Endowment effect and loss aversion: how to avoid the pitfall
The endowment effect is a cognitive bias that makes us overvalue what we already have. Just as Gollum obsessed with the ring, we cling to our ‘precious’ possessions and get caught in the trap of irrational decision-making.
What is the endowment effect?
The endowment effect is based on the concept of loss aversion and the prospect theory, which state that people are more driven to avoid loss than to strive for equal gains. In other words, the pain of a loss is higher than the joy of a gain of the same amount. That’s why, for example, if choosing between gaining £5, or gaining £10 and then losing £5, you are likely to choose the first option, even though the end result is the same.
Richard Thaler, Daniel Kahneman, and Amos Tversky are all behavioral economics pioneers who uncovered and studied the endowment effect. In Kahneman’s ‘Thinking Fast and Slow’, the author recollects numerous studies that show the bias at work.
Mugs and pens: higher value from the first touch
In this experiment, half of the students were given a token that at the end could be cashed in at a certain price. The students were then encouraged to trade the tokens with their fellow classmates. The experiment resulted in half of the students conducting the trade with equal asking and selling price.
The experiment was then repeated twice using consumer goods instead of tokens. Half of the students were first given coffee mugs with university insignia, and then, in the next experiment, boxed ballpoint pens with a visible price tag of $3.98. The number of trades was significantly lower: an average of five for coffee mugs, and nine for pens. But what struck researchers the most was that the seller’s price was twice as high as the buyers were willing to pay, even when the objective price tag was obvious in the case of the ballpoint pens. The researchers have explained it with the endowment effect.
From the very first touch, the value of physical items has increased in the eyes of the owners. The potential pain from giving the items away seemed higher than the objective market price, therefore forcing the sellers to set a higher asking price. On the other hand, the joy of acquiring the items seemed lower to the buyers, proving that owning the object makes you value it more.
How does the endowment effect impact your spending decisions?
The endowment effect is a powerful marketing tool and is used widely by businesses to attract potential clients. Consider free trials on subscription services, be it movie streaming, online courses, or premium plans on publications. The offer seems harmless and attractive (unless you forget to cancel the trial) — who doesn’t like to get free stuff? Yet using a service even for a short period of time creates a sense of ownership and attachment. As soon as the free trial comes to an end, the endowment effect may encourage you to overvalue it and pay for the full subscription. The prospect theory also comes into play, as the pain of a loss (the lost subscription after a free trial) is higher than the joy of a gain (buying the subscription without a free trial).
Another example of stimulating the endowment effect would be letting a customer try on a product physically. Think of test-drives in car dealerships, make-up and skincare free samples, or simply changing rooms in fashion retail. The tech giant Apple allows customers to touch and use products in the store — to tangibly experience how that new iPhone fits in one’s hand. The customer feels as if they already own the product, hence it’s harder to let go.
Not willing to switch a provider may be another sign of the endowment effect at work. It is consistent with the status quo bias. Numerous studies have shown that people are reluctant to change their preferences — be it a utility company or a health plan — even if there are objectively better options available. Customer loyalty trumps the unknown.
Opportunity cost: a mental tool to keep your head sober
Untamed, the endowment effect can cost you a lot of money and a lot of space. In some extreme cases, hoarders stimulated by the endowment effect struggle to let go of material things until the point when their house collapses. Hoarders usually justify their unhealthy behavior saying that they are simply aware of how much things cost. What they are not aware of is the endowment effect that makes them overvalue their possessions.
One of the groups that researchers have observed are immune to the endowment effect are experienced traders. As Kahneman writes, veteran traders have learned to ask themselves: “How much do I want to have that mug, compared with other things I could have instead?” Instead of pricing an item based on the pain the loss of an item would bring, traders focus on the opportunity cost.
The opportunity cost is a major concept in economics and represents advantages one misses out on when choosing one option over another. For example, if you buy a $6 worth mug, your opportunity cost would anything else you could buy for that $6. By using the opportunity cost as a mental tool against the endowment effect, the loss of an item becomes irrelevant, as it is compared to other options. In practice, opportunity cost means always keeping in mind other options to spend an amount of money. “What else can I buy for the cost of that item, and which one has more value or utility for me?”
The endowment effect is a cognitive bias that makes us overvalue the possessions we already have and overestimate the pain of losing these possessions. This leads to irrational decision-making, such as resistance to selling unnecessary items, overpaying for utility providers and subscriptions, or buying things we don’t objectively need. The endowment effect can be overpowered by the ‘opportunity cost’, or asking yourself a question: “What else can I buy for the cost of that item, and which one I objectively need and value more?”