Given the uncertainty in the world right now both in the markets and with life in general, I seem to be getting more questions than usual submitted to the mailbag for The Final Bar on StockCharts TV. We run a mailbag segment twice a week, and it’s really a great opportunity for me to help people along in their journey of navigating the markets.
In particular I’m getting questions on behavioral biases, and I thought it would be helpful to take a look at one example, the Endowment Effect. We’ll discuss what it is and how to minimize its impact in your decision-making.
To illustrate this emotional bias, I will use a coffee mug that I own from The Walden School. This coffee mug is incredibly special to me, but if you owned this mug it probably wouldn’t mean that much to you. Sure, it will proudly hold your coffee or tea, but if you break it or chip it or lose it, I’m sure you have plenty of other mugs. No big loss.
The Endowment Effect explains why this coffee mug has more value to me than to you.
For me though, this mug stirs up exciting memories. The Walden School holds a musician’s retreat every summer up in the mountains of New Hampshire which I was able to attend a few years ago. I spent an amazing, unforgettable week composing and arranging music, singing and playing with other attendees, and learning from expert composers and conductors. It was transformative. Every time I see this mug, it reminds me of that exceptional week- it takes me right back. As a result, this mug actually holds more value to me than to you.
This same thing tends to happen with our portfolios. With our portfolio holdings, we attribute greater value to them simply because we own them. This is essentially the Endowment Effect. You treat items that you own differently than those you don’t, purely because of the emotional attachment to them.
“With our portfolio holdings, we attribute greater value to them simply because we own them. This is essentially the Endowment Effect.”
Imagine your portfolio has been doing well, but a couple of your holdings start underperforming. And let’s say this portfolio includes Disney. It’s a stock you’ve owned for a while. You love this stock, you love the company, you love their story, but it’s starting to rollover and is really hurting your performance. The Endowment Effect basically compels you to want to continue to hold this stock even when the evidence clearly demonstrates otherwise.
This is how it manifests itself in your investing. It starts to hurt your performance because of this emotional attachment. To help minimize this emotional bias, here are a couple tricks to help keep yourself in check.
First, try the new money trick. If you own a stock and have started debating its value in your portfolio, ask this question: If you had new money today, would you put it in this stock right now? If the answer is yes, then you probably have some decent justifications for continuing to hold your old position. If the answer is no, or the ever popular, “Well no I wouldn’t put new money in it but I’m still OK holding it” then ask this second question: If you wouldn’t put new money in it, can you really justify why you should be keeping old money in it?
Covering up the tickers removes your emotional attachment and leaves you to focus more on the evidence.
A second tactic is to cover up the tickers. If you look at charts (which hopefully you do because they are a great way to understand market history and price and dynamics), grab some charts of the stocks you own, then grab a bunch of other charts as well. Put them in a big pile, cover up all the tickers, then analyze the charts individually. See which of the charts you find most attractive, then uncover the tickers. Are the charts you own the same ones you just identified as attractive?
If there is a disconnection, see what it is about those charts that is not as appealing as you might have thought. Covering up the tickers removes your emotional attachment and leaves you to focus more on the evidence.
Strategy number three is to think of stock positions as things you rent, not that you own. This is a mental shift in how you approach your current positions. Of course, being a shareholder brings responsibilities and I’m not suggesting you ignore those! But you should think of your positions as items you are renting, and at any point you can break the lease and get out of it with no penalty. You are just renting temporarily until your money is better suited elsewhere.
The Endowment Effect can creep into your portfolio and affect your decision-making. Using these three tricks can help minimize the impact of this behavioral bias and allow you to make financial decisions without emotional influence.
RR#6,
Dave
Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. Please see the Disclaimer page for full details.