Endowment Effect: Are You Overvaluing Your Possessions?

Ranbir is a corporate employee who has an old laptop stashed away in his cupboard. Even though the laptop is dysfunctional as its battery dies easily, the screen is cracked and many keys don’t work, Ranbir still doesn't want to sell it. Someone even offered him Rs. 2000 for it, but Ranbir said the laptop was worth more because he felt a sense of ownership for it. He feels that – since he bought it with his money – parting with it would be a huge loss.

*Example for illustrative purposes only.

While you may be laughing at Ranbir for preserving a dysfunctional laptop for the fear of loss, many people tend to follow the same approach when it comes to financial investments. For example, many investors may hold on to an underperforming stock simply because they own it. This behaviour in finance is called the endowment effect.

In this article, we will understand the endowment effect in detail, its examples, implications and practical tips to avoid it.

Table of contents

• Understanding endowment effect
• Everyday examples of the endowment effect
• Potential implications for investors
• Practical tips to reduce emotional bias

Understanding endowment effect

Sometimes, when we own some assets, we tend to overvalue these assets simply because they belong to us. This tendency in behavioural finance is called the endowment effect.

The origin of this concept goes back to the late 20th century, when Richard Thaler, a Nobel Prize-winning economist, introduced it. Thaler, along with psychologists Daniel Kahneman and Jack Knetsch, demonstrated in experiments that people often assign higher value to items they own compared to identical items they do not own.

In their experiment, they divided students into two groups:

One group got a free mug with the university logo, and the other group got nothing but was asked if they wanted to buy the mug. Then both groups were asked about the mug’s value.

Mug owners were asked how much they would sell it for. Their average answer was $5.25.

Mug buyers were asked how much they would pay for it. Their average answer was $2.25. Now, that’s a significant difference in the perceived value for the same mug.

Economist Richard Thaler explained it with ‘Prospect theory’, which says we hate losses more than we enjoy gains. If you own something, giving it up feels like a loss and if you don’t own it, buying it just feels like a possible gain. In other words, in our brains, losses tend to have more of an impact than the excitement of a gain.

Also Read: What is Investment: Meaning, Types and How to Start

Everyday examples of the endowment effect

Stocks held for too long

Many times, investors may hold underperforming shares, even when market trends suggest that reallocating funds may offer higher potential returns. However, these investors may feel these underperforming shares might bounce back simply because they own them.

Property attachment

Many property buyers, dealers and even owners may relate to this attachment. Some homeowners may value their old house far higher than market rates because of the memories attached to it. However, when buyers make some realistic offers, such homeowners may often refuse the offer because they might ignore market logic and prioritise their emotional connection with the house more.

Everyday items

Like in the above example, where Ranbir is attached to his old laptop, people may often refuse to sell or discard items because they perceive them to be more valuable simply because the objects are their personal possessions.

Potential implications for investors

Distorted values of the assets

The endowment effect may distort how we value things. Sellers may often overprice what they own, potentially keeping buyers away and leaving goods unsold. Buyers, meanwhile, may undervalue items they don’t own, leading to missed deals and poor resource use.

Inefficient rebalancing

Regular rebalancing is important to help maintain the risk–return profile of a portfolio. The endowment effect may discourage this because investors might resist selling existing holdings, even when their weight in the portfolio might have grown beyond target levels.

Missed potential gains

Clinging to familiar assets may cause investors to miss newer potential opportunities in other asset classes or sectors.

Practical tips to reduce emotional bias

Clear investment strategy

An investor is advised to be clear about their investment strategy and stick to it. When there is an investment strategy, the investor would know when to buy and sell an investment. The investment strategy may help in avoiding emotional attachments to individual investments.

Create exit rules in advance

It is always advisable to decide in advance the conditions under which you may sell an asset. This may include setting a target price, a time horizon or specific performance metrics. For example, setting a predefined stop-loss level or deciding to exit if fundamentals change.

Periodic reviews & rebalancing

Reviewing and rebalancing your investment portfolio periodically may be a suitable approach. Through this, the investor may understand the movement of their investment and whether it aligns with their overall investment strategy or not.

Also Read: Behavioral Finance: Meaning, Types, and Its Importance

Conclusion

The endowment effect reminds us that investing psychology can influence financial outcomes just as much as market conditions can. By recognising this bias, investors may become more aware of why they hold on to certain assets and whether those decisions align with their long-term goals.

At Bajaj Finserv AMC, we recognise that emotions are the cornerstone of investor behaviour – not just for investors but for investment professionals too. That’s why, behavioural finance is at the heart of our investment philosophy, InQuBe, which combines the Information Edge, Quantitative Edge and Behavioural Edge. By understanding, tracking and monitoring market sentiments and our own investment biases, we seek to make mindful and strategic investment decisions. Get the Behavioural edge by investing with Bajaj Finserv AMC. Read more about InQuBehere.

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