Shirley M. Mueller

If it’s mine, it’s worth more; if it’s yours; it’s worth less

.  This is the Endowment Effect, a cognitive bias by which we value something we own more than an equivalent item which belongs to someone else.  This kind of thinking is irrational yet it plays out daily in decisions.

For example, if we possess a piece of chocolate cake, we might sell it for $6.00.  But if we were buying it from someone else, that $6.00 would be too high for us to fork out.  As a buyer, we might consider paying $4.00 or less.

Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler (the 2017 winner of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017) use another variety of dessert in their classic experiment demonstrating the same point with chocolate bars.  The paper “The Endowment Effect, Loss Aversion, and Status Quo Bias,” was published in 

Endowment Effect: A Guide to The Emotional Trigger That Influences Your Customers’ Minds

In the experiment, participants are given objects of similar value to use for exchange in place of currency.  Some receive a chocolate bar which is equivalent in price to a coffee cup given to the others. Those with the cup are reluctant to exchange it for the chocolate bar and vice versa.  This indicates human propensity to value what we own over that which we do not.

This kind of irrational behavior applies to other financial situations as well.  For example, let’s say Dentist A owns a colonial home.  If Dentist A were to sell it, she would expect a higher price than if she were to buy a nearly identical house on the open market.   The doctor is partial toward what she owns.

Although economists originally hypothesized that the endowment effect occurrs because humans are loss-averse, new evidence suggests there is an additional reason under specific circumstances.  We identify with something that we bestow ownership on. 

Sara Loughran Dommer and Vanitha Swaminathan’s 

 demonstrates the point.  Dommer is an assistant professor of marketing at the College of Management, Georgia Institute of Technology in Atlanta and Swaminathan is on the faculty of the University of Pittsburgh. 

The two asked undergraduate students to role-play regarding a ball point pen transaction.  Those designated as sellers were given pens and asked if they wished to keep the pen or sell it for a cash amount—between $0.25 and $10.00.  Those selected as buyers were asked to decide if they wanted the pen or a cash amount in the same range. 

Before the experiment began, some of the undergraduates were asked to imagine a past relationship when they felt unloved and write down their feelings related to it.  The others were requested to write about an average day.

Students sellers who contemplated rejection valued their pens more than those who did not.  The authors concluded, "After a social self-threat, individuals likely have strong possession-self links because possessions can enhance the self and help individuals cope with the threat."

Dommer and Swaminathan did not discard loss-aversion as a reason for the endowment effect, but they did suggest that their ownership hypothesis is another explanation. Indeed, the emotion behind financial decisions is complicated! 

Articles

"If it's mine, it's worth more; if it's yours; it's worth less." This is called the Endowment Effect - irrational thinking that plays a part in our daily decisions.

The Endowment Effect: The Role of Loss-Aversion and Ownership in Making Financial Decisions

The most important task we perform in life is decision making. In no area could this be more apparent than in the area of financial decisions. Financial decisions not only affect us daily, but also have long-lasting effects on retirement. 

, the study of the biological foundation of economic thought. This discipline, in conjunction with behavioral economics, is shedding light on this murky area. Behavioral Economics is the incorporation of insights from psychology and other social sciences into the study of monetary behavior.

For example, the brain’s pleasure center (

) is stimulated in accordance with our partiality for an item. This can be measured using Functional Magnetic Resonance Imaging (FMRI), because neurons in the active parts of the brain require more oxygen.

If we desire chocolate cake and it is presented to us, our pleasure center lights up.  As the cake is consumed, however, the level of activity in the pleasure center quiets.  The same presentation of the chocolate cake no longer stimulates it.

But, if you are buying the piece of cake on another occasion, rather than simply being offered it for free from a trusted source, this scenario takes on new complexity.  Then, if the price is high, your brain’s price sensor (

), from deep within your brain, is activated. It can suppress the excitement of the pleasure center.  This may result in you declining the cake because you judge the price to be too high.  It is the executive brain (

) located near its surface that is the arbitrator of these dueling forces, the pleasure center (nucleus accumbens) and price concerns (the insula).

Likewise, if you have reason to think the cake is tainted with any unpleasing substance, your fear center (

) is activated. This stimulation acts like price concerns and squelches your desire to eat the cake. Again, it is the executive brain that is the mediator. 

Though brain interactions are much more complex than described, or even understood at this point, we now have a way to think about them that is more concrete than previously, one that enables us to visualize the process. For some people, imaging these brain interactions when they make decisions, including financial, help lead them to better selections. 

Next month, I will address the Endowment Effect. This is a bias in our thinking by which we value something we already own more than an equivalent item we do not own.  It influences us frequently. Now, Neuroeconomic studies tell us why. 

Shirley Mueller, MD is a physician turned financial consultant and investment educator who specializes in guiding clients, both one-on-one and in groups, about how to effectively self-invest using a simple and effective three-step approach.

Neuroeconomics help us understand why we make the financial decisions that we make.