same-sized lawn for $20.
- And in the third example, two survey questions were asked:
- Assume you have been exposed to a disease which, if contracted, leads to a quick and painless death within a week. The probability you have the disease is 0.001. What is the maximum you would be willing to pay for a cure?
- Suppose volunteers were needed for research on this same disease. All that would be required is that you expose yourself to a 0.001 chance of contracting the disease. What is the minimum payment you would require to volunteer for this program, given that you would not be allowed to purchase the cure?
What’s really interesting is that people gave vastly different answers to these two questions. A typical response is $200 for the cure and a $10,000 payment required to volunteer.
In a rational world, none of these would make sense. Thaler goes on to say:
“This shape of the value function implies that if out-of-pocket costs are viewed as losses and opportunity costs are viewed as foregone gains, the former will be more heavily weighted. Furthermore, a certain degree of inertia is introduced into the consumer choice process since goods that are included in the individual’s endowment will be more highly valued than those not held in the endowment, ceteris paribus. This follows because removing a good from the endowment creates a loss while adding the same good (to an endowment without it) generates a gain. Henceforth, I will refer to the underweighting of opportunity costs as the endowment effect.”
In plain English, his conclusion is that—all else equal—if we receive something, we feel worse about losing it than we would feel good about gaining it. We tend to place more value on the good if we have it in our possession than the value we would place on it if we had yet to obtain it.
Before we dig in too deeply on the academic theory about the endowment effect, let’s look at some examples of the endowment bias that happen in everyday life:
So, how much do you think your house is worth? It turns out that most people who own a home think that it is more valuable than it really is. A 2015 study published by the Journal of Housing Economics found that homeowners, on average, overestimate the value of their properties by about 8%. Sure, it could just be that homeowners are bad judges of real estate prices, but what is likely going on here is a manifestation of the endowment bias. Because you own the house, you are more likely to believe the house is more valuable than it really is.
Another example of the endowment bias happened in our office last year. One of my coworkers received two tickets for prime seats at the Tennessee versus Florida college football game for free. If you aren’t a college football fan, you may not grasp just how big of a deal this game was. Going into the season, Tennessee hadn’t beaten the University of Florida in college football in 11 years, and given the hype surrounding the Tennessee football team at the beginning of the season, it seemed like it was the perfect opportunity for Tennessee to finally end the streak. As a result, tickets were extremely expensive to attend this game. Now my friend who received the two tickets loves Tennessee, but he also loves an easy way to make some money.
He decided to list the tickets on StubHub for $500 a piece, and if they didn’t sell, he would happily go to the game. After hearing about this, our Senior Behavioral Analyst on staff asked him how much he would be willing to pay for those tickets. He said “no more than $125 each.” Why would someone only be willing to spend $125 on a ticket, but only be willing to sell it for $500? If the football game would only bring him $125 worth of enjoyment, then traditional economics would suggest that he should have been willing to sell the ticket for any price higher than $125. Believe it or not, even some of our experts have emotional biases.
Here is another example that is a little bit different, but might pertain to your experience. Have you ever purchased an item and justified it by saying “I’ll just return it if I don’t like it?” Chances are, you became attached to the product and didn’t return it. In a recent report, CBS ran a story on Lands’ End. Lands’ End is a clothing company based in Dodgeville, Wisconsin that specializes in Khakis and School Uniforms. On the surface, nothing looks particularly different about this company, but they have a very interesting return policy.
You can return any item at any time, regardless of the condition. You could even buy a pair of pants, wear them every day for five years, and then bring them back and get a full refund. This sounds like a recipe for disaster for a company’s bottom line! So, why would a company decide to do this? For one thing, it may be a good business decision because it creates brand loyalty. If a consumer feels like a company treats them fairly, they may be more likely to do business with them. However, there is another major factor at play…
Surprisingly, the return rates for Lands’ End products are within the industry standard. This doesn’t make sense, because you would think that a “rational” person would buy clothes from Lands’ End, wear them until they are done with them, and then return them years later for a full refund. But according to Valerie Folkes, a marketing professor at the University of Southern California, consumers are actually less likely to return an item if there isn’t a deadline. The reason? The endowment effect. She says that once you take something home, you’re much more likely to keep it. When you return an object that you own, it feels a bit like a loss. Exactly.
My last example goes back to sports. The Financial Times gave an example of the endowment effect in a November 2015 article titled “Investors psyched by the endowment effect.” At the time, the Boston Red Sox had a lot of good, young hitters, but they were lacking pitchers. On the other hand, the White Sox had some good, young pitchers, but were lacking hitters. A hypothetical trade was proposed to Chicago White Sox fans: the White Sox would trade one of their good, young pitchers, Chris Sale, for two good hitters, Xander Bogaerts and Mookie Betts.
80% of White Sox fans thought that this was a bad deal for the White Sox. Shortly after, the same hypothetical trade was proposed to Red Sox fans, and 100% of Boston fans were opposed to the trade. Why would both sides be opposed to this seemingly fair trade that would help both teams? According to the Financial Times article “The fact that a good player was already theirs, and that they were scared of losing him, trumped all else.” This problem is widespread in sports, and it helps explain why, often, trades don’t get completed—both sides tend to overvalue what they already own.
The endowment bias may also shed light on why teams are more willing to trade draft picks than actual players. In his paper “Toward a Positive Theory of Consumer Choice,” Thaler mentions, “trading the rights to draft a player will be preferred to trading the player since he will never enter the fans’ endowment.”
Now that we’ve examined some real-life examples, let’s dig in to the economic theory for the endowment bias.
First of all, you may be wondering why this is considered a bias. Well, traditional economic theory says that the price someone is willing to pay should equal the price at which that person would be willing to sell the same item. So, in my example about the football tickets, the price I am willing to pay for a ticket should be the same as the price at which I am willing to sell the ticket, excluding transaction costs. This is one of the key assumptions in classical economics, and the endowment effect clearly violates this.
There has been a lot of research done on the endowment effect over the years. One of the most commonly cited studies was done by JL Knetsch in 1989. In this study, a group of college students was surveyed and asked if they would prefer a coffee mug or a candy bar. The responses to the survey were split close to 50/50. However, shortly after filling out the survey, all of the students were given a coffee mug. The students were then given the opportunity to keep the coffee mug or to trade it in for a candy bar.
Given that the survey showed the class was split 50/50, a rational person would have expected that all of the people who selected that they would prefer a candy bar in the survey would decide to trade in their mug for a candy bar. However, this was not the case, and 89% of the students elected to keep the coffee mug instead of trading it in for a candy bar. The survey was replicated with another group of students, and instead of initially receiving a coffee mug, each student was given a candy bar. When given the opportunity to trade for a coffee mug, 90% elected to keep the candy bar.
Why would this happen? It is hard to explain rationally, but it is evident in this experiment that owning the coffee mug or the candy bar, despite the short time period, caused the students to increase the value of the item and they were not willing to part with it, even though they had previously indicated that they preferred the other item. This study sounds unbelievable if you haven’t experienced it, but when I was in grad school, our professor conducted a similar experiment with my class using something as boring as pens and coffee mugs with similar results.
A similar experiment was done by Kahneman, Knetsch, and Thaler in 1990. The experiment is fairly long and complex, so if you want to read about it in more detail, you can look up the paper titled “Experimental Tests of the Endowment Effect and the Coase Theorem” in the December 1990 edition of the Journal of Political Economy. In this experiment, half of the students in a group were given a coffee mug, and the other half were given nothing.
Those who were given a coffee mug were asked at what price they would be willing to sell the mug. Those who were given nothing were asked at what price they would be willing to buy the mug. Those who had a mug and were selling it had a median price of $5.75, while those without a mug were willing to buy one for a median price of $2.25! Once again, you can see that owning the item caused the students to assign a higher value to it than those who did not own it.
The authors conclude that these tests support the instant endowment effect: “the value that an individual assigns to such objects as mugs, pens, binoculars, and chocolate bars appears to increase substantially as soon as that individual is given the object.” The paper goes on to say, “Contrary to the assumptions of standard economic theory that preferences are independent of entitlements, the evidence presented here indicates that people’s preferences depend on their reference positions.”
Now that we’ve seen some real life examples and academic examples, let’s take a look at how the endowment bias can influence financial decisions.
The endowment bias most commonly manifests itself in the form of an investor being unwilling to sell an investment that they already own. This can occur in a few different ways.
In its most basic form, the endowment effect can cause an investor to be unwilling to sell a security that they previously purchased, just because they already own it. This is closely related to the status quo bias, but slightly different. People with the status quo bias fail to make changes simply because they don’t like change, while people with the endowment bias don’t make the change because they believe their investment is more valuable than they would think it were if they didn’t own it. This may be most problematic when an investment is no longer appropriate for the investor.
The most common form of the endowment bias for investors is related to inherited securities. For example, an investor may inherit investments from a deceased family member and, even when presented with a more compelling investment, may choose to remain invested in the inherited securities. If the investor would have received cash to invest, they would almost certainly have selected a more compelling investment, but because they already “own” the inherited securities, they are much less willing to part with them. This can be extremely problematic for an investor because it may cause them to hold investments that were more suitable to their deceased family member’s risk tolerance than their own risk tolerance.
Another way the endowment effect can impact investment decisions is that individuals may choose to only invest in securities with which they are familiar. For example, if an investor has been investing in corporate bonds for the past 20 years, they may be unwilling to change it up and start investing in municipal bonds, even if there is a compelling argument in favor of switching to munis. Investors with the endowment bias seek comfort in familiarity, and as a result, they may hold suboptimal investments. In this way, the endowment effect is very similar to the status quo bias. The motivation behind the behavior is a bit different, however, as the endowment effect causes an investor to place higher value on securities they own solely due to the fact that they own them.
Endowment bias can also impact portfolio managers. Cabot Research studied global equity portfolios worth more than $1 trillion in total and found that around 25% of investment managers suffer from the endowment effect. Cabot gives a hypothetical example where an investment manager buys a stock for $20, with a target of $50. If the stock rallies to $43 or $44 quickly, the manager cannot bear to sell until they have gained their full expected value. This tendency to “overvalue winners” costs the average portfolio manager with the endowment bias roughly 100 basis points, according to Cabot.
These examples show some of the problems caused by the endowment bias, but how can an advisor help an investor overcome this bias? The endowment bias is an emotional bias, so it may be very difficult to correct, especially in the case of dealing with an inheritance or working with a widow. One simple question, however, can usually get to the center of the problem. Ask the investor, “How would you invest this money if it were given to you as cash instead of an investment?”
Simply asking this question may help the investor realize that they should evaluate the opportunity as a new investment. Often, though, it may not be this easy. It can be hard to convince an investor that the deceased person probably didn’t pass on the investments expecting the recipient to own the exact same securities, but that they likely passed on the investments for the new owner to inherit the wealth, so slowly transitioning into more appropriate portfolios or investments might be a better option than fully rebalancing away from the inherited securities all at once.
The endowment effect is a very common bias that has wide-ranging implications in everyday life and investing. If you have questions about the endowment bias or want to share other examples, tweet us @lirio_llc, #LirioFinance, #ThinkingLikeaHuman.*
© Lirio, LLC