Endowment Effect Causes Us to Overvalue Things
Our next behavioral bias can lead us to make decisions that are less than optimal, often resulting in missed opportunities both in investing and in other facets of our lives. Endowment effect causes us to place a higher value on something that we already own, even though there might be ample evidence that an identical object could be readily acquired elsewhere for a lower price. A well-known study starts with a college professor who gives a coffee mug to each student in one of his class sections but does not give such gifts to his students in a second class section. A week passes and the professor asks all of the students to place a value on the mug. The students in the first class consistently value the mug at a higher price than the students from the second class. This overvaluation persists even when all the students are provided with the current selling price of the mugs at the university book store.
Endowment effect can cause investors to hold undiversified portfolios because they may refuse to part with financial securities they already hold. This behavior is often displayed when such securities are inherited. A financial asset that was appropriate for an octogenarian grandparent may be very unsuitable for a twenty-one year old grandchild who inherits it. However, the younger person often refuses to sell the asset and will not replace it with something more appropriate for their time horizon and personal tolerance for risk. Examples such as this are also called divestiture aversion. Some might claim that the grandchild simply has an emotional attachment to the inherited investment. However, there is also ample evidence that some investors will display divestiture aversion even when they had made the original purchase decision.
If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
