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The Endowment Effect: How Does it Impact Our Investing?

November 17, 2010


I have written and discussed the subject of behavioral finance in previous articles. Once described as psychological nonsense, behavioral finance has received noted attention in recent years. I am learning that this subject could cover volumes of texts books and academic lectures. Every time I think the topic has been exhausted, something new comes along to offer some unique insight as to how we make our investment decisions. I find it most useful when I recognize this behavior in my own decision making. One such example is a psychological phenomenon known as the endowment effect. Noted professor and author Richard Thaler first developed the theory 30 years a ago. Below is a passage from a economics journal describing the effect;

Endowment effect. People often demand much more to sell an object than they would be willing to pay to buy it.’ ‘Thaler (1980) coined the term “endowment effect” to refer to the finding that randomly assigned owners of an object appear to value the object more than randomly assigned non-owners of the object. For instance, in one well-known series of endowment effect experiments, Kahneman, Knetsch and Thaler (1990) found that randomly assigned owners of a mug required significantly more money to part with their possession (around $7) than randomly assigned buyers were willing to pay to acquire it (around $3). Kahneman et al. (1990, 1991) and Tversky and Kahneman (1991) attributed this result to loss aversion: owners’ loss of the mug loomed larger than buyers’ gain of the mug.”

It’s fascinating how we can observe this behavior in our own lives. If anyone has ever participated in a yard sale (tag sale, garage sale, etc.) it often comes into play. We seem unusually attached to things we own. We are only willing to sell something at a certain price, yet would not be willing to pay that exact same price for that exact same object.

How does this relate to our investing? We become unusually attached to holdings within our portfolio. Somehow we are unwilling to sell something we have put a great deal of time and effort into acquiring. What is even more amazing – if we had a chance for a clean slate (completely new portfolio), we may not make those investments today. This is particularly true for positions we hold at a loss. Our brains perceive that if we avoid selling today that the losses aren’t real. A quick and simple test to expose this flaw it to take an objective view (easier said than done) of the entire portfolio – position by position. Would we be willing to buy each position today? Our answers may be surprising. Another possibility - have someone else provide an independent eye to your positions. They won’t be victim to the endowment effect that potentially colors your view.

About the author:

William J. DeRosa, Jr., CFA
William J. DeRosa, Jr. is the General Partner of Anthem Asset Management, LLC is an independent investment management company. He has also served as Director of Equity Research and Senior Portfolio Manager at various buy-side asset management firms. Mr. DeRosa is a Chartered Financial Analyst and is a member of The CFA Institute.

Rating: 4.2/5 (6 votes)

Comments

softdude2000
Softdude2000 - 3 years ago
>>Would we be willing to buy each position today?

Are you suggesting there should be only buy or sell position and never a 'hold' position?

batbeer2
Batbeer2 premium member - 3 years ago
Good point.

You do not make money buying, you do not make money selling, you make money waiting - Munger.

Having said that, I do think the article addresses an important aspect of investing. There is such a thing as "the endowment effect" and it's bad for your wealth.

It's just that the solution proposed is as bad as the problem. IMHO there is no such thing as an objective review of a portfolio. Let someone review your picks and you have a second opinion. Let everyone chime in and you get the consensus opinion.

If you seek satisfactory returns, you need to interpret the facts differently and correctly.

So what then is the solution ?

IMO all you need to do is buy stocks that you are certain are too cheap by a wide margin. Sell them for any number of reasons but not because they went down.

I look at a stock in my portfolio thinking "wow I hope it drops 30% tomorrow" then I know it's OK. I look at it thinking "I hope it goes up 10% tomorrow so I can sell" then I know it's a mistake. When you know, you know.

Just some thoughts.


P.S.

It does help if you have fewer stocks in your portfolio. A stock by stock review takes less time.
graemew
Graemew - 3 years ago


This article puts forward some very important points. I can remember how a few years ago I watched my shares in a utility company that was heavily into renewable energy move up to a PE of around 30X. I was sitting on a big profit, but the world was buzzing about alternative energy then and I was so grateful to the stock for moving up that I held onto it. Of course it went down after oil prices collapsed and the financial crisis began. Eventually I sold out at a PE of around 9X since the company held a large amount of debt, profits had declined and the future looked grim.

It is amazing how we can sometimes justify ridiculously high valuations for companies we own, that we have become attached to.

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