As a part of our IDFC Digital Learning Capsules, today we shall be discussing Endowment Effect. We consider something more valuable the moment we own them. If we are selling something we own, we charge more for it than what we would spend on it ourselves. This is called the “Endowment Effect”.
Here’s a ‘real-life’ illustration of the bias in play:
Endowment Effect theory is a well-known concept in the world of Behavioural Finance. Endowment Effect says that we tend to value things more just because we own it. However, we don’t value things more in pricing terms if we don’t own it. Endowment Effect also says that we tend to love what we have already and if someday we need to change it, it’s not easy for us. We resist it a lot. So the final one-line conclusion is “If I own it, it’s good and it’s valuable and if I don’t own it, I am not sure, maybe it’s not worth it!”. You can see this in all aspects of your life. Check with any couple, who has the cutest child in the world? Check with any employee who loves his organization; ask him which is the best company to work for? Ask any murderer’s parents, if they really think their son/daughter is involved in crime and you can hear, “No it’s not possible, their son/daughter is innocent”. So the point endowment effect puts is, what is ours is clean, good, and worth something. This is what happens with most of the people, if not all.
To explain it in simple words; How much money do you expect for your mobile phone, if you wanted to sell it? And then think how much money would you like to pay to someone if you wanted to buy it? In most cases, one wants a higher price when he wants to sell and wants to get the same thing for a lower price. There is nothing wrong with this as we all are human and we will think from a money point of view. But take the underlying learning from here. If a person has something, he treats it very special and does not think rationally at times and it affects him a lot in his financial life. A lot of people don’t want to admit that what they have is ordinary and just like others. Let me take each area of financial life and show you how it’s applicable there.
Example of Endowment Effect with Stocks
You might be able to relate to this. The stocks you own are always worth and they have the potential to go up, that’s what you think. If the market goes up, you feel that your stock has the potential to go further up, and if markets go down, you say – “huh!, this is temporary, they don’t understand how strong fundamentals are for this stock, I will wait”.
In 99% cases, it’s nothing but an endowment effect, just because you have it, you start feeling special about it, but the other guy from some distance can clearly see what an idiot you have been so far! And in case you didn’t hold that stock, it might happen that you would have not recommended it to someone else, you could see things clearly only if you don’t own it. Even in mutual funds, if some of your friends ask you which funds he should go for, most of the people will recommend mutual funds which they already hold. For them just because they have bought some XYZ mutual fund, it’s one of the best (that’s why they bought).
We get comfortable & repulsive to change
Another big thing which happens to us is that once we buy something or own something, we start being very comfortable with it and find all the reasons why it’s good for us and why it’s not worth changing it. Look at your job portfolio, it’s the same!.
How Trial & Money-back guarantees make use of Endowment Effect
So now you will relate to Trial & Money-back guarantees. Once we bring something on Trail or buy product on money-back guarantee; almost never one’s returns back as they have tasted it, felt it, owned it, and now they believe that they need it. I have never seen anyone returning some product which was on a money guarantee! The sellers understand the power of the endowment effect and hence use it to their advantage. In his book called “Stocks to Riches”, Parag Parikh talks about an incident relating to this.
Raju : Mom, See what I have got !, The latest Stereo system . It will fit perfectly in our drawing-room. Wait till I play it , you will love the sound.
Mom : Raju, where did you get the money to pay for such an expensive item ?
Raju : Its on a 15 day trial basis , The shop round the corner allows you to use the goods before you buy it . Since college is closed for 2 weeks , I thought I will listen to music for some days .
Mom : Are you sure they will take it without any fuss ?
Raju : Off course Mom , dont worry , see here is the card . It says that they will take it back , No questions Asked !, if refunded with 15 days trial period.
Mom : Thats great , Handle it carefully . They may not take it back if it’s misused.
Raju : Dont worry , I will be careful .
After 14 days…
Mom : Raju , dont forget that trial period ends tomorrow, We will really miss this stereo , we had so fun listening to music .
Raj : Did you notice how exactly this fits our decor and space . I really love its sound . We wanted it from so long , Lets keep it only , and make the payment , anyways we needed it .
Mom : Yea , I think we should keep it , the price is also justifiable and within our budget and we really needed on for long and the best part is we got to use it without paying :
Did you see how Raju and his Mom got comfortable with the stereo? A seller knew that out of 10 times, 5-6 times people will get starting loving what they start using and accept it as part of their life. Not a big price to pay for 15-day trial!
One should think about his financial products from other’s eyes also and should be open to accepting that it’s time to find alternatives and change it. Don’t just concentrate on those points which make you believe that what you own is best, also see the bad side. Let me know if you realize that you have seen this endowment effect in your life?