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.