The Endowment Effect

The endowment effect is another important psychological barrier that helps people from realizing the full potential value of their investments. Like other cognitive biases, it obscures the thinking of the investor and gets them to make decisions, which can be described as “suboptimal,” to say the least. In this article, we will have a look at what the endowment effect is and how it can impact the portfolio of an investor.

What is the Endowment Effect?

The endowment effect is a cognitive bias that skews the investor’s perception of the valuation of an object depending upon whether they own it or not. Let us understand this with the help of an example. In one of the studies related to the endowment effect, people were given the same coffee mug and were asked to decide its value. There were two sets of people, one had to value the coffee mug as the buyer, whereas the other had to value the coffee mug as the seller. At the end of the study, it was found that the average price of the group of sellers was close to $7, whereas the average price of the group of buyers for the same object was close to $3! This was a huge variation considering the fact that the underlying object was the same.

In behavioral finance, this phenomenon is called the endowment effect. This means that when a person owns stock or an investment, they often become emotionally engaged with the object. This is the reason that they place an excessively higher value on the stock. As a result, their worldview of the market becomes skewed and biased. Since they are not able to value the stocks objectively, they are not able to devise trading strategies objectively either.

How the Endowment Effect Affects Investment Decisions?

The endowment effect impacts the investment decision in a wide variety of ways. Some of these impacts have been listed below:

• Overvaluation of the Portfolio: Most investors tend to have an emotional connection with their own portfolio. This is the reason that they tend to value the stocks and ETFs in their own portfolio at a higher rate. This causes most investors to effectively price their securities and sell them. They set target selling prices in their mind. However, once the target is hit, they keep on setting higher targets. This is because they feel that their own stock is such a great pick and that they would not want to lose out on such a great investment by selling out early.

• Holding on to a Mediocre Stock: If an investor purchases a stock that gives a great performance, in the beginning, it is likely that the investor will keep on holding the stock for a very long time. This is because the investor has become emotionally attached to a stock and hence views it as a winner. Hence, even if it gives a mediocre performance in the subsequent years, the investor will keep holding on to it. For example, if a stock provides a 25% return in the first two years and then a 5% return in the next ten years, investors would continue holding the stock for a very long time.

• The “Hold” Recommendation: Research analysts have an entire category of “hold” recommendations just to satisfy the endowment effect. Generally, there should be only two categories, i.e., buy and sell. If the current price is a good bargain and you are holding on to the stock today, you are effectively buying the stock. In a way, not selling can be considered to be buying in a highly liquid market. However, research analysts know that there are many investors who wouldn’t buy the stock at the current price. However, if they already have the stock, they will perceive it to be more valuable and hence wouldn’t sell it either. This is the reason that they have created an entire recommendation called “hold” because they know of the existence of the endowment effect.

How Can Investors Manage the Endowment Effect?

Now, since we know that the endowment effect can wreak havoc on a portfolio, it is important to learn how to manage it.

• Consider Opportunity Costs: The best way to avoid the endowment effect is to understand that it exists. This can be done by asking oneself the opportunity cost. If the benefits to be derived from the next best opportunity are considerably higher than the benefits from the current stock, then it must be sold, and the money must be reinvested to maximize the gains. If you look at a 5% gain in isolation, you are likely to fall prey to the endowment effect. However, if you consider the 5% gain in front of an 8% gain, you will be able to see the bias and avoid it.

• Psychological Ownership: Finally, it is important to view the stocks and investments as a means to an end. It is important that people do not get unnecessarily emotionally attached to their investments.

To sum it up, the endowment effect is a significant bias that skews the mind-set of the investors. The ability to avoid the endowment effect can be the difference between failure and success.