Endowment Effect: Can people learn to be as rational as economic theory supposes?

There is a tendency to fall in love with your portfolio and then think up all the reasons why to hold what you already own. Take this exaple from The Economist:

Some recent work should at least help. It explores the “endowment effect”, one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favorite sweater, or your house: would you swap either for something of equal market value? Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap. With barely 10% of students opting to trade, the endowment effect seemed established (you would expect 50% to have swapped, given the random allocation of gifts). Even after a short time with things of little value, ownership had overwhelmed the students’ prior tastes. Dozens of other tests have produced similar results, and have produced a wave of criticism of neoclassical economics. The criticism has been taken seriously, as it should be: if the endowment effect is real, people’s economic decisions are fundamentally different from what economists have assumed.

Of course the Endowment Effect is real! Trend following profits are rooted in all the elements of what has become known as behavioral finance. While economists may debate away the concept of the Endowment Effect, trend followers simply accept the reality — and follow trends.


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