One of my favorite people in the world is my cousin’s daughter, Charlotte. She turned 3 last month and her birthday party was a couple weeks ago. Like me, many of my friends are clinging tightly to the last shred of our adultolescense and haven’t taken the plunge to have kids yet. So, if it wasn’t for Charlotte and her pals I wouldn’t have much of a sense of what the world is like for toddlers.
Charlotte can’t really do any wrong in my book but this last visit I did pick up on a phrase she seems to have developed a fondness for – “hey, that’s mine!” Maybe you parents and grandparents have heard it before. It didn’t matter whether someone wanted to play with her brand new toy or just toss out the plastic fork she was eating with, the message was clear: drop it, move away slowly and nobody gets hurt.
Seeing her so attached to things that I knew had no significant meaning to her reminded me of some research I read recently about how people value things which they perceive to belong to them. In one of the first studies on this topic, researchers split participants into two separate rooms. Individuals in each room were asked to assign a price to a coffee mug. Members of the first group were handed the coffee mug at the beginning of the study and were told they could keep it. In the second group, members were simply shown the mug by someone at the front of the room.
People in group one assigned an average price of $5.87 apiece, this being the price at which they would be willing to sell their newly-acquired mug. Group two, stating the price at which they would buy the mug, gave it an average price of $2.21 – over a 60% difference. Researchers were puzzled at why there was such a difference in the pricing of identical objects. In subsequent studies a number of theories were tested to explain the results; in one study the items were even labeled with a price tag to see if that would level the discrepancy but time after time the spread persisted. It seems that we just value things more when we deem them ours.
They call this the endowment effect and it wasn’t until years later that the explanation was discovered in the unlikely field of behavioral finance. What they found was that the discrepancy in the value of the mugs had nothing to do with the objects themselves. It was entirely about the transaction of either giving up or acquiring the mug. The first is psychologically considered a loss while the second is considered a gain. Enter the behavioral finance concept of loss aversion, which states that the emotion associated with a loss can be up to twice as intense at that associated with a gain.
Because we find losses so painful, it changes our behavior from being purely logical. Absent the desire to avoid a loss, there is no explanation as to why the same coffee mug is worth so much more to one group than the other. But because giving up the coffee mug is a loss, and we seek to avoid the pain associated with losses, we expect to be paid more to give up the mug than we would to buy it.
As consumers, we are often bombarded with tactics that exploit this idea. Salespeople know that if you try on clothes or test-drive a car, you’re more likely to buy them. If you try something for 30 days, you’re more likely to continue it. Need I even mention how hard it is to put that puppy down after you’ve already fallen in love with him?
The endowment effect can impact you on the sales side as well. Have you ever felt the pangs of pain and sentiment as you prepare to sell a car or a home? Or even as you set out your belongings for a garage sale? That could be your desire to avoid the sense of loss associated with the sale. Without even thinking about it, it becomes pretty easy to overprice these items.
Of course all this can affect your investment experience as well. If you watch your investment accounts frequently, you can see your accounts hit a high number and think that is now how much your portfolio is worth. To have it go down after that feels as if someone has taken away something that belongs to you. That emotional roller coaster is one of the reasons we caution against checking your investments too often. If you are prone to monitoring your accounts, remind yourself that as an investor you don’t just own an account filled with dollars and cents. You are an equity owner in companies all over the world and as such are entitled to a piece of their future growth and earnings. That isn’t taken away because the market values of the companies fluctuate from day to day.
The next time the endowment effect has you scrambling to avoid a loss, remember there is only one thing in that moment you can’t afford to lose – your head.