The Endowment Effect: Why We Overvalue What We Own, Especially Investments

The endowment effect is a well-documented cognitive bias that describes our tendency to place a higher value on things we own simply because we own them, compared to their objective market value or what we would be willing to pay to acquire them if we didn’t already possess them. In essence, “ownership” creates a sense of attachment and inflated worth in our minds.

Imagine you bought a stock for $50 a share. If the market price drops to $40, you might be hesitant to sell, even if your initial investment thesis has changed or better opportunities have emerged. Conversely, if you didn’t own the stock and it was priced at $40, you might be less inclined to buy it at that price. This discrepancy in valuation – valuing something you own more than something you don’t, even when they are objectively the same – is the endowment effect in action.

This bias stems from several psychological factors. Loss aversion plays a significant role. Selling an owned asset, even at a small loss, feels like a tangible loss, which we are wired to avoid more strongly than we pursue equivalent gains. The pain of losing $10 feels psychologically more impactful than the pleasure of gaining $10. When we consider selling an investment, we focus on what we might lose (the potential sale price), rather than what we could gain by reallocating those funds to a potentially more profitable or suitable investment.

Another contributing factor is the mere act of possession. Once we own something, it becomes part of our “endowment,” our personal collection of assets. We develop a sense of attachment and even emotional connection, particularly to items or investments we have held for a while or believe we have put effort into selecting. This emotional attachment can cloud our judgment, making it difficult to objectively assess the true value and potential of the investment. We start to see the asset not just for its financial worth but also for its symbolic or personal value.

In the context of investing, the endowment effect can lead to several detrimental behaviors. Investors might:

• Hold onto losing investments for too long: Fearful of realizing a loss, investors may cling to underperforming stocks or other assets, hoping for a rebound that may never materialize. This “hope” is often fueled by the endowment effect – they feel attached to the investment and overvalue its potential simply because it’s already in their portfolio. This can lead to missed opportunities to cut losses and reinvest in more promising ventures.
• Miss out on better investment opportunities: The endowment effect can make investors overly attached to their current portfolio allocation, making them less likely to consider rebalancing or shifting investments to take advantage of market changes or emerging opportunities. They might be reluctant to sell existing assets, even if doing so would free up capital for investments with higher expected returns.
• Demand a higher price when selling: When it comes time to sell an investment, the endowment effect can lead investors to demand a price higher than the market is willing to offer. They overvalue their asset due to ownership and may miss out on a reasonable sale by holding out for an unrealistic price, potentially missing a favorable selling window.

Overcoming the endowment effect in investing requires conscious effort and a disciplined approach. Here are some strategies:

• Adopt a rational, objective perspective: Regularly evaluate your investments based on their current performance and future potential, as if you were considering buying them today for the first time. Ask yourself: “If I didn’t own this investment, would I buy it at its current price?” If the answer is no, it might be time to reconsider holding onto it.
• Focus on opportunity cost: Consider what you are giving up by holding onto a particular investment. Is your capital better deployed elsewhere? Think about the potential returns you could be earning in alternative investments rather than just focusing on the perceived loss from selling.
• Seek external perspectives: Discuss your investment decisions with a financial advisor or trusted friend. An outside perspective can help you identify biases you might be overlooking and provide a more objective assessment of your portfolio.
• Pre-commit to selling rules: Establish clear sell rules for your investments beforehand, based on objective criteria like performance benchmarks or changes in your investment thesis. Having these rules in place before emotions take over can help you make more rational decisions when the time comes to sell.

By understanding the endowment effect and its influence on our investment decisions, we can take steps to mitigate its impact and make more rational, profit-driven choices, ultimately leading to better long-term financial outcomes.