Divestiture Aversion, in behavioral finance also referred to as the endowment effect, is a behavioral bias that relates to the ownership of things. The main idea is that people tend to assign a higher value to things they own, compared to things they don’t own yet. In the case of investors, the endowment effect explains why they tend to hold on too investments too long.
On this page, we discuss what is the endowment effect in economics, discuss some examples of divestiture aversion that are based on actual experiments, and discuss some of the criticisms.
Endowment effect definition
What is the endowment effect? The endowment effect states that people’s willingness to accept greatly exceeds their willingness to pay. In other words, people irrationally overvalue items they own, compared to items’ ‘objective’ value.
Endowment effect example
One of the most famous examples of divestiture aversion refers to an experiment performed by the Nobel Prize winner Richard Thaler. This experiment was part of a publication called “Experimental tests of the endowment effect and the coase theorem”, which Thaler wrote together with Knetsch and Kahneman in 1990.
In the endowment effect experiment, a group of students received a coffee mug. Then, they were asked the price at which they were willing to buy the mug to other students. These students we refer to as the “Sellers”. Then there where the “Choosers”. These students did not have a coffee mug, but they were asked how much they were willing to pay for them.
The results were as follows. The Sellers were willing to sell the mug for $7,12. The Choosers were willing to pay on $3,12. Thus, the same coffee mug was valued more highly by the students who already owned them, compared to the students that had to buy them.
In finance, divestiture aversion can also be at play. In particular, it may be one of the reasons why people exhibit loss aversion and the disposition effect. They may be unwilling to sell stocks at a loss simply because they value the stocks higher than the current market price and thus are unwilling to sell. To give an example, suppose someone owns stock which he bought at $25. Having bought them, the endowment effect kicks in and he doesn’t want to sell them for less than $27. Next, the share price drops to $23. To the investor, the shares have not declined by just $2. No, instead he has the feeling they are undervalued by $4 and he is not will to sell them at such a high discount to someone else.
We discussed divestiture aversion. The effect is was first described by Thaler in 1990 and was illustrated using experiments with coffee mugs. The result of this bias is that mere ownership of an item makes people less willing to sell it again.