Do you hesitate to let go of your possessions? Take a look around — maybe it is the guitar you bought, now catching dust because you never learned to play more than a few chords, or the gold earrings your grandmother left behind. We all have objects we hold on to for a multitude of reasons — regardless of whether or not we are emotionally attached to them, or how long we have owned them.
The tendency to ascribe more value to items we own than to something we don’t is called the endowment effect. Coined by Nobel Prize–winning economist Richard Thaler, this cognitive bias establishes that we tend to overvalue objects because we own them, regardless of their objective market value. It also says that we would demand more money to sell something we own than to buy a new, similar object.
Businesses have used this bias to their advantage for a while now, by stimulating a sense of partial ownership among customers even before they’ve made the purchase. For instance, automobile companies offer prospective buyers the opportunity to take cars for test drives, brick-and-mortar clothing shops let customers try on clothes before purchasing, and furniture stores allow you to physically experience the furniture — which makes you imagine all the ways in which the object could make your life better, and in turn, increases the company’s sales.
Studies have attributed psychological factors related to loss aversion — which states that the sting of loss is greater than the pleasure of a reward — as a major cause of the endowment effect. As Anand Doctor, a member of the 1 Finance Advisory Committee for Qualified Financial Advisors — Mumbai Chapter, explains, “There is no definitive reason for this bias — it could be a combination of things.” He also speculates that we might ascribe more value to objects we own because we view them as an extension of ourselves.
When it comes to selling a property, for instance, Doctor says, an individual may be less biased and more logical if they were selling a property they purchased purely as an investment as opposed to a home that they have lived in. They may want to sell the latter at a high price because they are asking for a premium to let go of something that they hold close to themselves.
Similarly, self-associations to things like heirloom jewellery, which are often thought of as an investment, might turn them into mere possessions because they have been passed down through generations and an emotional attachment has developed. According to Doctor, such jewellery ceases to be a financial asset, because it will not be sold except in dire circumstances.
Endowment effect also manifests when it comes to stocks you may have inherited or invested in early on. If you’ve had success with the stock, you might find it difficult to sell it, even if that is the logical choice. This could lead to an investor’s net worth being concentrated in a single such stock.
“The impact of this is significant for portfolio management. Investors tend to think more highly of the holdings that are sitting in their accounts than the rest of the investable universe,” elaborates economist Barry Ritholtz in The Washington Post. “They believe their own holdings are more valuable than what the market is telling them.”
According to Doctor, in most cases, the endowment effect has a negative impact — like generating insufficient returns, increasing the risk profile of your portfolio, and locking your wealth in an asset you’re unwilling to sell. While holding the objects we value close to us may help us establish a sense of self, perhaps there is merit in introspecting and getting an unbiased opinion from a professional — especially if we want to make smarter decisions, improve our standard of living, and use our financial resources optimally.