Common Financial Mistake : Endowment Effect
Holding on to what you have is a financial mistake which very few people understand and acknowledge. People generally tend to overvalue what belongs to them relative to the value they would place on the same possession or situation if it belonged to someone else. This is called the endowment effect.
For example, a person will think that his son is the most intelligent or his daughter is the most beautiful girl of all. This is a very common and widely prevalent example of the endowment effect.
Examples of Endowment Effect
1. You might have bought a flat screen television for Rs.15000. But, unfortunately you found another superior model in the market in next few days at the same price, and hence willing to sell this TV. Fortunately, your friend is willing to buy it from you. What price will you quote? For sure, Rs.15000. Now assume you are in your friend shoes and he is in your position. What price will you be willing to pay to buy the TV from your friend? For sure, less than Rs.15000
2. Once an investor buys a stock, he will be rating that stock at a higher value and unwilling to sell at a loss. They think their stocks are highly valuable
3. Most trial offers and money back guarantees are at work because once you have used the product for a few days and enjoy their benefits, you would like to keep it and not return back to the dealer.
4. How many products and things we stack at our lofts and wardrobes and unwilling to part away with it at a discounted price ask?
5. Would you be willing to sell your bicycle – 1 year old, for 30% discounted price, even if a newer bicycle of the same model sells at the same discounted price?
6. How many of you still have your old model mobile phones at home just because during the exchange offer your existing phone was asked for a steep discounted price?
One of the most costly and regrettable consequence of endowment effect is how people deal with their retirement planning. It is relatively easy to set aside small sums of money during one earning years so as to accumulate a large retirement corpus due to the power of compounding. But many people fail to follow this basic principle. The main reason for that can be traced back to the psychological behavior of endowment effect people overvalue what they have (today income) and fail to properly value what they could have (financially independent retired life).
How to Recognize Whether You are a Victim of Endowment Effect
When you see the following tendencies in yourself while saving, spending, investing or taking insurance, it is very likely that you are a victim of endowment effect:
You find it very difficult to save money.
You think money today is worth more than money tomorrow; you do not think of the future but always want to live and consume what you have in the present.
You believe that your investments, whether a house or a piece of art or anything else, is worth more than your neighbors.
You do not believe in retirement planning.
You are always on the lookout for “trial period” or “money back” offers.
You believe investments are too risky.
You can not determine the true value of your investments and always depends on others for it.
Steps to Rectify this Mistake
Always view all situations and investments with the same eye : whether it is your own or that of somebody else.
Be wary of trail period or money back offers because it is likely that the trail period might get converted into a permanent one.
Learn to do a fair assessment and determine a proper value for your assets. The value should be the same : whether you own it or your neighbor does.
Remember that retirement planning is one of the most important facets of financial planning and the gateway towards achieving financial independence. Go back to Commandment 1 : Thou shall Make a Proper Asset Allocation plan and put yourself on auto pilot.
Try to evaluate anything as objectively as possible – keeping emotions apart
Check for opportunity cost during investing – cost of holding a bleeding stock VS a good opportunity to buy a good business at a bargain price..