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As humans, we’re all affected by different behavioral biases. We often let emotions dictate our actions, which can lead to unfavorable outcomes. These inherent biases make rational investing a difficult task. The endowment effect is one such bias that works against us as investors.
Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business, Richard Thaler defines the endowment effect as:
“The fact that people often demand much more to give up an object than they would be willing to pay to acquire it.”
Just like the family who can’t sell their house because they listed it well above its price range, we’ve all made the mistake of overvaluing something of our own before. Try having a garage sale, and you’ll see how unrealistic you are about how much your possessions are worth to others. We have a general inability as humans to objectively assess a situation from the other side and determine if we would accept our own offer.
Professor Thaler’s work provides one of the most famous examples of the endowment effect. After expressing no preference for either a coffee mug or candy bar, students were given one of the items as a gift. Then they were asked if they would like to trade their mug/candy bar for the other. The vast majority of the participants stuck with whatever item they were gifted, whether it was the mug or candy bar.
The same behavioral bias has been observed in chimps:
“When presented with a choice, 60% of the chimps preferred peanut butter to juice. However, when they were endowed with peanut butter, 80% of them chose to keep it instead of exchanging it for juice. It was as if the peanut butter became more valuable as soon as it was possessed. And an opposite endowment effect was observed when the chimps were given juice.”
The endowment effect is a product of loss aversion. Loss aversion refers to the increased regret we experience when problems come as a direct result of our actions. We’ll do almost anything to avoid losses. Sometimes loss aversion leads us to take no action at all instead of risking potential regret. We see this type of behavior with investors all the time.
Loss aversion and the endowment effect are the reason you’re still hanging onto that stock your grandfather gifted you years ago, despite its poor performance. You could sell the stock and invest in a more appropriate vehicle of your choice, but since you already own it, that becomes far more difficult than it sounds.
People become attached to positions in their portfolios all the time. Whether you buy shares of a favorite company, are gifted stock by a relative, or took a hot stock tip from your buddy, the endowment effect is at work. How the position found its way into your portfolio isn’t relevant. The fact that it is your own makes it more valuable to you.
How can we combat behavioral biases like the endowment effect?
The best thing we can do is study the biases. Awareness of their existence can help us create rules for ourselves as investors. In my opinion, a strict, rules-based investment methodology is a great way to avoid as many behavioral biases as possible.
We’ve learned a lot about relative strength investing from our friends at Dorsey Wright and Associates. Relative strength measures the performance of securities against one another. It really boils down to owning the best performing investments as measured against their peers. You may have heard an adage along the lines of, “Cut your losers and let your winners run”. That adage epitomizes relative strength investing, and this methodology does not allow us to become attached to any investments. You cannot cut your losers if you’re overly attached to them.
Relying on a systematic relative strength strategy helps us to avoid behavioral biases, like the endowment effect, as much as possible. We don’t treat our investments as pets, they’re more like hired guns. Their job is to appreciate in value. When an investment no longer meets the relative strength criteria, it’s gone.
Others may have their own methods that work for them, but this is our way of remaining objective and fighting the inherent behavioral biases we all have as humans. We cannot place a higher value on something simply because we own it.
Sources:
http://www.economist.com/node/11579107
http://www.princeton.edu/~kahneman/docs/Publications/Anomalies_DK_JLK_RHT_1991.pdf
http://www.ritholtz.com/blog/2015/06/the-big-disconnect-between-investing-and-human-behavior/