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The Endowment Effect – What It Is and How It Can Sabotage Your Budget

Have you ever been reluctant to let go of something you knew you didn’t need, just because you paid good money for it and don’t want to give it away for free? Do you ever find yourself cradling a prize or reward that, moments earlier, you wouldn’t have looked at twice – but now that it’s yours, you love it? There’s a name for this phenomenon: the endowment effect.

A term coined by Nobel Prize-winning economist Richard Thaler, the endowment effect is the hypothesis that people ascribe inflated value to items simply because they own them. It’s related to social psychology’s “mere ownership effect,” which states that people who own an object tend to value that object more highly than people who don’t own it. Sometimes called “divestiture aversion,” the endowment effect can have a powerful pull on your emotions and cloud your judgment when it comes to spending, saving, and how you approach your finances.

It’s also often exploited by marketers and companies to get you to spend more money.

Studies on the Endowment Effect

Thaler and his colleagues Daniel Kahneman and Jack Knetsch conducted a now-famous set of experiments that demonstrated the endowment effect at work. Using college students at Simon Fraser University, they designed an experiment in which they gave participants mugs purchased from the campus bookstore and then gave these participants the chance to “sell” the mug back to them. The participants were unwilling to sell their mugs for market value, and instead wanted over twice the original price of the mug in order to be willing to give it back. Even though the students were given the mugs for free as part of the study and hadn’t “owned” them for very long, they had ascribed a much higher value to them than was rational.

This wasn’t a case of the participants having long-term sentimentality for their favorite coffee mugs; the study authors concluded that the value we assign to an object we receive is almost instantaneous. The moment the students received the mug, they ascribed an inflated value to it.

Furthermore, when presented with the actual sticker price of the mug, these students still wanted more money than it was worth to part with it.

Many items lose value the moment you buy them, so this behavior doesn’t have a rational explanation. Still, companies often exploit it to get us to part with our hard-earned money and buy and keep things we don’t need – or sometimes even want.

The Endowment Effect in Action

Woman Trying On Gown In Fitting Room Store

Most of us operate in the real world and not in a college psychology study, but the endowment effect is everywhere, causing us to make irrational decisions that work against our best interests. However, by knowing what it is and how it affects our behavior, we can be more informed and logical in how we approach situations where it may influence our behavior and finances.

1. In Stores

Long before economists gave this phenomenon a name, companies understood that if they could make shoppers feel like they owned an item right there in the store, they were much more likely to purchase. Thus the advent of fitting rooms, where you can touch a fancy new dress, try it on, and visualize yourself wearing it to work, a party, or on a date.

Stores have long known that customers are much more likely to buy an item they’ve touched. The reason, according to a study in the Journal of Consumer Research, can be traced back to the endowment effect. If you physically handle an item, you start to feel like you own it. You can picture yourself with it in your life, and it starts to feel more like yours. You ascribe more value to it and might be willing to pay more because the item suddenly feels worth it.

If you’re in the market for some new living room furniture, for example, you may find yourself heading to IKEA or another furniture retailer with a big showroom full of vignettes that look like fully set-up living rooms and bedrooms. This arrangement lets you walk through and touch these items, sit on them, pull open drawers, and peek into cabinets. It also helps you picture a piece in a house – your house – rather than just seeing it as one of hundreds of tables on a concrete warehouse floor. By simulating ownership, stores can convince you an object is worth the price and that you need it.

Tons of companies now let you try something for 30, 60, or even 90 days, seemingly risk-free, with the option of returning the item if you don’t end up liking it. They’re banking on the fact that once you get that mattress, rug, or lamp into your house and set up with the rest of your stuff, you’re not going to return it. It’s already in your home and feels like yours, so in addition to not wanting the hassle of returning it, you now think it was worth the price, thanks to the endowment effect.

All of these strategies ensure that a shopper becomes emotionally attached to an item – often unconsciously – and is then willing to part with their money for it, even if it was initially outside their budget or they didn’t need or want the item to start with.

2. Subscription Services

Even if there’s no physical item, the endowment effect can still come into play. For example, say you sign up for a free trial of Spotify but have every intention of canceling your account once the trial period is over. Then, over the next month, you build playlists, get suggestions from the algorithm for new music, and customize your listening experience to your exact preferences. The app greets you every time you sign in, your account now feels like your own personalized radio station, and that $15 a month seems like a bargain rather than an unnecessary expense. Just a few months ago, you would have scoffed at paying for streaming music, but now that you’ve experienced it, personalized the service, and feel like you “own” it, you’re more than willing to add this expense to your monthly bills.

Think about how you watch movies and TV shows at home. If you’re like millions of Americans who have cut the cable cord, you probably have a subscription to a streaming service such as Hulu, Netflix, or HBO Go. There was a time when everyone watched only live television, whether it was with a cable box or simply using old-fashioned bunny ears. Now, we can all choose our favorite shows and movies, and these services learn how to predict our preferences. They can offer suggestions, remember where we were in an episode, and customize our viewing experiences in any number of ways.

By building this customization into their services, these companies make the consumer feel ownership of the product and ascribe an inflated value to it. Then, when the free trial ends, they want to keep “owning” the service and will pay more than they originally intended because they’ve endowed it with a greater value in their lives.

3. Free Trials

Perhaps you don’t have a cable account, and you think you would never pay for music. You’re perfectly happy listening to the radio and checking out DVDs from the library or borrowing them from friends. If you ever sign up for a free trial period, you’re diligent about canceling it before the trial is up and it converts to a paid account.

But then you notice that your iPhone memory is almost full and you won’t be able to take any more pictures or videos soon. It seems like an annoying problem to have to solve; how do you know which cloud backup service is the best one, and how will you figure out how to set it up? You’ve been using the free 5GB of iCloud storage that came with your phone, and it’s fine, so you go ahead and sign up for a paid iCloud account. You’re already familiar with the interface and like the free version well enough, so you figure it’s probably worth it to pay for the next level of service. Getting customers to pay for the next tier of something they’ve come to enjoy for free is how many companies bank on your submission to the endowment effect.

4. Irrational Money Choices

The reluctance to sell something – whether it’s a physical item or something intangible like stocks and bonds that you’ve purchased through Ally Invest – is also a function of the endowment effect. Humans are incredibly loss-averse creatures. Studies have shown that the pain of losing something can be twice as powerful as the joy of gaining something, and this loss aversion can cloud our judgment when it comes to many things, including the stock market.

If you ascribe a higher value to stocks you own, it can cause you to be reluctant to sell them for less than you perceive them to be worth. However, any good investor knows that stocks are only worth as much as someone is willing to pay for them on the market, so it doesn’t matter what price you feel they should fetch. If no one will pay that amount, that doesn’t mean you should hold onto them forever because you think they should be worth more.

You might also recognize this feeling if you’ve ever tried to sell a used car, boat, or other big-ticket item and were insulted if people tried to bargain for a lower price. We often believe that whatever we’re selling is valuable, and the amount we’re asking is a great deal; potential buyers who don’t see it this way are just trying to lowball us. In reality, any item is only worth what someone else will pay for it, and by inflating its value, we’re only setting ourselves up to be annoyed and disappointed.

5. Complacency

The endowment effect extends beyond goods and services that you buy and sell. It can also influence your behaviors, including encouraging complacency or inaction.

For example, almost half of the people in the United States who have gym memberships don’t use them. People like the idea of belonging to a gym and knowing they could workout whenever they want, but they don’t actually go to the gym enough to get their money’s worth from that monthly fee. Most know they could workout without a gym, but they think that paying for a membership is a worthy expense related to good health. Instead of being rational and realizing that not using the gym enough is a waste of money, we think the service is worth the money and are complacent about canceling it.

How to Combat the Endowment Effect

Thinking Clothes Closet Endowment Effect

At this point, you might be feeling like the deck is stacked against you and there’s nothing you can do. There’s no use trying to fight human nature, right? Don’t despair; there are steps you can take to conquer your instincts, and one of the easiest ones is simply to be aware of how your brain and its emotional triggers can influence your actions.

First, consider the usefulness of the item you’re thinking of buying or trying to sell. Keep in mind that as a general rule, 20% of the items we own give us 80% of the utility of all our possessions. This concept, called the Pareto Principle, is most often applied to business productivity, but it’s a useful tool when considering the stuff and services you spend your money on. Will the item you’re considering be – or is it already – useful, or is it just another thing taking up space that needs to be stored, cleaned, and cared for?

If you’re headed to a store to buy some new duds or get a deal on a sofa or TV, be mindful of what you touch and try on. It can be tempting to run your fingers over everything, but retailers know that if consumers touch items and try them out, they’re much more likely to buy them, and at a higher price.

If you’re trying to downsize, cut costs, or sell some items, ask yourself how much you would pay for these things if you didn’t already own them. Do a little research to see what similar items are selling for elsewhere. Take a hard look at that cute sweater that doesn’t fit or lawnmower you’re trying to unload and ask yourself if you’d pay your own asking price if you didn’t already own it. Be rational about the answer, and you’re more likely to let go of whatever it is for a fair price and happily send it off to its new home.

If you want to test your mettle, try putting the item in a closet you don’t use, in the basement, or somewhere else where you won’t see it and be reminded of its existence. Set a calendar reminder for a few weeks in the future and see if the item is even still in your memory. If not, get rid of it for whatever the going rate is and get it out of your life.

Finally, when it comes to stocks, bonds, and mutual funds, think about your investments as employees. Their job is to make you money. Forget what you bought them for and don’t think about how the price you paid made you feel (whether it was a great deal or a bad one); only focus on whether or not they’re still profitable. An investment is not a cherished pet or priceless family heirloom; it’s an employee who has to earn its keep or be released.

Final Word

The endowment effect and our aversion to loss aren’t always bad things. They help us maintain our home and possessions, weather long-term relationships through ups and downs, and instill in us a sense of pride in our stuff. As long as we’re careful, informed consumers who approach transactions armed with knowledge and a firm grasp of our budget parameters, we can make smart decisions.

Have you ever walked into a store to buy one specific item, only to walk out hundreds of dollars poorer? Have you ever held on to a possession or investment for too long because you felt it was more valuable than its going rate?

A grant writer and personal finance fanatic, Marisa is an avid traveler who lives in Pittsburgh, PA. When she’s not reading or writing for work or play, she enjoys running, thrifting, and searching for the most authentic Mexican food in the city.