The Endowment Effect

In 1990, behavioral economists Daniel Kahneman, Jack Knetsch, and Richard Thaler published the results of a now-famous experiment commonly known among behavioral scientists as “the mug study.”¹ The researchers divided Cornell University student volunteers into two equal groups. The first group received a coffee mug from the university bookstore; the other group received nothing. The experimenters then created a market between the groups to allow students with mugs to sell them to the students without mugs. Traditional economic theory predicts that under such circumstances, the parties should be able to find a price at which about half the mugs will exchange hands. However, in the experiment, very few mugs were sold due to a large gap in valuations; on average, students that were given the mug demanded more than twice the price that the students without the mug were willing to pay. Why did two similar groups of people differ so widely in their pricing? Based on the results of this study, which has been repeated and verified through additional experiments numerous times over the past three decades, the researchers determined that people place a higher value on things they own compared with things they don’t, whether it be a mug, a car, or an investment. The researchers labeled this phenomenon the “endowment effect.”

The endowment effect is a type of cognitive bias, or an error in thinking that occurs when people incorrectly process and interpret information in the world around them. In other words, it is what happens when one’s brain creates a new “subjective reality,” ignoring or minimizing its focus on objective input and, at times, leading people to make illogical choices. This phenomenon is particularly relevant to investment decisions because it has the capability of interfering with one’s ability to correctly evaluate market risk. It can also lead individuals to be overly attached to their investments. For example, a person who inherits shares of stock from a deceased relative may exhibit the endowment effect by refusing to sell those shares, even if they do not fit within the beneficiary’s investment goals or portfolio diversification.

The endowment effect is one of many types of cognitive biases that can irrationally influence investment decisions. Here, we highlight additional types of investment-related biases and offer three possible solutions to help recognize and minimize their negative effects.

Prospect Theory

Imagine a gameshow contestant who has just won a $10,000 prize; he is then offered a chance to double his winnings by correctly calling the outcome of a coinflip, but he also risks losing it all if he guesses incorrectly. Should he opt for this double-or-nothing opportunity? From a strictly economic viewpoint, these two options are equal. On average, people that flip the coin will receive $10,000, since half the group will win $20,000, and the other half will walk away empty-handed. Yet when faced with this type of decision, most people take the guaranteed payment. In fact, people will often “play it safe” even if the economic odds slightly favor taking a risk – for example, if the top prize in the gameshow situation is raised to $21,000, most people will still choose a $10,000 prize. The leading theory behind why people typically prefer the safer option – known as prospect theory – states that the mental pain of a loss outweighs the joy of an equally valued gain.² In the case of the coinflip, guessing incorrectly feels like losing $10,000, even though contestants walk away no worse off than they were before entering the contest. And while doubling one’s payout following a correct guess feels good, the economic benefit one receives in this situation doesn’t match the possible psychological detriment of receiving nothing.

Other Cognitive Biases

While the endowment effect and prospect theory are among the most well-known cognitive biases, they are far from the only ones that can affect financial decisions and risk assessments. Other notable cognitive biases include the following:

Managing Cognitive Biases

Cognitive biases aren’t always counterproductive. In many instances, they provide rules of thumb or information processing shortcuts so people can evaluate new data more quickly and easily to make both major and minor decisions. To a large degree, such biases are impossible, and frequently undesirable, to eradicate entirely. Yet it is important to find ways to manage these biases and mitigate their potential damage to one’s long-term planning and investing goals. Here are three evidence-based methods to help limit the negative impact of cognitive biases:

All three of these mitigation tools force decision-makers to slow down, think through their decision process, and consider a more well-rounded, well-informed approach. While these solutions may be inefficient for making insignificant or minor choices, employing them to minimize cognitive bias can be helpful in improving decisions that have long-term consequences.

If you would like to discuss cognitive bias more, please do not hesitate to reach out to your BBH relationship manager.