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Do We Overvalue What We Own?

I recently completed an online class by Professor Dan Ariely of Duke University. One of my favorite weeks during the class was The Psychology of Money. The 'endowment effect' was one of the more interesting topics discussed. This relates to how we value something that we own more than someone else might value the same exact object. Here is a short and entertaining video that introduces this topic.

When relating the endowment effect to financial planning we should think about how we value certain things that can have a very large impact on our financial lives. For example, think about buying or selling a house. Over the past few years the housing market has been in a terrible slump and most home sellers simply refuse to accept or even believe that their house if worth less than what they think it is worth. The reality of any market is that a house is only worth what someone else is willing to pay. If your house was worth $500,000 at the top of the market in 2006 let's say, and you think it is still worth that amount when others in your area are selling for $400,000, then maybe the endowment effect is impacting your thinking. Of course, if you wait long enough, maybe your house would sell for $500,000. (After many years.) The reverse can also be true when buying a house. Sometimes we may 'fall in love' with a particular house and begin to overvalue the house which then causes us to overpay. This clearly has long-term planning implications.

Stock investments is another area where we see the endowment effect. If a stock has gone down in value many people refuse to sell (and take advantage of the realized loss for tax purposes) because they believe it will eventually come back. Are they now overvaluing this stock because they own it? Maybe. There is also the case of investors who inherit stocks that mom or dad bought years ago (think telephone companies), but now they simply cannot bring themselves to sell these stocks regardless of whether they are a good investment or not.

The previous examples are some of the larger ones but try to think of smaller examples- say items around house. Have you ever tried to sell something that has just a little bit of sentimental value at a garage sale? Did you have a hard time letting go?

Over the next several weeks I'll try to discuss some of the various behavioral issues that have an impact on how we think about money.

 

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