The endowment effect
At last, your favorite band is performing in Italy after many years. You went to great lengths to buy a ticket and paid €100 for it. Now that the concert date is approaching, how much would you resell it for?
When you own something – whether you bought it or received it as a gift – and you assign it a higher value than what you would be willing to pay to acquire it, you're falling victim to a very common cognitive bias: the endowment effect. This bias involves attributing a higher value to items we already own – that are part of our 'endowment' – than their actual market value.
This distortion stems from an involuntary mental attitude that can lead us to make subjective and inefficient decisions, especially when the goods or services involved are linked to strong positive emotions.
In addition to the endowment effect, there's another unconscious mechanism at play: loss aversion, the tendency to experience the pain of losing something more intensely than the pleasure of gaining it. It's scientifically proven, for instance, that losing €50 causes more distress than the satisfaction of finding the same amount on the street.
In a famous experiment, Daniel Kahneman and professors Knetsch and Thaler gave mugs to a group of Cornell University students. Later, they asked them to sell or exchange the mugs for items of equal value. It turned out that the price students demanded to give up the mug was about double what they would have been willing to pay to acquire it.
Similar experiments - with different goods and diverse groups - have shown that the price we assign to an item we own is consistently higher than what we would pay for it as buyers. This is linked to the fact that the pain of parting with something far outweighs the pleasure we feel when acquiring it.
The combined effect of endowment bias and loss aversion can lead to misjudgments that compromise the sound management of our savings and investments. A classic case is when investors continue to hold onto stocks that are deeply in the red, with little chance of recovery, simply hoping they'll return to the purchase price.
In finance, a good way to counteract the endowment effect and loss aversion is to diversify your investment portfolio, and, if you lack experience, to seek advice from trusted professionals. Awareness is an important first step: to learn more about the endowment effect, watch our dedicated video.
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