Joy, sadness, impulsiveness and other everyday feelings that influence our actions and perception of reality can hinder our reasoning. They create cognitive biases (like the endowment and reflection effects), causing our brain to cut corners on sensible decision-making.
When faced with selling a car, buying a home, investing money or opening a business, we’ve probably experienced the endowment and reflection effects without even realizing. They’re closely related and can cloud our judgement about how to manage our finances.
What is the “endowment effect”?
The endowment effect is an unconscious bias that leads us to believe the things we own are worth more than similar or identical things not in our possession. It can end up working against us, especially in trade-offs: A seller’s price for something is above not only its actual value but also the buyer’s price (because the buyer doesn't own it). If a mobile phone, a car or anything we want to sell reminds us of special times, we tend to factor such emotional value into its price. Surely, we would value our home higher than our neighbours’, even if our houses looked the same. That tendency makes it harder for a buyer to take interest in what we’re offering (which will continue to depreciate over time).
The endowment effect can also affect shareholders. Accordingly, many investors will prefer to hold on to stock in listed companies, even when the share price goes down, because they’re convinced it’ll recover a particular value.
If you’re keen to learn about all types of investment, check out this article (in Spanish) by Tu Futuro Próximo, Santander Consumer España’s blog.
What is the “reflection effect”?
The reflection effect is what follows the endowment effect. According to behavioural economics, if that stock market investor who fails to sell off their stock when the share price begins to fall takes higher financial risks to try to recoup their losses, that tendency is known as the reflection effect.
Daniel Kahneman, a psychologist and the 2020 winner of the Nobel Prize in Economics for his research on decision-making, concluded with his partner, Amos Tversky, that losing affects people 2.5 more than winning. That our sadness about losing is more than two times greater than our joy from winning is a phenomenon they called “loss aversion”. It’s partially why the reflection effect causes us not to accept defeat and, instead, take unusual chances to try to recover losses.
If you're curious about loss aversion in behavioural economics, read this article (in Spanish) by Finanzas para Mortales (Finance for Mortals).
How to avoid cognitive bias
Feelings can strongly affect our objectivity about the economic value of what we own or the financial risks we’re able to take. Because of how quick we can grow attached to things, the endowment and reflection effects can easily impact on our financial health.
To avoid that, we must: