Wasting time recently on a discussion board for rabid sports fans, my eyes stopped on a phrase that shocked me: “endowment effect.” Dropped casually in among the emotional discussion of who’s the best offensive or defensive player was a high-fallutin’ term from economics. I thought it out of place for a moment, but quickly realized I was wrong. Message board combatants were arguing about a trade, and one of the fans was correctly accusing the other of overvaluing the player from his team that he proposed in the trade. I believe his precise words were, “You’re crazy! I’m not giving you (my star player) for (your scrub player).”
This is a classic example of the endowment effect in action. Understanding this effect could save you a lot of money. Or at least prevent you from making some bad trades.
Even if you’ve never heard of the endowment effect, it probably comes up in your own life nearly every day. The endowment effect makes selling a home unnecessarily heartbreaking. It often makes you overpay for things. I believe it keeps you paying for name-brand products even after they are obviously inferior or more expensive than lesser-known alternatives. Once you understand the endowment effect, you can notice it popping up in your own life, and then make some changes.
Sentimental Value vs. Market Value
Economist Richard Thaler coined the term back in 1980. It means simply this: You overvalue things you own because you become attached to them. They become part of your psychological endowment. If you try to sell them, you demand a price that is higher than you would pay if you were looking to buy that same thing. This gap between sale price and purchase price is the cause of a lot of unnecessary struggle in the marketplace. For example: Take that beat up 1984 Ford Mustang convertible in your garage (and by your garage, I mean my garage). If you try to sell it on Craigslist, you might demand $1,500 for it, subconsciously because you remember all those fun rides with your dog sitting in the back seat, and because you believe it runs better than it looks. But if you were to go out looking to buy that very car, you wouldn’t pay any more than $600 for it. (Look at the rips in the convertible roof!)
Thaler’s classic experiment, oft repeated, involves handing coffee mugs out to college students and asking that they sell them to other students. Sellers asked for around $7; buyers only wanted to pay around $3. The roughly 2.5-1 ratio has held in many subsequent tests. Once you own something, it becomes part of your endowment, which means you tack on extra value to it that represents the “cost” of losing it. Before you had it, there would be no cost for losing. Buyers feel no reason to pay this cost. They are buyers, not therapists! They aren’t going to pay for your separation anxiety.
What Was, What Could Have Been…
Back to sports for one moment. Fans love proposing trades, but they rarely make sense, because they can’t help overvaluing a player on their team who they’ve seen every day for a few years. They remember the all-star season three years ago, and expect a star in return, when everyone else sees the player as a has-been worthy of only a late-round draft pick.
The endowment effect has other names — or more precisely, it describes a phenomenon that’s been observed as “status quo bias” or “loss aversion,” which are exactly what they sound like.
You can most obviously imagine the impact of these habits if you think about selling your home. I believe endowment effect contributed to the painful length of the housing downturn, as sellers couldn’t help thinking “But John down the block sold his house last year for $500,000! I’m not taking a penny less than that,” while their houses sat and sat and sat on the market. (That example also describes anchoring, a behavioral trick we’ll discuss in a future column). But loss aversion shows up in more subtle ways on a daily basis. For example: Inexperienced traders nearly always have trouble selling stocks and funds at a loss, even when it seems certain losses will steepen, because they can’t help themselves from imagining, “I paid $30 a share for this stock, I can’t sell until it goes back up to $30 a share.”
There are far more everyday examples. Stores play with consumers’ heartstrings all the time by convincing them that a certain discount for an item is temporary. Shoppers report buying an item out of fear that they might lose it, or the sale price, more than out of need for the item — panic buying. That’s loss aversion marketing at its finest. One way to think about it: shoppers who already have tried on a shirt, or are holding a guitar, almost immediately feel ownership of the thing in their hands, and now will experience a loss if they put it back on a shelf. Items can become part of your psychological endowment almost instantly.
Loss aversion in general might be the easiest concept to understand. Consumers hate losing $100 much more than they hate missing the potential to earn $100, though ideally we’d value these things equally. Numerous studies have shown this impact: a gambler who has just lost $100 is much more likely to make a second bet (and attempt to recoup the loss) than a gambler who has just won $100. But here’s another example: Workers who are told they might earn a bonus of $100 by working hard this week DON’T work as hard as workers who are told they WILL get a $100 bonus, but they might lose it if they don’t work hard. Or one more example: Consumers get much more angry when stores position a price change as an increase rather than the end of a discount, even if the amounts are the same. At a gas station, you will never see a credit card penalty; you’ll see a cash discount.
This same phenomenon, albeit more subtle, helps nudge consumers towards paying extra for brands they know. What is a brand except an excuse to charge extra for a perceived value that is lost when a consumer switches? If this weren’t true, Advil would never be able to charge a 25-50& premium over generic ibuprofen.
All these irrational behaviors lead to wrong-headed decision making. People overpay to stick with products they know, and they undervalue the potential gain of taking a risk on a new brand of cereal, or a new bike, a car. This is why auto insurance companies can undercut each other when trying to convince you to switch policies; they can overcharge loyal customers.
Endowment effect isn’t the only force at play in these transactions – simple habits explain a lot. But understanding why you excessively value things you have or know will help you pay less in nearly every transaction you make. And it’ll probably help you (and me) say goodbye to that old clunker in the garage.
More Money-Saving Reads:
- What’s a Good Credit Score?
- How to Get Your Free Annual Credit Report
- What’s a Bad Credit Score?
- How Credit Impacts Your Day-to-Day Life