20
Emotional Bias #5: Endowment Bias

A wise man should have money in his head, but not in his heart.

Jonathan Swift

Bias Description

Bias Name: Endowment bias

Bias Type: Emotional

General Description

People who exhibit endowment bias value an asset more when they hold property rights to it than when they don't. Endowment bias is inconsistent with standard economic theory, which asserts that a person's willingness to pay for a good or an object should always equal the person's willingness to accept dispossession of the good or the object, when the dispossession is quantified in the form of compensation. Psychologists have found, however, that the minimum selling prices that people state tend to exceed the maximum purchase prices that they are willing to pay for the same good. Effectively, then, ownership of an asset instantaneously “endows” the asset with some added value. Endowment bias can affect attitudes toward items owned over long periods of time or can crop up immediately as the item is acquired.

Example of Endowment Bias

Investors prove resistant to change once they become endowed with (take ownership of) securities. We will examine endowment bias as it relates to inherited securities.

William Samuelson and Richard Zeckhauser1 performed an enlightening study on endowment bias that aptly illustrates investor susceptibility to this bias. Samuelson and Zeckhauser conducted an experiment in which investors were told to imagine that they had to newly acquire one of four investment options:

  1. A moderately risky stock
  2. A riskier stock
  3. A Treasury security
  4. A municipal security

Another group of investors was given the same list of options. However, they were instructed to imagine that they had already inherited one specified item on the list. If desired, the investors were told, they could cede their hypothetical inheritance in favor of a different option and could do so without penalty. In every case, however, the investors in the second group showed a tendency to retain whatever was “inherited.” This is a classic case of endowment bias. Some investors are reluctant to sell securities bequeathed by previous generations. Often, in these situations, investors cite feelings of disloyalty associated with the prospect of selling inherited securities, general uncertainty in determining “the right thing to do,” and tax issues.

Implications for Investors

There are some practical explanations as to why investors are susceptible to endowment bias. Understanding the origins of endowment bias can help to provide intuition that guards against the mistakes that the bias can cause. First, investors may hold onto securities that they already own in order to avoid the tax costs associated with unloading securities. Make sure you don't “let the tax tail wag the investment dog.” Such a rationale can be hazardous to one's wealth, because failure to take action and sell off certain assets can sometimes invite otherwise avoidable losses, while forcing investors to forgo the purchase of potentially more profitable, alternative assets. Second, investors hold onto securities because of familiarity. If investors know from experience the characteristics of the instruments that they already own (the behavior of particular government bonds, for example), then they may feel reluctant to transition into instruments that seem relatively unknown. Familiarity, effectively, has value. This value adds to the actual, market value of a security that an investor possesses, causing WTA to exceed WTP.

Box 20.1 contains a summary of investment mistakes that arise from endowment bias.

Am I Subject to Endowment Bias?

The following is a brief diagnostic test that can help to detect endowment bias.

Endowment Bias Test

Question 1: Assume that your dearly departed Aunt Sally has bequeathed to you 100 shares of Netflix. Your financial advisor tells you that you are too “tech heavy” and recommends that you sell Aunt Sally's shares. What is your most likely course of action?

  1. I will likely hold the Netflix shares because Aunt Sally bequeathed them to me.
  2. I will likely listen to my financial advisor and sell the shares.

Question 2: Assume that you have purchased a high-quality municipal bond for your portfolio. It has been providing income for you, and you are happy with it. Your financial advisor analyzes your bond holdings and recommends switching to a corporate bond, of comparable quality, with which you are unfamiliar. Your advisor explains that, after taxes and fees, the corporate bond can be expected to provide a slightly better return than your current municipal bond. What is your most likely response?

  1. I will stick with the municipal bond because I am familiar with it.
  2. I will sell the municipal bond and purchase the corporate bond, even though I am unfamiliar with the corporate bond.

Test Results Analysis

Question 1: A reluctance to unload Aunt Sally's Netflix shares can signal susceptibility to endowment bias.

Question 2: People who decide that they would probably hold on to the municipal bond, due to familiarity with it, are likelier to exhibit endowment bias than people who would be willing to reallocate, even into unfamiliar territory, at a financial advisor's request.

Investment Advice

Generally, endowment bias tends to impact investors in two main contexts: (1) inherited securities, and (2) desire for familiarity.

Inherited securities. In the case of an inherited security, for example, you might ask: “If you had received, as cash, the current value of this security, what portion of that inheritance would you allocate into this specific security?” Often, the answer is none or very little. It can also be useful to explore the deceased's intent in owning the security. “Do you think that Uncle John's primary intent was to leave you this specific number of shares of this specific security? Is it possible that he was concerned about your general financial security?” Again, investors usually affirm the latter conclusion, paving the way to a more sensible allocation. If the investor does believe that his or her deceased relative valued, specifically, the opportunity to bequeath holdings in this exact security, then you might need to try a different line of questioning: “Okay, Uncle John wanted you to have these shares. But, if he really didn't want you to sell them, then … what did he want you to do with them?” Keeping in mind your long-term goals is essential in this situation.

Desire for familiarity. Familiarity can be a difficult craving to overcome. Comfort is crucial to an investor, and it may not be wise to take a portfolio in any direction with which you might be significantly uncomfortable. The best way to address an investor's desire for familiarity is to review the historical performance of the unfamiliar securities. This way, you can develop familiarity with the new investment instrument and achieve a corresponding comfort level.

Note

  1. 1   William Samuelson and Richard J. Zeckhauser, “Status Quo Bias in Decision Making,” Journal of Risk and Uncertainty 1(1) (1988): 7–59.
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