Thinking, Fast and Slow - Endowment Effect

By The Boy Who Procrastinates - May 19, 2019

Following the previous 2 book reviews on Thinking, Fast and Slow by Daniel Kahneman, with respect to the subjects of anchoring effect and prospect theory, I will be sharing on another concept which is likely to be innately relatable to most of us. 

Have you ever noticed that most babies may throw violent tantrums when deprived of items they considered theirs? Undoubtedly, our sense of ownership emerges at a tender age but this also raises the questions: Why are we so attached to our things? How will this sense of attachment impact our financial decisions?

Endowment Effect

First postulated by Nobel Prize-winning economist Richard Thaler in 1980, the endowment effect refers to the tendency of irrationally ascribing higher value on items that we own, regardless of its objective market value. 

In the same vein, this cognitive bias describes the idea that people are more likely to pay more to retain an object which they own than to acquire that same object when they do not own it. 

The Mug Experiment

To demonstrate how the endowment effect affects our decision making, Kahneman, Knetsch and Thaler have conducted a series of experiments in 1990, with the most prominent one being the Mug Experiment.

Coffee mugs were distributed (for free) randomly to half of the participants that formed a group of Sellers while the remaining constituted the Buyers group. 

The Sellers had their mugs placed in front of them and the Buyers were invited to look at their mugs. Subsequently, the Sellers were asked if they would sell it for a price range between $0 and $9.25. The Buyers were similarly asked to indicate the price which they would be willing to purchase the mug at.
The results of the experiment has validated that Sellers who owned the mugs, placed a significantly higher value on the mugs as compared to the Buyers. This points to the inherent value placed by human on mere ownership.

Specifically, the median selling price was determined to be $7.12, more than twice as high as the median buying price of $2.87.

Causes of Endowment Effect

One of the prevalent explanations put forth by Kahneman suggests that once an individual has owned something, his reference point has shifted. In the case of the Mug Experiment, the Seller has experienced an alteration in his reference point as his updated status quo incorporates the ownership of the mug. 

Consequently, forgoing the mug for its cash equivalent is framed as a loss from this new reference point. In the previous post, we have established that human have a natural tendency to be risk averse and that the pain of losses hurts much more than joy derived from gains of comparable magnitude. 

Social psychologists have proposed that the establishment of ownership for an item creates a link between the item and our identity. Owned objects may be regarded as part of the "extended self" and it could be difficult to separate from things once we feel like they are part of us. 

However, it is noteworthy that exchange goods is not susceptible to endowment effect. The value of exchange goods is mainly derived from the monetary value obtained by exchange. Some examples of exchange goods include money held for spending and goods held specifically for sale. Loss aversion plays little role in such routine economic transactions in which buyers and sellers trade goods for money, both of which were held for that purpose. 

For most things are differently valued by those who have them and by those who wish to get them: what belongs to us, and what we give away, always seems very precious to us.                                                      — Aristotle, The Nicomachean Ethics Book IX

Marketing Tactics

Over the years, marketing tactics have often capitalised on this inherent bias observed in human to boost sales performance. 

Car dealerships usually offer the opportunity for potential buyers to take cars for test drive. You see, allowing people to try the products is an effective technique to kick start the endowment effect. That is also the reason why zealous car sales executives would encourage potential car owners to take a spin and experience the possession of the cars. 

Similarly, many apparel retailers and online fashion stores such as ASOS and Zalora, offer free exchanges and refunds/returns for the clothing purchased.  With the implementation of free return policy, retailers may see improvement in their sales volume as shoppers are encouraged to spend with the understanding that they are able to return the products if it does not suit their preference

That is when the endowment effect kicks in. The longer the product is in the hands of customers, the more attached they will feel towards it. Eventually the clothes form a part of their identities and they are less likely to return the clothes. 

Endowment effect can also fit into the idea of free trials offered by software products and online services. Offering potential customers a taste of the service allows them to claim ownership to it if they enjoy the service. 

Free trial is also especially effective as the amount of time a prospective customer gets to utilize the product is limited, thus forcing them to make a purchasing decision once the trial period is up. And customers are likely to purchase at the end of the trial period to avoid being deprived of the value provided by the service. 

For example, Netflix offers a free month of service for potential customers. As people watch more movies and series during this trial period, Netflix collects data, customizes and enhances the viewers' experience. By personalizing the profile for each viewer, it makes it harder for customers to end their subscription to Netflix. 

Making Financial Decisions

Much alike to owning a mug, the irrational behavior induced by endowment effect can also be observed in the field of finance. It often impacts the way investors value financial products like stocks. 

The cognitive tendency to love what you own, does colour investors' perceptions. We subconsciously feel that the stocks or bonds in our portfolios are worth more than the value assigned by the market. Many of us often exhausted hours of research and analysis on stocks which leads to the eventual inclusion of these assets in our portfolio. Having done the homework, we would have convinced ourselves that these stocks carry higher value than they should. 

We tend to overvalue the worth of the stocks that we own and could potentially be holding onto a position longer than we should. That is perhaps one of the reasons that it is difficult to cut your losses psychologically. 

Indian Lottery 

In the case of oversubscription of Initial Public Offerings (IPOs) in the Indian market, the issuers conduct a lottery to randomly assign the shares due to the local regulatory requirement.

Lottery winners are allocated shares at IPO price while lottery losers are only able to purchase the share after it has started trading on open market. 

Theoretically speaking, the holdings of this randomly allocated stock across the 2 groups are expected to converge over time. This is due to the equivalently distribution of investors who wish to own the stocks engendered by random assignment. That is to say that the 2 groups of lottery winners and losers are equally keen in owning the shares

In 2016, Anagol et al. studied and tracked the behaviors of approximately 1.5 million investors who were affected by these lotteries in 54 IPOs over the period of 2007 to 2012. 

The findings revealed that the lottery winners are 35% points more likely to hold the IPO stocks than losers even after 2 years. 

Contrary to initial expectations, winners of randomly assigned IPO lottery shares are substantially more likely to hold these shares than lottery losers.

Overcoming the Endowment Effect

Admittedly, there are a few occasions when I let my emotions cloud my judgement, become too attached to the positions in my portfolio and holding onto stocks longer than I should have. 

To combat the endowment effect, Kahneman has advised that the buying price is irrelevant history for a rational agent. All that matters is the current market value. By reducing the significance of a reference point, the loss aversion that we feel when we exit our positions will be less pronounced. 

Furthermore, Kahneman has observed that when owners view their goods as carriers of value for future exchanges, there is no expectation of endowment effect. Perhaps we may resist falling in love with our stock positions by viewing them as mere tools for achieving financial independence. 

Alternatively, we may take a step back and ask ourselves the following questions to keep endowment effect in check:

  • If I did not own this share today, would I buy it?
  • Does my initial investment rationale still stand? 
  • Are there better options available? 
At the end of the day, we should equally scrutinise both of what we own and what we do not and learn to not hesitate to reduce positions if it no longer fits into our investment strategy. 

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Disclaimer: Kindly note that this is not a sponsored post. The author is in no way affiliated with the publisher/author and does not receive any form of remuneration for this post. The Boy who Procrastinates has compiled the information for his own reference, with the hope that it will benefit others as well.

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