Endowment Effect - Definition
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Endowment Effect Definition
The endowment effect is a term used in behavioral finance where a person finds something worthy because he or she already owns or possesses it, and not the one that he or she doesnt own or possess yet. This effect is also known as divestiture aversion. As the object is possessed by the person, thats why it carries more value. There are investors who resist switching assets, and prefer investing in specific assets because of being familiar with them. And, they will prefer sticking to them in spite of their unprofitability.
A Little More on What is the Endowment Effect
According to researchers, individuals tend to find value in something that they already have than something similar they dont have. As per the old adage, A bird in the hand is worth two in the bush. It is not important is the specific object was bought or offered as a present, the endowment effect still persists. For instance, a person buys a wine case at quite a low price. Now, Mr. A makes an offer to the person for buying that wine case at a higher price. As per the endowment effect, the person wont accept that offer in spite of having prospective financial gains from the deal. Here, he or she is preferring his or her own welfare rather than monetary benefits, and thats why, he or she would be more interested in drinking the wine on his or her own, rather than offering it to somebody else. People who own or possess collectible items, or organizations who consider their possession to be more valuable than anything else can also be driven by the endowment effect. There are cases when the shares of deceased person get transferred to his or her nominee. Here, the nominee follows the endowment effect by not agreeing for divesting those shares, irrespective of their risks involved. He or she would still stick to them even if they dont fit in the given investment goals, and have a negative effect on the portfolio. For avoiding poor returns ahead, it is important to assess if the shares negatively or positively impact the asset allocation strategy.
Impact of the Endowment Effect
Not just in finance, this sense of bias can be found outside too. Several studies on endowment effect have been conducted, and one of the most popular ones is stated as follows: There was a college professor who taught two sections of a class: one section on Mondays and Wednesdays, and the other section on Tuesdays and Thursdays. To the students who attended Mondays and Wednesdays class,the professor gave an amazing coffee mug having the universitys logo imprinted on it for free. However, the Tuesday and Thursday class didnt receive anything. After a couple of weeks, the professor asked students about the price of that coffee mug. The students from Monday and Wednesday lecture who received the mug put a higher quote than the ones who didnt. While surveying for the least selling price of the mug, its average price was more than that of students who didnt have the mug.