Since time immemorial, conclusions have been drawn and the subtle eccentricities of human behavior have been converged to a standardized hypothesis under the (overly simplifying) assumption of Homo Economicus. Homo economicus, the economic man, is the assumption that all men (and women) are rational, led by narrow self-interest, always seeking to maximize personal utility for monetary and non-monetary gains at all costs. To put it simply, this assumption of the rational human being could not be any less “human”, as has been proved throughout history during several economic and political crises. Finally, it was Daniel Kahneman, an Israeli-American psychologist, and Nobel laureate, and Amos Tversky, an expert in judgment and human decision-making, who laid the foundation for behavioral economics in their 1979 paper, “Prospect Theory: An Analysis of Decision under Risk”. They emphasized the role of risk aversion on human decision-making and claimed that people viewed the risk associated with profits different from those of losses. This idea brought about a new perspective in the domain of economics and finance, and behavioral finance becomes the new up and coming field. In this article I cover about The Endowment Effect.
In 1990, a group of psychologists led by Daniel Kahneman at the University of California, Berkeley, conducted a study wherein they gave a group of students coffee cups to have and asked them to value it, that is, for how much they would be willing to sell the cup. The average price they settled on was $5.78, a reasonable amount. In the second part of the study, another group of people were shown the exact same coffee cup and were asked how much they would pay to buy the cup. The price this group of prospective buyers came up with was $2.21, a 68% discount from what the seller group valued the cups at. The obvious question that comes to mind is, why would knowing a coffee cup is yours lead you to value it more? This is explained by the Endowment Effect.
The Endowment effect is an emotional bias that can lead people to value an object that they own higher than, say, how much its market valuation might be. In other words, any person is more likely to demand a higher price to sell something that belongs to him but will be willing to pay a much lower price to buy the same commodity when he does not own it. Why is there a disparity in valuing the same commodity, from two different perspectives? The answer lies in the fact that humans, after all, unconsciously assign a higher weightage to their emotions rather than their rational thinking.
Also referred to as Divestiture Aversion, psychological arguments claim that the higher perceived value rises out of ‘mere ownership’ of the object, but this is not entirely true. When a person owns a commodity, has had it for a considerable period of time, he attains a sense of belongingness, and is naturally reluctant to let go of it unless faced with an irresistible offer. But it is not necessary that the Endowment effect will preside only in case of goods that have a sentimental value for the owner. Loss aversion refers to the human tendency to weigh losses more heavily than gains, that is, typically one will prefer not to lose $10 than gain an additional $10. This is the reason why people prefer to hold on to their losing stocks rather than divesting them at a price lower than their perceived valuation of the same. In the coffee cup example, even when the seller group had the cup for a few minutes, they were willing to let it go only at a higher price, because in this case ownership makes people more aware of the loss of selling the cup over its actual price, even though they acquired the cup for free.
The Loss Aversion explanation is more popular in the case of behavioral finance, and rightly so, because it explains not just the Endowment bias but also several other behavioral anomalies. Going deeper into the technical aspect of it, there is a valuation paradigm attached to this phenomenon and the reason why this distortion in measuring worth creeps up because psychologically, peoples’ maximum willingness to pay (WTP) for a commodity is much lower than the minimum amount they are willing to accept (WTA) to give up the same commodity when they own it.
The Endowment Effect is an anomaly, it distorts market behavior and makes it unpredictable. In any market, if buyers and sellers perceive the value of a single commodity so differently, then the market will never clear. Many a time, a person holds on to a particular stock not because it is a great investment but because of their emotional biases. This can cause inefficiencies in market mechanisms and makes it difficult to appropriately forecast future market trends.
Many brands, however, have used the endowment bias to their own benefit, to increase sales of their products. Companies have steered their marketing strategies to attract more customers by giving them a sense of ownership, by making them feel they own the product. One of the most common examples is that of Apple showrooms, that let visitors use products without a time limit, and without any intervention from the staff. This inculcates a sense of belongingness among customers, and they are willing to attach a higher price to the product, and are more likely to buy it, even if it is at a high price. Similarly, the music streaming app Spotify offers a one-month trial period for its premium subscription so users can start to consider their digital services as something they own, and once the trial period expires, they are more willing to pay the $9.99 per month subscription fee. This is opposed to users getting the option to buy the premium version without having the chance to sample it (in which case, not having felt that they own the product, they would be less likely to pay for it).
To err is human nature, and when it comes to dealing with human emotions and biases, there is no way to effectively predict future trends or arrive at conclusions. The only thing as volatile as the stock market, if not more, is the human mind, and perhaps this is the reason why behavioral finance has gained such significance since its inception. The Endowment Effect is only one of many biases that affect markets, and all we can do to curb such anomalies is to try and be as rational and unbiased as possible.