That seemed sensible. Yet the cost was several hundred pounds. This sounded like a lot to insure our belongings for just one weekend against an event that was presumably extremely unlikely. Or did the high premium mean that theft was not uncommon? I was determined to make a rational decision about whether to buy the insurance or just risk it. So what do you think I decided to do?
In Chapter 10, we will see how poorer people sometimes don’t take out insurance because their poverty forces them to think about the difficulty of paying the premiums in the short term rather than the disastrous financial consequences of a fire, flood or theft in the long term. I didn’t have this problem. If I’d really wanted to, I could have afforded to pay for the policy.
Given we know costs like these can seem inconsequential in the context of a huge transaction like a house purchase, perhaps you think I opted to take out the insurance?
Well I did, but not out of relative thinking. And not because I was acting prudently either. No, the impulse to take the insurance in this case, as in many cases, was fear of loss. I wasn’t making a purely rational financial decision. Instead I was, as it were, insuring myself against anxiety in the present and potential regret in the future. Regret aversion was at play again.
As it happened, I struck lucky. The removal van wasn’t stolen over the weekend, but, more than that, it turned out the removal company had forgotten to take out the insurance policy on my behalf, so there was nothing to pay. The perfect outcome. No outlay and no regret.
THE POWER OF OWNERSHIP
Here’s a classic study conducted by Amos Tversky and Daniel Kahneman back in 1990: students were told they would be playing the parts of either buyers or sellers. The sellers were each given the gift of a coffee mug and told it was theirs to keep or theirs to sell if they chose to do so. The sellers then named the minimum price they would be prepared to sell the mug for.
Buyers were now shown the mugs and asked to name the maximum price they would offer for one. On average the buyers were happy to pay a top price of $2.25. But for the sellers this wasn’t enough; they wanted twice as much.7
Now you might suppose that both sellers and buyers were simply driving a hard bargain; that in the end they would settle on a mutually agreed price. But the sellers held out, even though it was pretty clear that, at nearly $5, they were asking for more than these buyers were prepared to pay.
This is called the endowment effect. In simple terms, it means we tend to value things we already own more highly. We endow them with a greater value. It happens even when we have only owned the items for a very short time. In this instance, the students hadn’t even seen these particular mugs until the morning of the experiment. They hadn’t paid for the mugs or even chosen them. And yet their determination to keep them was such that they named an over-inflated price.
It may seem hard to believe. Yet the findings of Tversky and Kahneman on the endowment effect have been replicated again and again in many similar tests. It’s one of the areas where the evidence is really strong.
Consider this scenario: I come into your living room and see a cushion on your sofa. You only bought it the other week, and so it can’t really be said to have great sentimental value. Yet even if I offered you a bit more than the price you paid for the cushion, I suspect you’d refuse my offer. The nuisance factor would come into your thinking, no doubt. You bought the cushion because you wanted a cushion. Sell it to me, and you have buy to another one. But it’s not just the bother. The cushion is yours now. In monetary terms, it doesn’t make a great deal of sense. How difficult would it be to replace the cushion with an exact replica? And by accepting my deal, you’d make a small profit into the bargain. But we don’t always think purely in mercenary terms. With loss aversion, we want to hold onto what we have. The same happens here.
Of course, this strength of attachment doesn’t apply to things we’ve acquired for the purpose of selling them. Successful traders want to make a profit, but they also want to shift their stock rather than hang onto it. And as sites like eBay demonstrate, there are things we own, sometimes for years, which we will happily sell on. That said, it’s often the case that inexperienced sellers start off setting the level of the bid threshold too high, probably because even though they don’t want that old sideboard any more, having chosen to buy it once upon a time and then owned it for a while, its value is higher in their eyes than in the eyes of others.
If you’ve ever witnessed the reluctance of children to swap with their sibling when they’ve opened the wrong Christmas present by mistake, then you have seen the endowment effect in action. In a study conducted in New Mexico five-, eight- and ten-year-olds were given either a ‘super-ball’ or a keyring shaped like a toy alien. When the children were asked beforehand what they thought of the two gifts, they rated the ball more highly. But even so, when the children who had received a keyring were given the chance to swap it for a ball, 40 per cent chose to hold on to it.
To check there wasn’t something peculiar about these two gifts, the exercise was repeated with other objects. Whether they were given the chance to trade a mechanical pencil for a highlighter or a calculator for a box of six coloured pens, the same thing happened. Children in all the age groups are on average twice as likely to stick with whatever they were first given than to agree to swap.8
Imagine you are looking to trade in your car and buy a new one. Your old car is in pretty good condition without too many miles on the clock and according to the Blue Book, the bible of second-hand car prices in the US, it looks as though you should get $6,000 for it. The first dealer you visit offers you $6,500 for your car and has the new model you want for $8,500. But knowing it’s always good to get a second opinion, you visit another dealer. This one says your old car is only worth $5,500, but they have the same new car you want for just $7,500. Which deal would make you happier?
The net result is of course exactly the same. Either way you pay $2,000 to swap your old car for the newer one, but in a finding which by now probably won’t surprise you researchers report that most people preferred the first deal. Yes, people would rather overpay for a new car provided they felt they were well compensated for the car they already own.9
The endowment effect is also at work when companies offer free trials. The inertia of most customers means that once people have been lured into taking out a subscription for a magazine with that apparently generous offer of six free copies, they generally maintain the subscription for years. But the second reason why free trials work is that people get used to having something – in this case, a magazine in the post – and by cancelling the subscription they are imposing a loss on themselves.
Let’s return one more time to the capuchin monkeys in that lab at Yale. It seems the endowment effect influences their behaviour too. When given the chance to trade a piece of fruit for an oatcake, a foodstuff they like equally well in other circumstances, the capuchins are reluctant. Perhaps offering them an extra oatcake would be an incentive? But no, the monkeys still preferred to hold on to what was already theirs. They would only trade the fruit they already had if they were given masses of oatcakes in return.10
So the instinct to hang on to what we’ve got is as strong in us as in apes. Money should help us overcome this instinct. Yet it appears that such is our attachment to money that sometimes, far from lubricating the wheels of commerce, it can act as a brake. Even when we’re offered more money, we won’t let go.
Of course there are many situations where the existence of money does facilitate exchange. That is the point after all. But key to making that happen is getting the price right. And it’s to that subject that we turn next.
5
THE PRICE IS RIGHT
Why a high price is not always a sign of quality, why your brain is a wine snob, why sometimes we’d rather pay more