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Home » All, Business, Decision-Making

The Endowment Effect

By on July 1, 2011 – 8:46 am  No Comment

Peter R. Worrell, MAPP '09 is the Managing Director/CEO of The Bigelow Company LLC. Bigelow, originally established in 1935, is an independently owned merger and acquisition advisory firm whose clients are exclusively highly successful private entrepreneur owned enterprises. Worrell is passionately committed to the practical application of positive psychology to optimize entrepreneurs' decision making in the domain of risk. Full Bio. Peter's articles are here.



As an entrepreneur owner-manager of a successful business, would you be willing to buy your business today at the same value that you would agree to sell it?

According to Kahneman, Knetsch, and Thaler, people exhibit the endowment effect when they value an asset more when they own it than when they don’t.

Traditional economic theory holds that a rational person’s willingness to pay for an asset should always equal that person’s willingness to sell it for the same price. But behavioral economics studies (and our own scar tissue!) consistently show that the minimum selling price that owners state for an asset almost always exceeds the maximum purchase price that they are willing to pay for the same asset. Effectively then, (scratching our heads) ownership of an asset in and of itself “endows” the asset with some ethereal added value from the owner’s point of view.

The Danger of the Endowment Effect

A classic case of endowment effect occurs when a business is inherited. Often in these situations, owner-managers say that they have feelings of distress or disloyalty associated with considering new ownership alternatives for a business bequeathed from a previous generation. They are confused about what is the right thing to do and at what value. Endowment effect influences owner-managers to hold onto businesses that they have inherited, often regardless of whether it is in the best interest of the owner-manager or of the business itself! Endowment effect can result in decision paralysis where an owner-manager, having placed an irrational premium on a business that he or she owns, slowly liquidates the business, year by year, through inaction.

In the balanceRecognizing the Endowment Effect

Are you the victim of endowment effect? Ask yourself this: “If I had the value of my business in risk-free cash securities today, what proportion of my cash would I invest in this business today? At what price?” In the case of an inherited business, you might ask yourself, “Do I think that when my family left me this business that they thought that I would automatically accept the responsibility of keeping ownership of it forever, whether or not it is in the long-term best interest of the business or my family?” Familiarity with an asset you own is like comfort food. It feels good; it’s comfortable. But if you wouldn’t buy the business you own now for its fair market value for cash, then why do you own it?

Engelmann and Hollard have gathered empirical evidence that trading experience in markets matters greatly when trying to overcome this bias. Across all asset types, market-specific experience and the magnitude of the endowment effect are inversely correlated. In other words, when an owner-manager has significant accumulated merger and acquisition experience, the endowment effect decreases and at some point becomes negligible. But most owner-managers do not have this experience. This has major implications for business owners for whom a recapitalization or sale transaction is an “only once-in-a-lifetime transaction.” They have no deep trading experience and thus can become unwitting victims of the endowment effect.

This is the Age of the Entrepreneur. There are many qualitatively meaningful reasons to own a business independent of its value. If you recognize the danger inherent in endowment effect (that most of us have) then you can better choose how to act to assure the longevity of the business beyond yourself as the current owner-manager.


 
References

Kahneman, D., Knetsch, J.L., and Thaler, R.H. (1991). Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias. The Journal of Economic Perspectives, 5(1), 193-206.

Engelmann, D. and Hollard, G. (2010). Reconsidering the Effect of Market Experience on the “Endowment Effect.” Econometrica, 78 (6), 2005–2019.

Images
Magnified dollar courtesy of Brooks Elliott
In the balance courtesy of winnifredxoxo

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