In the last article, we discussed the loss aversion bias that impacts our trading decisions. In this article, we’ll explore another bias known as the endowment effect and its impact on trading, along with ways to reduce its effects. endowment effect in trading is similar to loss aversion. you’ll will learn why in this article.
What is Endowment Effect?
The endowment effect is a cognitive bias that occurs when individuals assign a higher value to items they own compared to identical items they don’t own. In the context of trading, this means that traders tend to overvalue assets they already possess and are reluctant to part with them, even when presented with opportunities to maximize profits.
In other words, people place a higher value on items they own compared to identical items they don’t own.
Research about Endowment Effect
The researchers recruited a group of students from an advanced economics class, specifically targeting individuals with high intellectual capacity, to conduct their studies.
The participants were divided into two groups, with one group receiving mugs while the other group did not receive any items.
The mugs being used in the study were regular items sold at a school supply store and did not possess any distinctive features.
The group that received the mugs was asked about the minimum amount they would be willing to accept in exchange for the mugs, while the group that did not receive any mugs was asked about the maximum amount they would be willing to pay for the mugs.
There was a significant disparity between the individuals who owned the mugs and their willingness to sell them for approximately $6, while those who did not own the mugs were willing to pay around $2.5, resulting in a price difference of approximately twofold.
Therefore, the researchers suggested that the observed price difference could be attributed to humans’ inherent bargaining tendencies.
When individuals intend to sell something, they tend to set higher prices as a starting point, anticipating negotiation and potential price reductions. Conversely, when individuals aim to purchase something, they tend to begin with lower prices, expecting negotiation and the possibility of increasing the price.
Consequently, the researchers proposed the introduction of a market where participants could engage in buying and selling transactions with one another. They believed that by establishing an open market, the bargaining tendencies would be eliminated, allowing the true and actual prices to emerge.
Upon the introduction of this market, they discovered that buyers were now inclined to purchase the mug at $2.75, while sellers were setting their price at $5.25. Despite the influence of bargaining tendencies, the price discrepancy for the same mug remained roughly twice as large.
Essentially, this indicated that individuals who possessed the mug were willing to sell it at a price twice as high as those who did not own one.
To uncover the underlying reason behind this phenomenon, they implemented an additional technique.
We have buyers without the mug, sellers who possess the mug, and a third group introduced into the equation. They conducted a similar experiment in another class, but this time they included a group of choosers.
Their approach involved systematically going through each price increment, such as $1, and posing the question to buyers whether they were willing to purchase the mug at that price.
If the buyers agreed, it was recorded. Similarly, they asked sellers if they were willing to sell the mug for $1 and marked the response.
The choosers, on the other hand, were presented with the option of either acquiring the mug or receiving the equivalent amount of money.
Subsequently, they proceeded to the next price point, $2, and repeated the entire process. This iterative approach was continued for every subsequent price point.
Their findings revealed that buyers who did not possess the mug were willing to pay an average maximum amount of $3, and they were reluctant to purchase the mug at a higher price. On the other hand, sellers who owned the mug expressed their willingness to sell it within the price range of $5 to $6.
Considering their circumstances, we would anticipate the choosers to behave similarly to the sellers. This is because both the choosers and sellers have the option to choose between the mug or money. On the other hand, buyers can only purchase the mug, while sellers have the ability to exchange the mug for money at any given time.
The choosers, however, possess the flexibility to select between receiving the money or acquiring the mug at any point in time.
Contrary to expectations, the choosers ended up making choices similar to the buyers, despite being in a situation comparable to the sellers.
While the choosers opted for the mug at $1 and $2, they switched to choosing cash when the price reached $3.
The puzzling aspect is why the choosers were willing to accept the money at $3, which aligns with the maximum amount the buyers were willing to pay to purchase the mug.
While The sellers only wanted to sell somewhere around 5 to 6 dollars. because they owned the mug.
The sole distinction among the sellers was that they possessed the mug, while the others did not.
Hence, despite being in a similar situation as the sellers, the choosers opted for $3 because they did not possess the mug, whereas the sellers owned it.
That was the experiment they conducted to prove that owning something versus not owning it indeed influences one’s behavior.
This phenomenon is known as the endowment effect, which illustrates that individuals tend to attribute greater value to something simply because they own it.
And the longer you own something the more you value it.
The point is that you actually value something more than it actually is.
In order to understand the underlying reasons behind the inflated valuation, they proceeded to conduct an additional experiment. They distributed surveys to both owners and non-owners of the mug, asking them to rate and provide reviews. Surprisingly, the owners rated the mug in the same manner as the non-owners did.
Hence, the sellers did not perceive the mug to be inherently better simply because they owned it.
This realization led researchers to understand that it is not solely the act of ownership that makes individuals perceive their possessions as better. Rather, it is the perception of the loss associated with giving up those possessions that is significantly magnified, surpassing its actual magnitude.
This observation aligns with the concept of loss aversion. and loss aversion is highly correlated with the endowment effect.
When individuals possess something, the pain associated with losing it outweighs the emotional satisfaction experienced when acquiring it.
This suggests that the primary effect of endowment is not to amplify the attractiveness of owned goods, but rather to intensify the distress associated with relinquishing them.
Here is the Research Papers if you want to read them yourself.
How Endowment Effect Affects Trading?
Holding onto Losing Positions: Traders may become emotionally attached to losing positions, refusing to sell them even when the market indicates further downside potential. This reluctance to let go stems from the perceived loss aversion associated with selling at a lower price than the purchase price.
Overvaluing Current Holdings: Traders may overestimate the value of assets they own, leading them to set unrealistic price targets or resist taking profits at opportune moments. This can result in missed opportunities for capitalizing on market movements.
Resistance to Diversification: The endowment effect may cause traders to favor maintaining their existing portfolio allocations, even in the face of evidence suggesting the benefits of diversification. This reluctance to adjust holdings can hinder portfolio optimization and risk management efforts.
The endowment effect has a big influence on trading, as it becomes particularly pronounced when individuals enter a position and become instantaneously endowed with a bias that causes them to overvalue their holdings.
The endowment effect leads you to perceive something as being more valuable simply because you own it, not necessarily because it enhances its appeal. This valuation stems from the fear of losing or not having the item rather than any inherent qualities of the item itself.
When you purchase a stock, you become endowed with it, and the fear of potential regrets and emotional pain associated with selling it at the wrong time may prevent you from letting go. This fear stems from the possibility of the stock’s price continuing to rise after you have sold it, leading to a sense of regret. Consequently, you may choose to hold onto the stock to avoid experiencing those negative emotions. which is extremely bad for your risk management.
What you need to understand is that once you purchase a stock, this bias will naturally come into play since humans are prone to it. This is precisely why it is crucial to have a trading plan in place to prevent this bias from influencing your decision-making process.
Once you are in a position you can’t trust yourself to make decisions.
Overcoming the Endowment Effect
Adopt a Rational Mindset: Recognize that emotions can cloud judgment and lead to biased decision-making. Strive to approach trading decisions objectively, focusing on data-driven analysis rather than emotional attachment to assets.
Set Clear Trading Rules: Establish predefined criteria for entering and exiting trades, including profit targets and stop-loss levels. By adhering to a systematic trading plan, traders can minimize the influence of emotional biases such as the endowment effect.
Embrace Flexibility: Remain open to adjusting trading strategies and portfolio allocations based on evolving market conditions. Avoid becoming overly attached to specific assets or positions, as this can impede adaptability and hinder performance.
Practice Detachment: Cultivate a mindset of detachment from individual trades or investments. Remember that trading is a probabilistic endeavor, and each trade is just one of many within a broader portfolio strategy.
Seek Feedback and Accountability: Engage with peers or mentors to gain external perspectives on trading decisions and challenge ingrained biases. Accountability mechanisms, such as journaling trades and reviewing performance metrics, can help identify and address instances of the endowment effect.
Similar to other biases a straightforward method to avoid endowment effect is by implementing a proper Trading Plan and always following it. We will delve into the details of Trading Plans in future discussions.
Conclusion
The endowment effect, a cognitive bias where individuals overvalue items they own, significantly impacts trading behavior. Traders may become emotionally attached to losing positions, overvalue their holdings, and resist diversification due to this bias. However, awareness and understanding can help reduce its impact.
By adopting a rational mindset, setting clear trading rules, being flexible, practicing detachment, and seeking feedback, traders can overcome the challenges posed by the endowment effect. Implementing a structured Trading Plan is essential for minimizing its influence and improving trading results.