Two weeks ago, I wrote about the pitfalls of the sunk cost fallacy. Last week I alerted you to the bias of loss aversion. Since I mentioned the endowment effect last week, I thought it’d be good to cover it sooner rather than later, so this week, we’ll look at the endowment effect.
The endowment effect can be tricky in that if it’s not described in the right way, it’s likely to be misinterpreted. In short, it means that people want more money for something than they’d be willing to pay for it. Put differently: we overvalue that which we own. You could think of a simple example of this through the course of a negotiation. When negotiation with someone, we’ll probably overvalue what we bring to the table. Someone may offer you $50 for your 25-year old keyboard (piano), but you think it’s worth at least $75. Barring any outside appraisal, the endowment effect is likely at play here.
Now here’s where it might get a little confusing, so bear with me: one of the possible explanations for the endowment effect is that humans are loss-averse. Remember loss aversion from last week? The idea that we’d rather avoid losses than reap rewards. If we apply this knowledge to our example above, let’s say that the piano is actually worth $35, but you want $75, and you’re being offered $50. Because humans are loss-averse, it’s causing you to suffer from the endowment effect, which is causing you to overestimate the value of the piano. As a result, you’re forgoing a $15 gain, given the current value of the piano and the price you’re being offered.
Let’s look at another example, this time, from sports. Often times, general managers have their eye on certain players. They believe this player is going to fill the void that their team has and if they could only sign that one player, all of their troubles would be solved. Throughout the courtship of said player, the general manager is already imagining that the player is part of their team. In so doing, this general manager is likely to end up overpaying for the player. Why? Because of the endowment effect. The general manager feels that the player they’re about to acquire is already theirs and so not acquiring the player would be like losing the player. And because they already imagine the player to be on their team, they’re going to overvalue the player as a result of the endowment effect.
Though this example comes from sports, we can see the skeleton of it and apply it to just about any situation where someone “wants” something and has already imagined it as their own.
Before we get into some ways of avoiding the endowment effect, I want to make sure that I convey the point that the endowment effect applies to more than just things. Another way of looking at it is your customers (if you own a business). It’s never easy to fire a customer, but we’ve learned — sometimes — it must be done. As you might imagine, it can be quite hard to fire a customer because — among other reasons — we tend to overvalue that customer.
Ways for Avoiding the Endowment Effect
1) Am I emotional?
A seemingly obvious way to avoid the endowment effect is assessing whether our emotions are involved. Don’t get me wrong, emotions are a good thing, but they are a surefire way to overvaluing things that you own. That is, if you find yourself overly connected to something, your emotions might be getting in the way.
2) Independent Evaluation
This dovetails nicely with the idea of being unemotional. To guard against succumbing to the endowment effect, be sure to have an independent appraisal of whatever it is that you’re looking to sell of yours. While you’ll still have the final say on what you sell and how much you sell it for, having a second pair of eyes look at your side of the “deal” might help you determine if you’re judgment’s clouded.
I wasn’t going to include this initially, but after reading the research, it certainly fits. Before I go on, I should say that folks might be confused in that I just suggested asking whether one is emotional and now I’m saying to practice empathy? For those wondering, being emotional is not the same thing as being empathetic. Back to empathy and the endowment effect. In situations where we’re selling something, researchers found there to be an empathy deficit when the endowment effect was present. So, to counter this, you should try to empathize with whom you’re negotiating.