This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 14 February 2015.
Have you ever noticed a house for sale in your neighbourhood which seems to have been on the market forever? First one real estate agent sign appears, then another and another, and pretty soon the house looks like a primary school polling booth on election day. You can only imagine the conversations the real estate agents must be having with the sellers – ‘Yes, we know you want a million dollars, but you only paid five hundred thousand for it last year, perhaps you need to adjust your pricing a little bit?’. After about six months the agents lose interest, the advertising boards begin to fade and fray and still the sellers cling to their outlandish expectations. Usually the house eventually gets taken off the market for a year or so, until the same process is repeated again and again.
A key behavioural driver of this type of attitude in selling a home is known as the endowment effect. The theory is simple: people tend to assign greater value to something just because they own it. For example, in a famous study in 1990, researchers found that people who were given a free coffee mug demanded twice as much to sell it, as compared to what they thought it was worth before it was given to them. Though it was the same coffee mug, the simple act of ownership more than doubled the value that they assigned to the mug. You can see how this behavioural trait can be easily applied to the real estate market and of course to the stock market. Once an individual buys a house or share in a company, it immediately becomes more valuable in their eyes when compared to a potential buyer of the house or share. This can cause problems which go beyond a collection of old and faded real estate agent signs on the sidewalk. When dealing with shares, an investor who overvalues their shareholding is unlikely to ever sell, holding firm to the belief that their shares are worth more than the current market price. Such an approach can naturally lead to inappropriate decision making. There are times when it is best to sell your shares, rather than hold them all the way to the grave, but the endowment effect gets in the way of such rational decisions, often to your detriment.
One way to try and combat the damage caused by falling prey to the endowment effect is to ask yourself a simple question: if I had the money now, would I still buy this company, or would I buy something else? If the answer is something else, it’s time to sell and move on. And if you do have a neighbour with a growing collection of real estate agent signs, tell them about the endowment effect, I’m sure they’ll thank you for it. Maybe.