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Wednesday, June 21, 2017

The endowment effect in investing

Wednesday, June 21, 2017 Posted by Vernon Go , , , , , No comments


In behavioral finance and social psychology, it is a cognitive bias known as The Endowment Effect. In short and simple words, this effect means that, we as humans, have a tendency to (over-) value things we currently own more than we would value them if they were somebody else’s.

First postulated by Richard Thaler in 1980, the endowment effect is one of the first cognitive biases observed to violate standard economic theory. The endowment effect states that 'people often demand much more to give up an object than they would be willing to pay to acquire it' (Thaler,1980).

We naturally exhibit a tendency to be lenient on evaluating the performance of what we own. Investors, therefore, tend to stick with certain assets because of familiarity & comfort, even if they are inappropriate or have become unprofitable. The endowment effect is an example of an emotional bias.

That car you have that constantly breaks down?  You’d never buy it from someone else, because better ones are on the market right now.

That crappy job you’ve stayed in for years?  You probably would never take it again if you knew what you know now because you know that there are better ones out there on the market right now.

The endowment effect has immediate implications for investors. Simply put, the cognitive tendency to 'love what you own' applies to the shares, bonds, and funds in your portfolio which leads us to scrutinizing less our choices and even our investment portfolio. In many cases defending them irrationally–than you otherwise would.

Is it Good? Bad? Both?

The endowment effect isn’t all bad. It allows us to have some comfort in difficult times.  How many times have you heard people justify their current awful situation as a “blessing” when pretty much anyone else would say it was a curse?  That is, at least partly, the endowment effect in action.

But, on the downside, the endowment effect has a highly insidious effect on your career, finances, relationships, etc.. You “stick” in bad situations, investments, relationships, and jobs longer than a “smart” person would, because your brain is wired to make it so. This is also the reason why people tend to hoard or also the Real Reason It’s hard to get rid of things.

It seems this is already hard-wired into us as this same bias has helped our ancestors survive and reproduce; in a very dangerous environment; it is better to be risk-averse and live to see another day than to take a chance and die, and over-valuing what you already have probably made sense in an environment where acquiring desirable things was much harder than it is now.

Recognizing the existence and power of these biases is the first step to overcoming or perhaps at a basic level – being able to spot and control them.

For every type of investor, it is important to be mindful of the ‘endowment effect’ and judge the various financial products you currently own versus what is available in the market impartially as best as possible, especially when you already own one or more of them.

Where does the endowment effect show itself in your life and experience?  Please do share!

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The writeris an RFP® - registered financial planner and helps people through CERTA, Inc.’s financial education programs (www.certa.ph).He is also a Real Estate Broker, author of the award-winning personal blog – www.vernongo.com and an Instagram travel-micro-blogger (@PhantomNomad).
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Originally Published in Philstar - The Freeman Newspaper last June 20, 2017.

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