The endowment effect and IKEA effect

What's mine is more valuable

The endowment effect (close cousin of the IKEA effect)

In this post, you’ll learn why you place extra value on things you already own. And how marketers, retailers, and employers use that behavioral trait to entice you into action (or inaction). From your willingness (or unwillingness) to pay market price, to the value of a chocolate bar that is already in your hand; the endowment effect examples trickle all the way into your investment portfolio.

  1. The endowment effect
  2. Clever marketing
  3. The IKEA effect
  4. Staff incentive schemes
  5. Self-control and bonuses
  6. Your investment portfolio
  7. Be smart!

The endowment effect

The endowment effect states that you value something more because you own it. This is well-explained by the classic mug experiment

Participants in the study were randomly divided into two groups. In the first group, each participant was given a mug and asked what the minimum price would be for them to be willing to sell that mug. In the second group, the participants were given nothing but were asked what the maximum price would be for them to be willing to pay to buy the mug.

Standard economics would predict that those two prices would be the same. But they weren’t.

The minimum selling price was higher than the maximum buying price. Participants who were given a mug expected a higher price to give up the mug, than the price that other participants were willing to pay to purchase the mug. This shows that people will pay more to retain something they own than to obtain something owned by someone else. 

The endowment effect

The endowment effect states that you value something more because you own it. This is well-explained by the classic mug experiment

Participants in the study were randomly divided into two groups. In the first group, each participant was given a mug and asked what the minimum price would be for them to be willing to sell that mug. In the second group, the participants were given nothing but were asked what the maximum price would be for them to be willing to pay to buy the mug.

Standard economics would predict that those two prices would be the same. But they weren’t.

The minimum selling price was higher than the maximum buying price. Participants who were given a mug expected a higher price to give up the mug, than the price that other participants were willing to pay to purchase the mug. This shows that people will pay more to retain something they own than to obtain something owned by someone else. 

The endowment effect

This happened even when there was no cause for attachment to the mug and it was only given to them a few moments before they set their price. What we can learn about this is that once you have something, foregoing it feels like a loss (and we are all loss averse).

This is also why we are better at collecting things than throwing things away.

Clever marketing

Now, what might a wise marketer do with this knowledge? Perhaps tell you to try the products out for a bit before paying? How many mobile apps say you’ll get 30 days free use and only billed thereafter? You think, “great, let me use this for 30 days and then I’ll cancel”. But… once you’ve started using it, you build an attachment and cancelling it feels like a loss. Marketers are so clever.

The IKEA effect

IKEA effect

If you’re beginning to understand the motivation for the endowment effect, you’ll probably understand why it’s sometimes referred to as the IKEA effect. What happens when you visit IKEA? You like the design of a piece of furniture. You purchase a box of parts and directions on how to piece them together. You’re “building” your own desk. What happens next is that you place a higher value on it than anyone else would (even if the desk isn’t perfectly level). That’s the IKEA effect.

So, possession of an item is one thing. Now we add the fact that you are actually building it yourself! Explains why owner-built properties in the real estate market tend to be overpriced…

If you’re beginning to understand the motivation for the endowment effect, you’ll probably understand why it’s sometimes referred to as the IKEA effect. What happens when you visit IKEA? You like the design of a piece of furniture. You purchase a box of parts and directions on how to piece them together. You’re “building” your own desk. What happens next is that you place a higher value on it than anyone else would (even if the desk isn’t perfectly level). That’s the IKEA effect.

IKEA effect

So, possession of an item is one thing. Now we add the fact that you are actually building it yourself! Explains why owner-built properties in the real estate market tend to be overpriced…

Staff incentive schemes

Another example of how the endowment effect is used is with staff incentive schemes. This was tested on a group of teachers.

All teachers were incentivised to meet certain performance targets. However, the payout of the bonuses was done differently for different groups.

In one group, teachers received the bonus at the end of the year (if they met the targets). In another group, teachers received 50% of the bonus at the beginning of the year and the other 50% at the end of the year. However, if they didn’t meet the targets, they needed to pay back the 50% that they got at the start of the year.

Any guesses as to which group performed better?

By a significant margin, the group of teachers that would have to pay back part of the bonus outperformed the other group. They were up against the feeling of losing the 50% bonus they had already received.

This is a textbook example of how share options and retention schemes work. Pay you at the start of the term. That way, they can almost be assured you won’t leave until that term comes to an end.

The endowment effect

Another example of how the endowment effect is used is with staff incentive schemes. This was tested on a group of teachers.

All teachers were incentivised to meet certain performance targets. However, the payout of the bonuses was done differently for different groups.

In one group, teachers received the bonus at the end of the year (if they met the targets). In another group, teachers received 50% of the bonus at the beginning of the year and the other 50% at the end of the year. However, if they didn’t meet the targets, they needed to pay back the 50% that they got at the start of the year.

Any guesses as to which group performed better?

The endowment effect

By a significant margin, the group of teachers that would have to pay back part of the bonus outperformed the other group. They were up against the feeling of losing the 50% bonus they had already received.

This is a textbook example of how share options and retention schemes work. Pay you at the start of the term. That way, they can almost be assured you won’t leave until that term comes to an end.

Self-control and bonuses

Similar to how I said, “marketers are so clever”, I’m tempted to say “HR is clever”, but I can do better than that: “You are clever”. But there’s one proviso… you’ve got to have self-control.

Because you know you’re psychologically wired to value something once you own it, why not turn this on its head? Any payouts you receive that still have clauses attached to them (retention payments, performance payouts, etc.) – invest the money!

The endowment effect

This might sound bizarre, as we all want to spend payouts, but consider for a moment that you haven’t technically earned that money yet.

You haven’t worked the x number of days or met the target. If you invest these payouts rather than spend them, it also gives you the freedom to change your mind if you decide you want to move companies. And that then removes the anxiety of losing something.

By definition, a bonus is a “reward”, usually for good performance. Why not make the bonus payment feel like that? Too often we ‘bank’ on that bonus and spend it before we receive it. There’s a risk here, in that you can’t always be certain you’ll receive a bonus. But even if you do, imagine the joy of receiving a payout and then rewarding yourself, rather than paying off something you couldn’t wait for? Just an idea…

Similar to how I said, “marketers are so clever”, I’m tempted to say “HR is clever”, but I can do better than that: “You are clever”. But there’s one proviso… you’ve got to have self-control.

Because you know you’re psychologically wired to value something once you own it, why not turn this on its head? Any payouts you receive that still have clauses attached to them (retention payments, performance payouts, etc.) – invest the money!

This might sound bizarre, as we all want to spend payouts, but consider for a moment that you haven’t technically earned that money yet.

You haven’t worked the x number of days or met the target. If you invest these payouts rather than spend them, it also gives you the freedom to change your mind if you decide you want to move companies. And that then removes the anxiety of losing something.

By definition, a bonus is a “reward”, usually for good performance. Why not make the bonus payment feel like that? Too often we ‘bank’ on that bonus and spend it before we receive it. There’s a risk here, in that you can’t always be certain you’ll receive a bonus. But even if you do, imagine the joy of receiving a payout and then rewarding yourself, rather than paying off something you couldn’t wait for? Just an idea…

The endowment effect

Your investment portfolio

If we over value things – merely because we own them (the mere ownership effect) – that implies that we will overvalue our investments. In turn, making it difficult for us to sell them at market value. 

Adding the IKEA effect to this, imagine the impact of building your own portfolio? All the time and effort you put into researching different shares and investment vehicles. Doesn’t matter how dodgy the result, you’re attached.

Also, research tells us that the more effort you put into something, the more you value the outcome (a behaviour known as effort justification). So, if you’re inclined to do lots of research before buying something, you get hit with the endowment effect and effort justification (doubly screwed).

Your efforts aren’t unjustified. Our susceptibility to confirmation bias implies that we need to do a bit of research before executing a purchase decision. But what you need to be careful of is how you then perceive that investment after you’ve bought it. Stay open-minded.

The IKEA effect

If we over value things – merely because we own them (the mere ownership effect) – that implies that we will overvalue our investments. In turn, making it difficult for us to sell them at market value. 

Adding the IKEA effect to this, imagine the impact of building your own portfolio? All the time and effort you put into researching different shares and investment vehicles. Doesn’t matter how dodgy the result, you’re attached.

Also, research tells us that the more effort you put into something, the more you value the outcome (a behaviour known as effort justification). So, if you’re inclined to do lots of research before buying something, you get hit with the endowment effect and effort justification (doubly screwed).

Your efforts aren’t unjustified. Our susceptibility to confirmation bias implies that we need to do a bit of research before executing a purchase decision. But what you need to be careful of is how you then perceive that investment after you’ve bought it. Stay open-minded.

The IKEA effect

Be smart!

At the very least, be mindful of the endowment effect. It’s great that we can buy something and try it out with the option of returning for a full refund if we’re not happy. But don’t entertain this type of consumer behaviour. Beware behavioral economics. You now KNOW that you’re less likely to give things up once you have them in your possession.

Be mindful of overvaluing your investments simply because of the vast amount of effort you put into analysing them. Don’t miss future changes because you’re happy with your historical research efforts. Always acknowledge evidence that tries to disprove a decision.

The IKEA effect: When you build something yourself you value it way more than you should.

Norton, Mochon, Ariely

Building an IKEA desk is fine but equating its value to that of a craftsman is beyond biased. It’s the same senseless comparison when you try compare your IKEA investment portfolio to that of one put together by a professional.

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More in this series on behavioural biases

In case you missed it, see our previous posts in this series:
  • Heuristics and biases in decision making – This was the first post in the series which shares some behavioural economics research. Specifically, the heurstics and biases that influence our relationship with money. It uses System 1 and System 2 thinking examples from Daniel Kahneman’s New York Times best selling book, Thinking Fast and Slow, to help us be more conscious of the workings of our brain. 
  • Mirror, mirror, on the wall, stop telling me I’m wonderful – This post focuses on the impact of overconfidence bias in decision making. It introduces the illusion of knowledge bias and the illusion of control bias to illustrate the difference between confidence and carelessness. It also discusses the better than average effect, the self-serving bias and fundamental attribution error. You’ll learn how to confront some unpalatable truths and get out of any false sense of comfort (if you’re up for the challenge?).
  • Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussing confirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.
  • Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.
  • Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.
  • Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This posts looks at some examples of this anchoring effect.
  • The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.
  • Regret, it’s not a nice feeling – Regret influences the decisions we make and pushes us to conform to social norms. Examples of regret avoidance show us how this makes complete sense yet no sense at all.
  • When the past influences the futureThe Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.
Or if you want to jump ahead...
  • How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.

Have you held onto an investment for too long?

Do you have any examples of where you placed an unreasonably high value on something, just because you 'created' it?

Let us know in the comments below.

Challenged by your psychology?

Interested in removing the emotion from your investing decisions?

Have you held onto an investment for too long?

Do you have any examples of where you placed an unreasonably high value on something, just because you 'created' it?

Let us know in the comments below.

Challenged by your psychology?

Interested in removing the emotion from your investing decisions?

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About the Author

I am passionate about helping people understand their behaviour with money and gently nudging them to spend less and save more. I have several academic journal publications on investor behaviour, financial literacy and personal finance, and perfectly understand the biases that influence how we manage our money. This blog is where I break down those ideas and share my thinking. I’ll try to cover relevant topics that my readers bring to my attention. Please read, share, and comment. That’s how we spread knowledge and help both ourselves and others to become in control of our financial situations.

Dr Gizelle Willows



Dr Gizelle Willows

 

PhD and NRF-rating in Behavioural Finance