We can often find ourselves acting in ways that don’t make sense. Your spring-cleaning plans go awry when you can’t seem to part with your favorite pair of pants circa 2005, even though they haven’t fit for the last decade. You have a set of golf clubs that’ve been sitting in your basement for the last five years because you know that this year you’ll finally get back on the course. This phenomenon is referred to as the endowment effect, where we overvalue the items we own simply because they are ours. Ownership is a blessing and a curse for most of us; we love having “stuff” but it is usually difficult to part with our things.
This strong sense of ownership leads to huge inconsistencies with human’s behavior. Due to this type of erratic behavior in otherwise rational humans, Behavioral Economics and Behavioral Finance were born. Dr. Richard Thaler, known for his groundbreaking work in Behavioral Economics, actually coined the term “endowment effect” in 1980. His example involved a wine lover who had bought some bottles of wine a long time ago for $10. The bottles had appreciated in price, but our wine lover would neither purchase any more nor would he sell any of his current bottles. This “endowment effect” describes a situation where your price to sell is higher than your willingness to pay.
Unfortunately, there is little you can do to prevent yourself from falling prey to this bias. Ironically, Thaler put his own example to the test. A few years ago he had some very expensive bottles of wine stolen. Dr. Thaler then was quoted saying he was “now confronted with precisely one of my own experiments: these are bottles I wasn’t planning to sell and now I’m going to get a check from an insurance company and most of these bottles I will not buy. I’m a good enough economist to know there’s a bit of an inconsistency there.”
Since Thaler’s enlightened theory of the endowment effect, there has been a surge in research to understand why we act in this irrational way. Every economic model would say that if we value a mug for $5, that valuation should not change if we own the mug. But each new economic study conducted on the endowment effect defies that rational theory. If we used to value that mug at $5, once we own the mug that value increases.
Dan Ariely, the James B. Duke professor of Psychology and Behavioral Economics at Duke, dedicated an entire chapter to the endowment effect in his book Predictably Irrational. Based on his research on Duke’s campus, Ariely has observed three irrational quirks in human nature with respect to ownership. The first of these quirks is that we fall in love with what we have. We instantly get attached to our things and their value skyrockets instantly once we own them. Do you remember the feeling you got the last time you bought a new cell phone, a new house, or a new car? The infatuation you have with this new item in your line up can quickly turn into love. Even after you’ve had these items for a few years, the thought of getting rid of them brings back that “warm glow of remembrance” and the memories you’ve made.
Secondly, we focus on what we lose rather than what we might gain. It’s the same feeling you get when a relationship ends, you can recall every great moment together and forget all the reasons that you ended things in the first place. Before our items have even left our possession we’re already mourning their loss.
The final irrational behavior Ariely observed was that we assume others observe the transaction the same way that we do. As we all know, that’s not usually the case. Whilst we’re surrounded by that warm glow from all our memories, prospective buyers will see our belongings from a more analytical point of view. If you sell your home the potential buyers will notice the cracks in the walls and they don’t have those fuzzy memories of ownership to distract them from any potential flaws.
These concepts are easily applicable to investing in the stock market. Ownership can be a serious irrational flaw when it comes to personal investment. So many individual investors will consistently hold on to positions for the promise that they can give us the same results over and over again, even when they’ve passed their prime. Once an individual investor puts a position into their portfolio, their valuation will likely be higher than the market’s valuation even before they do any fundamental analysis. Investors can get unusually attached to their portfolio holdings, even if they aren’t performing well. In fact, our brains perceive that losses in our portfolio aren’t real until we sell and thus we naturally become lenient on evaluating their performance. It may be time to take a fresh look at your portfolio and see if your assets still deserve their spot.
There are a few things that you can do to try to eliminate the endowment effect on your portfolio. The first step would be to build in preventative measures. Sit down and come up with a list of measurable qualifications that your portfolio should meet, and set up a procedure to handle the underperformers. Look at your holdings every six months and make sure your portfolio still is well-diversified, is in alignment with your risk tolerance, and make sure they still meet your set qualifications.
Additionally, having a fresh set of eyes look at one’s portfolio is usually a beneficial exercise. A portfolio review assists one in determining where his or her portfolio construction may not match up with one’s optimal personal investment strategy.
Another solution would be to completely transfer your portfolio to professional wealth management. When you delegate this task to a professional it can help you focus on your long term goals and take the emotion out of the decision making process. We at Wolf Group Capital Advisors are a Registered Investment Advisory firm. Registered Investment Advisors have a fiduciary duty to provide advice and investment recommendations that are in the best interests of the client. This provides an added level of comfort for first time investors using professional management.
Ariely, Dan. “• The High Price of Ownership (Why We Overvalue What We Have).” Predictably Irrational: The Hidden Forces That Shape Our Decisions. New York, NY: HarperCollins, 2008. N. pag. Print.
“It’s Mine, I Tell You.” The Economist 19 June 2008: n. pag. The Economist. Web.