Head to Toe


The Free Choice Paradigm

Today I wanted to delve a bit into psychology and show how you can avoid pitfalls in your financial life by being aware of how your brain thinks.  Specifically, the free choice paradigm and the endowment effect and how they color all decisions we make based on previous decisions we’ve made. I’ll detail how the endowment effect shapes our thinking as well as ways to avoid falling into dangerous decision making.  First, let’s start with what these two concepts are.

The Free Choice Paradigm

The free choice paradigm essentially states that once you make a choice or decision, your preferences change to favor that choice or decision in the future.  A study that illustrates this had a group of people rank six pieces of art from ones they liked most to least and were then told they could take the piece they ranked either third or fourth.  Most people took the one they ranked third, but were asked to rank the pieces again a few weeks later. They ranked the one they took as second this time around and the one they left behind as fifth.  That may seem like everyone simply justifying their initial choice, but there was a wrinkle in the experiment.

They also asked a group of people with short term memory loss (anterograde amnesia) to go through the same process.  Instead of waiting several weeks, they waiting until the short term memories faded, reintroduced themselves and started the experiment again, asking each person to rank the art.  Even those with short term memory loss who had no recollection of seeing the art or doing the experiment, ranked their third choice as second and their fourth choice as fifth on the second ranking.  This shows that you have a preference for what you’ve picked in the past, regardless of whether you remember picking it or not. This leads us to how the free choice paradigm affects financial decision making with the endowment effect.

The Endowment Effect

The endowment effect details the idea that once you own something, be it a stock or a house or anything else, you assign that thing more value.  In and of itself, this isn’t a bad thing, but it does mean you can easily make poor financial decisions without realizing it.  Simply because you bought that house or made that investment, you look more favorably on it, but that doesn’t mean it’s a worthwhile investment any longer.  Anyone who has tried to sell an old computer or other item will understand when you can’t get any takers for what you think is a fair price, only to sell it for much less than you were expecting.  

With that being said, let’s talk about how to avoid falling into pitfalls and retaining assets once they no longer provide benefit.  In order to counteract the effects of the free choice paradigm and the endowment affect, the only thing to do is get an outside perspective on your situation.  I have mentioned before how vital having a trusted 3rd party is to look at your financial situation and this is a huge part of that benefit. It’s not that a financial planner knows things you couldn’t possibly learn, it’s that having an impartial assessment can show you blind spots that you wouldn’t have even thought exist.  

Because of the free choice paradigm and the endowment effect, our decisions are biased without our knowing and so we must seek outside perspective to limit the effect they have in our lives.  If you have questions about either of these concepts or want to chat about getting some outside perspective, comment or email me and I’ll be happy to have a conversation.  

behavioral finance for doctors