Endowment Effect
In behavioral economics, the endowment effect (also known as divestiture aversion) is the hypothesis that a person’s willingness to accept (WTA) compensation for a good is greater than their willingness to pay (WTP) for it once their property right to it has been established. People will pay more to retain something they own than to obtain something owned by someone else—even when there is no cause for attachment, or even if the item was only obtained minutes ago. This is due to the fact that once you own the item, forgoing it feels like a loss, and humans are loss-averse. The endowment effect contradicts the Coase theorem, and was described as inconsistent with standard economic theory which asserts that a person’s willingness to pay (WTP) for a good should be equal to their willingness to accept (WTA) compensation to be deprived of the good, a hypothesis which underlies consumer theory and indifference curves.
https://en.wikipedia.org/wiki/Endowment_effect
Endowment effect is at work if the minimum value anyone is willing to accept exceeds the maximum value that person is willing to pay for the same product or service.
This is because, once you start owning a product, it becomes yours and have an emotional attachment to it, and hence if someone wants to buy it from you, you expect them to pay more. But, when you want to buy similar things from others, you would like to pay less.
Endowment Effect in our daily lives
- You might have bought a flat screen television for Rs.15000. But, unfortunately you found another superior model in the market in next few days at the same price, and hence willing to sell this TV. Fortunately, your friend is willing to buy it from you. What price will you quote? For sure, Rs.15000. Now assume you are in your friend’s shoes and he is in your position. What price will you be willing to pay to buy the TV from your friend? For sure, less than Rs.15000
- Once an investor buys a stock, he will be rating that stock at a higher value and unwilling to sell at a loss. They think their stocks are highly valuable
- Most trial offers and money back guarantees are at work because once you have used the product for a few days and enjoy their benefits, you would like to keep it and not return back to the dealer.
- How many products and things we stack at our lofts and wardrobes and unwilling to part away with it at a discounted price ask?
- Would you be willing to sell your bicycle – 1 year old, for 30% discounted price, even if a newer bicycle of the same model sells at the same discounted price?
- How many of you still have your old model mobile phones at home just because during the exchange offer your existing phone was asked for a steep discounted price?
Overcoming Endowment Effect
- Try to evaluate anything as objectively as possible – keeping emotions apart
- Check for opportunity cost during investing – cost of holding a bleeding stock VS a good opportunity to buy a good business at a bargain price
My experience
- I have a few mobile phones at home which I did not want to tender for a meagre Rs.500 during an exchange offer
- I was holding back my bicycle (bought for Rs.3000 approx) which was offered for Rs.1000, for a long time and then I had to sell recently for Rs.500
- During my initial days of investing, I was holding dud stocks just because I have bought them at a higher price, and when markets provided opportunity with good businesses to buy, I did not have cash.
To read more on Behavioural Biases in Finance and Investing, read my eBook here:
https://investing007.wordpress.com/2013/11/05/my-first-ebook-was-published-today/
