What creates this endowment effect? Do we overestimate the value of the objects we own, or does parting with them cause too much pain? Consider the following experiment. Students were asked to rank in order the attractiveness of six prizes. A less attractive prize—a pen—was given to half the students in the class. The other half of the class had a choice between the pen and two chocolate bars.
Of those given a choice, only 24% of the students picked the pen. The candy bars were more attractive. Later, the students that were originally given the pen then got to switch to the chocolate bars if they wanted to. Even though most students ranked the chocolate higher than the pen as a prize, 56% of the students endowed with the pen elected not to switch. Judging from this experiment, it appears that you do not overestimate the appeal of the object you own. Rather, you are more affected by the pain associated with giving up the object.
Endowment and Investing
How does this bias affect investors? You will have a tendency to hold onto the investments you already have. Consider that you have just inherited a large sum of money. You can invest the money in different portfolios. Your choices are a moderate-risk company, a highrisk company, U.S. Treasury bills, or municipal bonds.
Researchers have asked people many versions of this question. In some versions, the subjects were told that the inheritance was already invested in the high-risk company. In other versions the inheritance was in the form of the other investment options. How the inheritance was originally invested was a major factor in the decision of what to do with the money. The high-risk choice was more popular when the inheritance was already invested in the high-risk company. The Treasury bill option was more popular when the inheritance was already invested in Treasury bills. Clearly the expected risk and return of portfolios dominated by Treasury bills is very different from that of portfolios filled with high-risk companies. Yet the subjects of the studies were influenced more by the status quo than by their own risk and return objectives!
This endowment effect in particular hits home with me. Recently, my wife was given a substantial sum of money by her parents. The gift was given in the form of U.S. savings bonds. As an investment, savings bonds are about as conservative as you can get.
They offer very low risk and consequently offer very low returns.My in-laws have enough wealth to meet their retirement needs and are invested in a very conservative manner. My wife and I are in the accumulation phase of our lives with a couple decades remaining until retirement. The investment needs of my in-laws are very different from our needs.
What should my wife do with this money? By the way, my wife has some investment education that comes from participating in an investment club, but she isn’t that interested in investing. However, she does have an inhouse expert—me!
I suggest, “You should liquidate the savings bonds and buy a fully diversified portfolio of conservative stocks.”
She likes the savings bonds.
“Students pay a lot of money to take my undergraduate and graduate courses in investing. In addition to being a finance professor, I am an investment consultant, expert witness, and national speaker,” I say, trying to gain credibility.
Her parents gave her those savings bonds.
In short, it was all I could do to convince her to invest half of the gift in stocks. Note that it was not the savings bonds’ safety that she valued. She wouldn’t put the money into certificates of deposit, a bank savings account, or money market mutual funds either.
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