What is Endowment Effect? How it Influences Decision Making in Investment?

Rupesh Oli

Introduction

The endowment effect refers to a cognitive bias that leads an individual to value an object they own higher than its actual market worth. It can be simply understood in two given scenarios: one when an individual owns the particular object, and the other when they do not own it. An individual tends to place a higher value on an object, in the first scenario, when they have owned the object. On the contrary, they would not place the same value, in the second scenario, when they do not own that particular object. Hence, the Endowment effect can be understood in terms of the behavioral psychology of an individual where s/he highly values an object owned by them. The objects that possess the emotional and symbolic significance to an individual showcase the trait of endowment effect primarily.

The endowment effect is alarming because it causes a psychological barrier in the minds of an individual that does not let him/her realize the full potential of the particular object they have owned or investments they have made. For instance, when an individual gets emotionally attached to the stocks they own, they perceive and place a higher value on that specific stock. As a result, they are not able to plan their trading or investment strategy effectively because they are not realizing the real market worth/value of the stock they own, leading to skewness and biasness. This biasness occurs as an individual overvalues the stocks they own, regardless of the fair market value. The endowment effect can also be understood by another terminology named ownership effect.

When someone tries to acquire a certain object, their Willingness to Pay is typically lower and when it comes to selling the same object they own, their Willingness to Accept for the offer they are provided with, increases. Even if the object was acquired a few minutes or hours ago, it does not matter as the endowment effect is what can be seen once they accept the object and when it’s time to let it go, they would not readily give it up.

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Some Examples to Illustrate Endowment Effect (Based on Literature/Research Paper)

The research entitled “Experimental Test of the Endowment Effect and the Coase Theorem”, published under Journal of Political Economy in 1990, conducted by three authors Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler showcases an experiment where the participants were provided with a mug and given two options: sell or trade the same mug they were provided before, with the pen that is equally valued as a mug. What the research found out is, once the participants acquired the mug (had their ownership established on the mug), Willingness to Pay was approximately ½ if compared to Willingness to Accept.

To further clarify, let me depict it in terms of numbers. When two sets of people were categorized in the experiment, one group was provided with the responsibility to value the mug as if they were buyers. On the contrary, the next group had to value the mug or provide the price tag of the mug through the seller’s perception. Hence, it can be seen that the experiment categorized two groups as buyers and sellers. When the research (experiment) was concluded, it came up with the thought-provoking result: the average price tag that buyers came up with was approx. $3, whereas sellers came up with a price tag of $7 for the same object (mug), they were provided with. It concluded with the fact that the variation in the price difference that both buyers and sellers came up with, was as huge as double. Nevertheless, the underlying object was the same. It is nothing but the perfect illustration of endowment effect or biases towards the object that an individual possesses when they own it vs, they don’t own it.

Another literature titled “The Behavioralist Visits the Factory: Increasing Productivity Using Simple Framing Manipulations”, published in 2012 in Journal named Management Science with two authors Tanjim Hossian and John A. List, found out that the workers in the factory worked more harder to maintain the ownership of provisional bonus they were awarded with. However, it was not the same case with the bonus that they were yet to be rewarded with. Hence, they were trying their best to maintain their ownership than they were about to gain.

Zim Carmon and Dan Ariely in their literature entitled “Focusing on the Forgone: How Value Can Appear So Different to Buyers and Sellers” published in 2000, conducted an experiment where the participants were provided with the task to decide both the selling price and buying price hypothetically for NCAA final four tournament tickets. Again, the result was analogous, as everybody expected. The hypothetic selling price, or Willingness to Accept was massively 14 times higher than the hypothetic buying price, or Willingness to Pay.

Major Factors Affecting the Stock Prices

How Endowment Effect Influences Investment Decisions?

As people refuse to divest the stocks they already own, it may impact their portfolio’s diversification. Due to their emotional attachment with the stocks they own, they might be neglecting the opportunity costs that come when they would have sold those specific stocks at the right time to bag down the profit.

Loss aversion is what mostly affects the investors. It is because investors tend to stick with the stocks they already own, and the prevailing market value of that specific stock does not meet their perceptions/expectations. This may impact them negatively, as the stocks might not guarantee the surety of good performance in the long run.

Investors tend to neglect the ownership of better-performing stocks in the contemporary context in place of the below-average performing stocks on their portfolio, they miss out on what they could have achieved through the perfect substitution when the stocks they own were not performing as good as they used to.

As the investor sets the selling target price on their own, without analyzing the current market value of the stocks they own, they tend to overvalue their portfolio. Due to the influence of the endowment effect, they deprive themselves in terms of effectively pricing the stocks they own. They would not want to lose out on the investments they made by selling it.

Investors often hold to mediocre stocks, one of the influential impacts showcased by the endowment effect among the majority of investors. Let’s take an example. Suppose an investor bought 200 shares of a company. The particular company provided them with a good return over the first three years with a 30% return on an annual basis. However, they provided only 10% of the return for the next five years. Since the investor gets attached to the stock over the span of eight years, they overlook its declining return that could have been easily avoided through the replacement of better-performing stocks exactly when the stocks they own started providing them the lower returns.

If the current price of the stock reaches the oversold zone, it signals the opportunity for the investors to buy. On the contrary, it is the signal to sell when the stock reaches the overbought zone. However, many investors disregard the opportunity market is providing them. They tend to prefer the hold strategy because they perceive the stock they hold more valuable, and refuse to sell it.

Status quo simply refers to the context where the person does not want change currently. The two major reasons primarily for the status quo are fear of loss and emotional attachment with the object they own. Since we are analyzing from the perspective of investment, let us take stock as an object they acquire. Hence, investors do not want to deviate from the state they are currently in.

Reference price theory and motivated taste change theory are two of the major theories that exhibit the endowment effect. Reference points of investors/traders differ that impact their decision-making when it comes to investing or trade, as per reference point theory. For instance, a trader who wants to sell his/her stocks would not like to place a sell order at a lower price, whereas the buyer is exactly wanting that particular stock at a low price so that s/he could afford it. Further, investors’ perception of the utility of a particular stock inclines after owning it and when it comes to purchasing the same stock for the second time, the decision gets influenced as per motivated taste change theory, creating the psychological conflict in terms of investment perception s/he possesses.

The potential for recognition of better stocks available diminishes when investors get attached deeply to the stocks they own in their portfolio. Hence, an investor must adapt to the strategies mentioned below in order to overcome the endowment effect and bolster their decision-making in investing.

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How To Overcome the Endowment Effect?

An investor needs to put an end to psychological ownership. It is what makes them emotionally attached to the stocks or the overall portfolio they possess. They should look out for better investment opportunities.

As an investor, you need to always ask yourself one question “Are there better investments available instead?” If the answer is Yes, they should replace the below-average performing stocks with the ones that are performing better contemporarily.

Always look out for the opportunity costs. If you are getting a higher return from the upcoming opportunity to invest/trade than the stocks you are currently holding on, then why not leverage it? You need to get out of the trap created by the endowment effect and think in terms of returns you would be gaining. Suppose, you are receiving a 10% return on the stocks you are currently holding on. What if you could get about a 15% return if you could have identified the opportunity cost and went for better-performing stocks?

You need to have a clear exit strategy at times when your stocks are performing poorly and an entry strategy for the stocks that are performing exceptionally over the period of time.

Due to the endowment effect, an investor tends to overlook the negative aspects of the stocks s/he currently owns, and only considers positive aspects the particular stock possesses. Hence, you need to evaluate stocks based on their quarterly or annual report and the financial ratios they are exhibiting, which provides you with the actual progress of the company in terms of its numbers.

You need to be always open to current trends and the financial information of the stocks you possess. No matter if it is minor or major info, it is vital for the next steps you would take in your investment journey.

Conclusion

The endowment effect can lead to biases and skewness when it comes to investing. If identified the consequences it possesses, it can provide an investor with a certain competitive advantage over the others. An investor needs to have solid analysis skills, and always try to hunt for the potential stocks that could strengthen their portfolio. Apart from it, they must have the will to eradicate the stocks from their portfolio that are performing below average, instead of getting emotionally attached to it. Whether it be in terms of EPS, P/E ratio, annual returns, dividends, Return on Equity, or other critical financial factors, they should try to hold the better-performing stocks only, which could potentially reward them with better returns in the long run. Hence, an investor needs to be aware of the impact the endowment effect creates in his/her investment decision-making and try to opt for the best possible ways to overcome it.

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