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Ranjit's dilemma
Ranjit has been trying hard to get his client Mr. Mehra to sell the sizeable holding he has in shares of an IT major which he had acquired steadily years ago and which have appreciated phenomenally over the last decade, and to put that money into diversified equity funds. Mr. Mehra readily agreed to the concept a year ago. But when it came to actually giving the sell order, he baulked. He told Ranjit, "Let's sell when it hits 1000". The price then was 952. Six months later, it hit 1000, but Mr. Mehra hesitated again - because he thought the bull run in the stock would continue, so why sell out now? Ranjit shared data that showed how the IT stock was underperforming the market over the last 1 year and also shared research reports that suggested tough days ahead for the IT sector. Mr. Mehra agreed with Ranjit's analysis, he saw the point Ranjit was making about the prospects of an equity fund doing potentially better than the IT stock he owned, but somehow could not bring himself to give a sell order and clean out his holding in the stock. Ranjit was left scratching his head in frustration, not knowing how to convince Mr. Mehra to do what he was convinced was right for the portfolio.
The endowment effect
Mr. Mehra's seemingly illogical behaviour is very common among investors - behavioural finance experts have a name to describe it - they call it the endowment effect. The value of something that you already own is always larger in your eyes than the value that an objective third party would assign to it. When you don't own it, you value it like others do. But once you own it, you wouldn't part with it at the same price - you demand more. Think of investors and their real estate decisions. When they go to buy, they look for deep discounts and rubbish the "going rate" in the locality. But, if they are sellers in the same locality, suddenly the "going rate" becomes the bare minimum they will even consider - and then they demand more citing a variety of reasons including better view, better amenities and so on.
In psychology and behavioral economics, the endowment effect (also known as divestiture aversion and related to the mere ownership effect in social psychology]) is the hypothesis that people ascribe more value to things merely because they own them
https://en.wikipedia.org/wiki/Endowment_effect
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One of the most famous examples of the endowment effect in the literature is from a study by Daniel Kahneman, Jack Knetsch & Richard Thaler, in which participants were given a mug and then offered the chance to sell it or trade it for an equally valued alternative (pens). They found that the amount participants required as compensation for the mug once their ownership of the mug had been established ("willingness to accept") was approximately twice as high as the amount they were willing to pay to acquire the mug ("willingness to pay"). [https://en.wikipedia.org/wiki/Endowment_effect]. The picture of the mug experiment below captures this phenomenon in a single image.
Leveraging endowment effect in marketing
Marketing professionals are trained to exploit the endowment effect to maximize sales. When a free trial is offered for a limited period, you start using the product or service. You now "own" it, and its value goes up in your eyes. When the free trial period ends, you are willing to pay the asking price (provided you are satisfied with it). If you didn't have a free trial and were to directly purchase it, you would be willing to pay less.
Money back guarantees are another marketing tactic that exploit this behavioural trait. The fact that you have a money back option induces you to buy. Once you start using it, it becomes a lot more valuable to you and very few therefore actually opt for the money back (provided again that the product / service actually delivers).
Resolving Ranjit's dilemma
That's all very well from a marketing angle. But, how should Ranjit convince Mr. Mehra to cast away his endowment effect and take a more rational look at his options? How can you do likewise when you find a client falling prey to the endowment effect? For starters, education will help. Letting your clients know about the concept of endowment effect is a good way for them to realize themselves the fallacy of their thought processes. Sending them a link to this article could be a starting point in this endeavour. Once you know that your client has understood what endowment effect is, and importantly, understood that it is a common behavioural fallacy, he might be more inclined to hear and appreciate the logic of your arguments. You are not telling him he is wrong - you are simply pointing out that what's happening is a common behavioural trait and is not unusual. That would open him up a lot more to hearing you out than if you were to suggest that he is wrong and you are right.
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