Most would agree that personal finances are about psychology as much as money, with our choices significantly more important than any mathematical equation. The endowment effect is a powerful force when it comes to the things we own, and it is therefore worthwhile to take some time to understand how this phenomena influences our personal finances.
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While everyone has their own unique set of decision-making calculations, there are certain trends and behaviors that are widespread. The endowment effect is one of these psychological influences that impact our financial decisions, whether we are aware of this or not.
What Is the Endowment Effect?
The endowment effect is the tendency to place a higher value on items that are in our possession. In short, we tend to overvalue items that we own and undervalue those that we do not.
The late Nobel prize winner Daniel Kahneman details an experiment demonstrating this phenomenon in his thought-provoking book Thinking, Fast and Slow. In an experiment he designed along with a few of his colleagues, Kahneman gave half of the participants an attractive coffee mug with the insignia of the university where they were conducting the study.
Those participants who had been given a mug had the option to sell their newfound possession; those who had not been given a mug had the option to purchase one. The sellers–who had only just recently been gifted the mug–offered a selling price on average of $7.12. The buyers, however, were on average only willing to pay $2.87 for the same mug. (As reference, Kahneman notes that the mugs cost about $6.)
The difference in the prices is fairly remarkable, and underscores the idea that once something is in our possession we are reluctant to part with it. While this has implications in the artificial setting of a controlled experiment, it also has real world effects for each one of us.
How Does the Endowment Effect Affect Our Personal Finances?
Our personal finances are comprised of both our spending and savings, and our investment strategy plays a large role in the amount of monies we are able to accumulate over time.
We can readily understand the impacts of the endowment effect when we think about our investments. When it comes to our portfolio, according to the endowment effect, we will be less likely to sell a stock or asset that we have owned for awhile. This could be the case even if the fundamentals are pointing towards a future drop in price, as we will have come to feel an attachment to the equity.
Even if you have reached the conclusion that now is the right time to rebalance your portfolio, you may still find yourself under the influence of the endowment effect. For instance, you may feel less connection to stocks that you have only recently purchased versus those that have resided in your portfolio for longer periods of time.
Beyond investing, the endowment effect can be seen at work throughout our lives as consumers. One-month trials long trials free of charge and other marketing devices are designed to make us feel a connection to a product or service. Once we have developed this “pseudo” ownership, it can be difficult to part with these items (even if they were never actually ours to begin with).
How Can We Mitigate the Negative Impacts of the Endowment Effect?
Being aware of our tendencies is always an important first step on the road to sound decision-making. If we are aware of the endowment effect and how it influences our choices, it follows, we will be better positioned to ensure that we are able to counteract any decisions that are detrimental to our finances.
Taking the time to regularly review our portfolios can help us to ensure that we are investing in ways that align with our long-term goals. While this does not need to be a daily affair, looking over our investments and how they have been performing can help us to rebalance our holdings. Working with a licensed advisor can provide a more objective perspective, which can further assist us to take the emotion out of some of our investing decisions.
On the other side of the ledger, understanding how companies try to market their goods and services can help us to avoid unnecessary consumption. Indeed, being cognizant of the hidden costs of “free trials” can help us to take a step back and really think about whether the offer being dangled in front of us is something that we truly want.
Conclusion: Thinking, Fast and Slow
Kahneman wrote that his intended purpose in Thinking, Fast and Slow was to “improve the ability to identify and understand errors of judgment and choice.” The Nobel Prize laureate wrote about our two systems of decision-making: our fast, intuitive system and our slow, deliberate system.
Our first reaction–some refer to this as “going with our gut”–is not always right. Leveraging our second system takes effort and energy, though it can help us to dig down into the roots of specific problems and challenges.
The endowment effect causes us to assign higher values than we should to what we own. Being aware of how our minds work, and overriding our initial decisions when they are faulty is a necessary step towards making better choices.
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