The Endowment Effect
The endowment effect is another important psychological barrier that helps people from realizing the full potential value of their investments. Like other cognitive biases, it obscures the thinking of the investor and gets them to make decisions, which can be described as suboptimal, to say the least. In this article, we will have a look at what the endowment effect is and how it can impact the portfolio of an investor.
What is the Endowment Effect?
The endowment effect is a cognitive bias that skews the investors perception of the valuation of an object depending upon whether they own it or not. Let us understand this with the help of an example. In one of the studies related to the endowment effect, people were given the same coffee mug and were asked to decide its value. There were two sets of people, one had to value the coffee mug as the buyer, whereas the other had to value the coffee mug as the seller. At the end of the study, it was found that the average price of the group of sellers was close to $7, whereas the average price of the group of buyers for the same object was close to $3! This was a huge variation considering the fact that the underlying object was the same.
In behavioral finance, this phenomenon is called the endowment effect. This means that when a person owns stock or an investment, they often become emotionally engaged with the object. This is the reason that they place an excessively higher value on the stock. As a result, their worldview of the market becomes skewed and biased. Since they are not able to value the stocks objectively, they are not able to devise trading strategies objectively either.
How the Endowment Effect Affects Investment Decisions?
The endowment effect impacts the investment decision in a wide variety of ways. Some of these impacts have been listed below:
How Can Investors Manage the Endowment Effect?
Now, since we know that the endowment effect can wreak havoc on a portfolio, it is important to learn how to manage it.
To sum it up, the endowment effect is a significant bias that skews the mind-set of the investors. The ability to avoid the endowment effect can be the difference between failure and success.
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