Have you ever noticed that the person selling a business always wants more that you think its worth? Ian de Lange of Seed Investment Consultants aptly describes a common ailment of business owners known as the endowment bias.
This is the theory that people place a higher value on an asset once their right to that asset has been established. In other words people, and more specifically, investors, place a higher value on an investment that they own relative to that same investment if they did not own it.
The term “endowment effect” was coined by Richard Thaler, now at the Graduate School of Business at the University of Chicago. An owner implicitly or explicitly demands a premium for an owned asset. For instance, in one well-known series of endowment effect experiments, researchers Kahneman, Knetsch and Thaler (1990) found that randomly assigned owners of a mug required significantly more money to part with their possession (around $7) than randomly assigned buyers were willing to pay to acquire it (around $3).
In a follow-up, there was a 3rd group known as Choosers. Choosers were not endowed with a mug. Instead at each of the prices that buyers and sellers considered, the Chooser was given the choice between receiving that amount of money or the mug. Choosers behaved MUCH closer to buyers than to sellers. This suggests that the endowment effect does not stem from buyers, but from sellers over-valuing the goods once they own it.
This bias is also referred to as the status quo bias. This bias is very evident in an owner of a business, looking to sell. Having built up emotional attachment to the business, and when it comes to selling, a business owner invariably has a higher notion of the value than the potential buyers. But in the cup test it’s evident that this bias goes even beyond the emotional attachment – it's instantaneous and even apparently felt by those who buy and sell for a living.
The bias is inconsistent with standard economic theory which says that a person’s willingness to pay for an asset should be equal to their willingness to accept compensation for that same asset.
The effect of this bias is seen in an investor’s approach to shares that have been inherited, received by way of share options or merely acquired at various prices. Even after taking into account the impact of switching costs and taxes etc, there is this natural bias to retain an asset in a portfolio. You may have practical examples of this type of bias in your own investment management.
Leave a comment