Lesson 2.5 · 5 of 5 · Emotions and money
The endowment effect: why you overvalue shares you already own
The endowment effect means we value something more simply because it is ours. In the 1990 mug experiment, owners asked a median $7.12 while buyers offered $2.87, about 2.5 times less. With inherited or employer shares, the simple test is: would I buy this today, at this price?
Terms in this lesson
- Diversification
- You spread your money across several investments, so one mistake does not hurt too much.
- Portfolio
- All your investments in one place: stocks, ETFs, bonds, cash.
- Stock
- A small piece of a company that you can buy on the stock exchange.
The test: your mug
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Create a free accountThe mug experiment: Kahneman, Knetsch and Thaler (1990)
Definition
What is the endowment effect?
The value we put on something goes up once it becomes ours.
Daniel Kahneman, Jack Knetsch and Richard Thaler published the experiments in 1990 in the Journal of Political Economy. At Cornell, in a class of 44 students, those in every other seat (22) were each given a mug with the university logo that sold for $6 in the campus bookshop. Theory said half the mugs, 11, should change hands. Across four markets there were just 4, 1, 2 and 2 trades. The median selling price was more than twice the median buying price.
Experiment 6, at Simon Fraser University, added a third group. The 77 students were split at random into sellers (given a mug and asked what they would sell it for), buyers (asked what they would pay) and choosers (choosing between a mug and a sum of money).
Inherited shares and your employer’s shares
In investing, the endowment effect shows up most with shares you did not choose yourself: inherited, received as a bonus, or bought for years through the company you work for. Because they are yours, you judge them more kindly than you would judge a new share.
From the research
How much do employees hold in their own company’s shares?
About a third of the assets in large US retirement plans were in the employer’s shares.
In 2001 Shlomo Benartzi showed in The Journal of Finance that about a quarter of the contributions employees could direct freely also went into company stock. He calls this “a dubious strategy” from a diversification point of view. At firms with the worst share performance over the previous 10 years, employees put 10.37% of their freely directed contributions into company stock; at those with the best, 39.70%. Yet the allocations did not predict future returns. Benartzi explains the pattern by people extrapolating the past, not by the endowment effect, but the result is the same: too much in one place.
The question: “would I buy it today?”
Ready to start?
What to do in practice
Ask yourself: if I had this amount in cash, would I buy this share today, at this price, in this quantity?
The question moves you from the seller’s seat to the chooser’s, which is where prices in the experiment were more realistic. If the answer is “yes”, you keep it for a reason. If it is “no”, or “yes, but less”, you have found out how much is endowment effect and how much is conviction. The answer does not mean selling everything: you can keep part of it, by choice.
- Write down what the holding is worth todayin pounds, not as a percentage of the original price
- Imagine it is cashwhat would you do with that sum, from scratch?
- Decide the weighting you would choosewhat your plan says for a single share
- Adjust gradually, with the tax worked outand write the decision down, so you do not reopen it at every fall
Lessons are educational. They are not a recommendation to buy or sell. Investing involves risk and you can lose money. Sources: D. Kahneman, J. Knetsch, R. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem”, Journal of Political Economy 98(6), 1990, pp. 1325-1348; D. Kahneman, J. Knetsch, R. Thaler, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias”, Journal of Economic Perspectives 5(1), 1991, pp. 193-206; C. Plott, K. Zeiler, American Economic Review 95(3), 2005, pp. 530-545; S. Benartzi, “Excessive Extrapolation and the Allocation of 401(k) Accounts to Company Stock”, The Journal of Finance 56(5), 2001, pp. 1747-1764. The portfolio and £8 mug examples are illustrative.