The endowment effect causes you to over-value things you own. This normal human bias can siphon your wealth by:
- Reducing your free time.
- Increasing clutter.
- Increasing spending.
Awareness of the endowment effect can help you improve your wealth. But awareness alone is not enough – you also need self-discipline.
What is the Endowment Effect?
Let’s say you have a painting in your home. You find it’s worth $1,000.
Now ask yourself, would I buy that same painting for $1,000 if you saw it at a store? If you answered no, the “rational” decision is to sell the painting in your home.
Logic says you should sell the painting for $1,000 if you wouldn’t buy it for $1,000.
But most people won’t sell the painting or (insert item you own). Instead, they will hold on to it. Or they will try to sell it for more than it’s worth, and no one will buy it.
This is the endowment effect at work.
I suffer from the endowment effect. You suffer from the endowment effect. Monkeys suffer from the endowment effect.
The endowment effect is a normal human bias. It causes us to over-value the things we own.
We build an emotional connection to the items we own. So it feels like a loss when we dispose of these items. This triggers our loss aversion bias.
The Endowment Effect: A Biological Basis
It is well known that we feel the pain of loss more intensely than we feel pleasure from gains. It hurts about twice as much to lose $50 than it is pleasurable to win $50. This is called the loss aversion bias. The book Thinking Fast and Slow covers this effect in awesome detail.
To learn more about the loss aversion bias, check out Behavior and Investing: 7 Ways to Control Emotional Biases.
Our biology has not caught up to our modern environment. We are still designed for a hunter-gatherer-style environment, where we roamed in groups of 100 or less.
We would die if we lost 10 pounds of food. But if we gained 10 pounds of food, we would be marginally better. Perhaps we would not even be able to carry the extra food around.
The results of a loss were more catastrophic than an equivalent gain.
The endowment effect is linked to loss aversion. It hurts to let go of goods we own or goods that we have an emotional attachment to.
The Endowment Effect and Spending
I guarantee you know some die-hard Apple fans. I’m talking about the company, not the fruit.
Apple is able to build an emotional connection between the user and the product. Steve Jobs was a genius. He fostered an emotional connection between the customer and the product. Apple and its user base were empowered by a common mission – to “think different” and alter the world through creativity.
The emotional attachment to the brand created an endowment effect for customers. Apple fans will be more likely to pay more for other Apple devices like the IMac and IPad.
Marketers understand psychology. They build an emotional connection with the consumer (you). They know that the endowment effect can improve the odds that you will buy their products.
For example, a car company may engineer your test drive experience in a way that enforces an emotional bond between you and a new SUV. Once you are bonded to the SUV, you feel a sense of ownership. This sense of ownership causes you to value that specific SUV more than any other.
The Endowment Effect and Simple Living
Life is like a lime – you want to squeeze it for everything it has to offer. Your most valuable resource is time. It is important to combat the ticking clock.
Jake, how in the world does this relate to the endowment effect?
The endowment effect can add complexity to your life, and complexity consumes your time. Let’s look at a few examples of how the endowment effect can drain your time.
Clutter
I like to keep my home free of clutter. I retain only the necessary functional items, except for books. I hoard books.
This way I spend less time buying, cleaning, organizing, and disposing of things.
The endowment effect may have you overprice items you are trying to sell. Or perhaps you have difficulty letting go of goods you own.
You have to fight the endowment effect to sell or donate things you don’t need. To fight the endowment effect, you’ll need to master the art of letting go.
Outsourcing Low Frequency Use Items
Maybe you intent to splurge a little on good experiences. You could buy a cottage, boat, RV and a Jet Ski. The endowment effect urges you to own these items.
I often make more financial sense to rent low-frequency use items. This will save time and effort in buying stuff, maintaining stuff, organizing stuff, and disposing of stuff.
Home Ownership
As you may expect, the endowment effect will push people towards homeownership. For a rational rent vs buy decision check out this post and the rent vs buy calculator.
I rent, and I love the simplicity that comes with it. There is no stress about managing or paying for home maintenance. Plus, I don’t require a huge emergency fund to capture potential home maintenance expenses.
Conclusion
The endowment effect causes you to over-value items that you own. This can influence a variety of behaviors that can hurt you financially:
- Selling your stuff for a price that is too high.
- Extra clutter due to reluctance to sell or donate your stuff.
- Biases you towards ownership relative to renting (homes, cottages, toys, ect)
- Higher spending when you have an emotional attachment to brands.
- A small amount of anger when someone else parks in “your spot”.