Recognizing the Endowment EffectSubmitted by Summit Financial Advisors on May 23rd, 2016
Antiques Roadshow has become one of the most popular programs on public television. It’s part game show, part history lesson, but surprisingly it’s also a laboratory where we can examine the psychological side of economics and behavioral finance.
As a viewer, you feel a thrill with each appraisal, watching the “winners” discover the untapped wealth in their dusty collectibles and family heirlooms.
But the closing minutes of the show can also be entertaining, as the “losers” depart with dashed hopes of hidden fortunes.
These folks are generally good-natured when they learn their keepsakes are not worth keeping. Yet, you can sense the disappointment as they bring their prized possessions back home, realizing the sentimental value they placed in these objects is much higher than the actual monetary windfall they were hoping to find.
What is revealed in Antiques Roadshow is a form of the endowment effect on display. A common phenomenon in psychology and behavioral finance, the endowment effect occurs when we form irrational, emotional attachments to the things we possess and endow them with higher prices or values because they're “ours” and we’re reluctant to part with them.
Because of the endowment effect, I would suspect that most of the “winners” on Antiques Roadshow don’t sell their newly uncovered treasures, even though they stand to make a nice profit on the sales. Neither would many of the “losers” dump their now worthless collectibles. In both cases, it’s likely both types of owners simply take their possessions back home, returning them to the rooms and attics where they were kept before the show. 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 or less than originally projected).
Another example of the endowment effect concerns a bottle a wine. An economics professor and fine wine connoisseur purchased a particular bottle many years ago for $5. Today, the wine is valued at $100. But the professor refuses to sell. Why? Because it’s painful to part with something of value, especially when we’ve invested time and emotion in owning it.
So what do antiques and wine have to do with investing? The effects of the endowment effect can also impact our portfolios and retirement accounts. We may get attached to a certain stock or other type of investment product, usually not for any fundamental reasons. Often, just the act of making a decision — picking a stock for investment — is enough to build an emotional connection that’s becomes difficult to overcome.
For example, let’s say you bought a technology stock many years ago. You may use the technology everyday in your life, or believe wholeheartedly in the company’s values or mission statement. Either way, you have developed an emotional bond with this investment. You stay invested as the share price rises to lofty heights, and the company becomes a darling of market analysts. But then the stock price falls, for any number of logical or illogical reasons. Soon, it’s below the price you paid. The market is telling you the stock is worth much less that you think. Yet, you explain it away by blaming the “irrationality of the market”.
Now it’s feasible that you are in the right — maybe the market is being irrational by underpricing the true value of the company. But that won’t be known until some point in the future, when the stock price adjusts to reflect the actual business’s value (if that ever happens.) The truth is, any investment or other type of asset is only worth as much as what someone else is willing to pay for it. That’s what reflected in the market price. In any case, the reason for your attachment may be less rational than most investors (or advisors) are willing to admit.
When we let the endowment effect influence our investment decisions, the result is often a portfolio of assets that have outlived their usefulness or are no longer appropriate for our financial situation. This is especially true as people near retirement and continue to hold on to positions they’ve owned for extended periods of time. Because of the emotional endowment they’ve attached to a certain holding, selling it is out of the question. Whether the asset will perform well or poorly in the future doesn’t seem to figure in their thinking. Of course, this can be dangerous and ultimately costly, as you enter the distribution phase with the assets you’ve accumulated for income in retirement.
Without negative intent, some investment advice can also reinforce the endowment effect. “Invest in what you know” implies an intimate understanding of the investment you’re making. That understanding only gets deeper over time, making emotional attachments easy to develop. “Love what you own” makes this connection even more explicit. How painful is it to part with something or someone you love? Love works for relationships, but in financial affairs, it can lead to trouble.
Plus, it’s empowering to make choices. We become more invested in the things we choose and the decisions we make. That’s also how emotional bonds are formed. Breaking those bonds is painful, so we’re reluctant to do it.
How to counter the endowment effect
The hard coding in our brains that creates the endowment effect is difficult to change. Our preference for avoiding loss and pain over seeking pleasure is a basic instinct that has evolved over time. In our ancient past, avoiding loss and pain was a useful skill — it was critical to merely surviving. Today, this instinct helps us more in making quick decisions and preserving our mind power for more analytical tasks.
Our best defense against the irrational outcomes of the endowment effect, at least when it comes to our financial lives, is to attempt be objective when making choices. Become an impartial judge of every investment — especially when you’re at a decision point such as the choice to buy, sell or trade. The bestadvice may be to seek advice from your trusted advisors such as independent financial planners, tax advisor, attorney or competent peers.
Mostly, investors are blind to the behaviors and psychological tendencies that get us into trouble. Knowledge about these behaviors is often said to be the first step in making a change or breaking a habit. Once you know what the endowment effect is and understand how it works, you can take steps in advance to lessen its influence on your decision-making.