Bob Seaberg, Independent Consultant
“What is mine is myself … I am what I have.” Jean-Paul Sartre’s words from “Being and Nothingness” speak to the heart of the psychological dimension of possessions and encapsulate the power of the endowment effect. Or, as George Carlin more colloquially put it, “Have you ever noticed that their stuff is sh*t, while your sh*t is stuff?”1
The endowment effect is an emotional bias that causes people to value what they own at a higher level than the possession is worth simply because they own it. Those possessions in particular can include primary homes, art and collectibles and equity investments. In fact, a British consultant firm has called the endowment effect “the most widespread psychological flaw” among investors, a flaw which has been both pervasive and extremely costly.2
The endowment effect was first noticed by Richard Thaler in a 1980 article in which he discussed a wine lover who had purchased several bottles of a Bordeaux wine at low prices. The original $10 price had ballooned to $200 in wine auctions, but, while the owner would occasionally drink a bottle, he refused either to sell his other bottles or to buy any at the $200 price. Several years later, the pioneers of behavioral finance, Amos Tversky and Daniel Kahneman, noted that this effect resulted in large part from loss aversion. When having to sell something meaningful to them, sellers feel a real sense of loss, and in order to compensate for that, they demand a price well above the market value of a similar item. Later research linked the endowment effect to the status quo bias. As in Thaler’s example of the wine lover, the status quo bias influences someone to do nothing, because people prefer to hold on to what they already have.3
When they wrote of the status quo bias, William Samuelson and Richard Zeckhauser described an experiment in which students were informed they had inherited a large sum of money. They were then given choices of exchanging what they had received for another investment, among them, a high-risk stock, a moderate-risk stock, treasury bills and municipal bonds. Their favorite choice was to retain what they had inherited, a great example of the endowment effect (and the status quo bias) at work. In the investing world, a clear tendency is for investors to hold what they already own. This is evident even, or especially, when the price of a stock has fallen, and investors elect to continue holding. The propensity is also the same with professional fund managers. Talented stock pickers will buy a stock at a particular price expecting it to reach a certain higher level. But if the price reaches only part way to that level, the manager will continue to hold, electing not to sell until it reaches its full expected value. Unwilling to get less than what they felt was full value for the investment, these managers would instead tie up capital in what is often termed “dead money,” potentially creating significant lost opportunity.4 Their decision-making has been governed more by the pain of giving up something. The fact is people tend to treat opportunity costs differently from actual costs; and sacrificed gains are less painful than perceived losses.
More recent research on psychological, or subjective, ownership has opened up a new avenue to explain the pull of the endowment bias. Beyond loss, it appears, actual possession creates an association between the self and the item, thereby increasing its value. That is, the object becomes part of one’s extended self: hence the power of Sartre’s statement. Both biology and social experiences — nature and nurture — play a role in forming people’s relationships to their possessions. Most important, these possessions express one’s ability to control the social and physical environment and actually help to define a person in relation to others. That is, because of the importance placed on possessions by society, they play an important role in both self-understanding and self-identity. Perhaps the best conclusion is to link psychological ownership with both loss aversion and the status quo bias in understanding the pervasive nature of the endowment effect.5
The length of time one owns something also becomes a factor in the strength of the endowment effect. Possessions provide people with a sense of comfort and also forge an emotional connection with their past. No doubt this helps explain the fact that valuation can increase with the duration of ownership. The things we have owned the longest are those we not only often find more difficult to sell but also those we appreciate more.6
In addition to stock market investing, the prevalence and force of the endowment effect also can be seen in examples drawn from the housing market. During the 1990s boom-bust period in the Boston condominium market, researchers noted that, among higher-priced condos, the difference between original prices and expected selling prices averaged between 25-35%, even though market values were falling not rising. The differences were up to two times as large for owner-occupiers than for investors. A later study demonstrated that higher status, ascribed to household income and home values in certain neighborhoods, meant a greater gap between self-reported home value and a home’s actual market worth. Given this research, one would expect to see an increased influence of the endowment effect among ultra-high net worth investors. Research on the Beijing, China, housing market confirmed this status effect as well as the overall effects of psychological ownership and its interactions with housing cycles. Clearly, these examples also add credence to the underlying notion that self-identity is tied in part to the meaning society places on possessions.7
There is, finally, another relationship between psychological ownership and decision-making that bears comment. It may indeed involve decisions to remain, and even increase, commitments to projects that are not succeeding as planned. Often termed “escalating commitments,” this would cover the phenomenon of “doubling down.” In blackjack, the phrase refers to doubling one’s initial bet after seeing the first card or cards; in investing, it entails doubling one’s ownership of a stock that has fared very badly after an initial purchase. Averaging down can be a useful tool, if, for example, the only thing which has changed about a company is its stock price. But, it is often a way to reassert the assumed value of the stock because of the decision to own it in the first place, a decision which has hardened over time. That is to say, it indicates a form of self-justification in line with psychological ownership. As with any such stock, one can elect to sell and take a loss, hold and hope, or buy more shares to lower the original cost basis. The endowment effect clearly favors the hold- and- hope choice, and psychological ownership may in fact incline to escalating the commitment. However, either of these alternatives may prevent an investor from taking necessary capital losses and then redeploying remaining capital more wisely.8
One of the critical services a financial advisor can provide is to help ultra-high net worth clients understand the pull of the endowment effect, the status quo bias and loss aversion in our decision-making, things it is hard for us to see on our own, and help us resist coming under the sway.
1 George Carlin, “A Place for My Stuff.”
2 John Authers, “Investors Psyched by the Endowment Effect, https://www.ft.com/content/f9b17740-9205-11e5-bd82-c1fb87bef7af., November 25, 2015.
3 Richard Thaler, “Toward a Positive Theory of Consumer Choice,” Journal of Economic Behavior and Organization, 1980. Daniel Kahneman and Amos Tversky, “Choices, Values and Frames,” American Psychologist, April 1984. William Samuelson and Richard Zeckhauser, “Status Quo Bias in Decision
Making,” Journal of Risk and Uncertainty, 1988. Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler, “Anomalies: The Endowment Effect, Loss Aversion and the Status Quo Bias,” The Journal of Economic Perspectives, Winter 1991.
4 H.Kent Baker and John R. Nofsinger, “Psychological Biases of Investors,” Financial Services Review, 11 (2002). Authers, “Investors Psyched by the Endowment Effect.”
5 Jon L. Pierce, Tatiana Kostova and Kurt T. Dirks, “The State of Psychological Ownership: Integrating and Extending a Century of Research,” Review of General Psychology (2002).
6 Michael A. Strahilevitz and George Loewenstein, “The Effect of Ownership History on the Valuation of Objects,” Journal of Consumer Research (1998).
7 David Genesove and Christopher Mayer, “Loss Aversion and Seller Behavior: Evidence from the Housing Market,” Quarterly Journal of Economics, 2001. Grace Wong Bucchianeri and Talya Miron-Shatz, “Taking Stock of Housing Wealth: Reported Home Values,” July 2010. SSRN: https://ssm.com/
abstract=1877206. Helen X. Bao and Cynthia M.Gong, “Endowment Effect and Housing Decisions,” University of Cambridge PERC Working Papers Series, December 2014.
8 Jochen Reb and Terry Connolly, “Possession, Feelings of Ownership and the Endowment Effect,” Judgment and Decision Making, April 2007. Barry M. Straw, “Knee Deep in the Big Muddy: A Study of Escalating Commitment to a Chosen Course of Action,” Organizational Behavior and Human Performance, 1976.
For general reference and educational purposes only. The information provided herein is not intended to address any particular matter and may not apply depending on the context, as all clients’ circumstances are unique. No legal, tax or other advice is being offered herein.
Important Risk Information for Securities Based Lending: You need to understand that: (1) Sufficient collateral must be maintained to support your loan(s) and to take future advances; (2) You may have to deposit additional cash or eligible securities on short notice; (3) Some or all of your securities may be sold without prior notice in order to maintain account equity at required maintenance levels. You will not be entitled to choose the securities that will be sold. These actions may interrupt your long-term investment strategy and may result in adverse tax consequences or in additional fees being assessed; (4) Morgan Stanley Bank, N.A., Morgan Stanley Private Bank, National Association or Morgan Stanley Smith Barney LLC (collectively referred to as “Morgan Stanley”) reserves the right not to fund any advance request due to insufficient collateral or for any other reason except for any portion of a securities based loan that is identified as a committed facility; (5) Morgan Stanley reserves the right to increase your collateral maintenance requirements at any time without notice; and (6) Morgan Stanley reserves the right to call securities based loans at any time and for any reason.
With the exception of a margin loan, the proceeds from securities based loan products may not be used to purchase, trade or carry margin stock (or securities, with respect to Express CreditLine); repay margin debt that was used to purchase, trade or carry margin stock (or securities, with respect to Express CreditLine); and cannot be deposited into a Morgan Stanley Smith Barney LLC or other brokerage account. Securities based loans are provided by Morgan Stanley Smith Barney LLC, Morgan Stanley Private Bank, National Association or Morgan Stanley Bank, N.A, as applicable.
Morgan Stanley Smith Barney LLC is a registered broker/dealer, member SIPC, and not a bank. Where appropriate, Morgan Stanley Smith Barney LLC has entered into arrangements with banks and other third parties to assist in offering certain banking-related products and services.
Investment, insurance and annuity products offered through Morgan Stanley Smith Barney LLC are: NOT FDIC INSURED | MAY LOSE VALUE | NOT BANK GUARANTEED | NOT A BANK DEPOSIT | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY
© 2018 Morgan Stanley Private Wealth Management, a division of Morgan Stanley Smith Barney, LLC. Member SIPC.
CRC 2070176 04/18 FOR9207133 CS 9207133 07/18