What is... | November 28, 2012

What is the endowment effect?

Most people probably know a home owner who is very emotionally attached to their property. Their home is their castle and they are convinced it is worth a lot more than the market rate.

Research has found an effect on our thinking which applies to small and potentially less-loveable items (such as a famous example involving coffee cups) as well as large and emotionally-charged items (such as houses). This is called the endowment effect. It can cloud judgement.

It can make, for example, home owners reluctant to sell, even when others think it makes financial sense to do so.

A mug’s game?
The famous experiment involving coffee cups found cup owners wanted a substantially higher price to sell than buyers wanted to pay. The median selling price for the cups – which had been given free of charge to the sellers – was more than twice the median price sellers were willing to pay. The experiment was published in a 1990 paper by Daniel Kahneman – a Nobel Prize recipient – Jack Knetsch and Nudge  co-author Richard Thaler.

We overvalue what we have
The academics write that the endowment effect can also be seen in the way businesses and organisations behave. An example is a company that is reluctant to sell a certain divisions – even though they would not consider buying the division if they didn’t already own it.

Economist Chris Dillow blogs for eZonomics about how the endowment effect can make people reluctant to sell investments. At one end of the scale, he cites the investors in a football club, who were reluctant to sell. Dillow writes that the condition is particularly difficult because hard working people are particularly vulnerable to it as the harder we work for something (researching a company before buying a share), it seems the more likely we are to over-value it.

My house is my castle
Homeowners may be particularly susceptible to this thinking trap. Consider the time, money and emotion people invest in their property. They might give their home a higher value than an impartial observer or a first time visitor. In fact, a European study finds owners overestimate the price of their property on average by 5-10%.

ING senior economist Ian Bright explains in a video that this could lead to difficulties if they refuse to accept a price that is lower. In the 1990 paper, the authors write that reluctance to sell for less than the “perceived entitlement” could be a reason the number of properties put up for sale tends to fall when house prices drop.

I can see clearer now
How can we protect ourselves from the endowment effect? It’s difficult. One idea is to take a step back and ask yourself: “if I didn’t own this share, would I buy it?” Seek opinions from others to allow you to check your valuations of things owned against those from friends and family.

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eZonomics team
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