Endowment Effect: The Cost of Ownership

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My mother is subject to arrive for weekend visits with a box or two full of my childhood memories crammed into the backseat. Some objects resonate with me, providing a brief window into my youth, but most carry far greater importance for her, almost as though she is projecting upon me how she thinks I should remember my childhood. It’s an incredibly motherly thing to do and one full of good intentions.

Early last year my parents came into town to see their grandkids, and once again, a large cardboard box with my name on it ended up in the foyer. Instead of the usual comments dripping with contrary subtext about doing whatever we wish with the contents, this time my mother implored me to check the value of the Star Wars toys included.

In her opinion, such memorabilia dating back to the late 1970s was bound to be worth a hefty sum; at the very least, more than what my parents paid for it. Never mind the fact that all three of her boys played with the minifigures and random allotment of ships. The Millennium Falcon was missing a windshield along with other minor attachments, while Luke Skywalker was absent a thumb.

While she was not expecting any meaningful payday, she was alarmed to find out that such toys were worth mere pennies on auction sites such as EBay. We all have items, large and small, that fill our lives and thereby assume an inflated significance. After all, those purchases were important enough for us to buy in the first place, right?

Actually, no. Humans are plagued by a cognitive bias known as the endowment effect that spreads into every facet of our lives. The endowment effect is defined as people ascribing more value to things just because they own them. Economist Richard Thaler, who first made the observation in the 1970s, teamed with Daniel Kahneman and Jack L. Knetsch in 1990 to test the theory with coffee cups. Half of a group of Cornell undergrads were given cups, while the other half was left empty handed. Each group was tasked with establishing a selling price and a buying price. The results were intriguing: the students in possession of the coffee mugs demanded a minimum price of $5.25, while the have-nots were unwilling to pay more than $2.75.

Behavioral scientists have long believed that humans are purely loss averse, meaning that losses hurt more than similar gains feel good. A 2009 experiment by Carnegie Mellon professor Carey Morewedge, however, challenged that assumption by dropping brokers into the coffee mug scenario. The brokers demanded higher prices when selling or buying mugs if they happened to own mugs identical to the ones they were selling or buying. In other words, ownership, not loss aversion, was the driving force behind the bias.

The endowment effect is so intertwined into our daily thinking that it can shift thought processes after certain purchases are made. Thaler provides the example in a 2006 study of someone that purchases a bottle of wine for a dinner. While that bottle is initially treated as an investment and will remain as such provided its emptied at the dinner table, it can quickly turn into a monetary loss scenario if the bottle is dropped on accident before consumption and breaks.

Thaler himself acknowledged being susceptible to the endowment effect after having several expensive bottles of wine stolen, telling The Economist that he was “now confronted with precisely one of my own experiments: these are bottles I wasn’t planning to sell and now I’m going to get a cheque from an insurance company and most of these bottles I will not buy. I’m a good enough economist to know there’s a bit of an inconsistency there.”

What has flummoxed economists and behavior psychologists alike is the endowment effect’s lack of boundaries. It has nothing to do with wealth, nor emotional attachment or physical possession. It is likely an underlying culprit in the ever-present “sell high, buy low” paradox that plagues most investors, both amateur and professional. Once a stock purchase is made, we place added significance to its value and therefore always want a bit more before selling while willing to wait for it to recover even if there’s no reason to believe that it will in the short term. Once a stock plummets, investors’ panic often overruns the endowment effect and we sell when we can least afford it.

Owen Jones, a biological sciences professor at Vanderbilt University, and Sarah Brosnan, an assistant psychology professor at Georgia State University, found evidence that evolutionary factors potentially play a prominent role in the endowment effect in a 2007 study.

The researchers found that chimpanzees not only exhibit the endowment effect, but that the effect was “far stronger for food than for less evolutionarily salient objects, perhaps due to historically greater risks associated with keeping a valuable item versus attempting to exchange it for another.” The study determined that while 60 percent of the chimpanzees preferred peanut butter to juice, some 80 percent chose to keep the peanut butter in their possession instead of trading for the alternative. Meanwhile, juice became more valuable once it was in a chimp’s possession, even if that particular chimp preferred peanut butter.

If you want to see the endowment effect up close, pull out those old toys that your children have not touched in two years and tell them the toys are being added to the yard sale pile. For a reason they cannot explain, the thought of departing with those toys results in an uncomfortable experience. There is little difference when the same test is applied much later in life, such as when the grandparents come for a visit.

Greg

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