What is the endowment effect and why is it bad for investing?
Consider typical human behavior situations:
- Person A had bought a ticket for the Champions League final for $200 half a year before the games started. One month before the final the price of the ticket soared to $2000. Having learned that Person A had such a ticket, his neighbor offered him to buy it out for the new price. However, Person A declined the offer. In fact, he had a chance to earn $1800 but it didn’t feel like enough. This is a typical case of the endowment effect. The ticket will bring his owner unforgettable emotions that cannot be measured in money. Before having bought the ticket the Person A was only ready to pay $200 for it. However, after becoming the lucky owner of it he estimated it as something of a much higher value.
- Person B had bought a coin collection at a flea market on a business trip. For some time after coming back home, he used to spend his nights looking at the coins and enjoying the purchase. Eventually, he lost interest in the collection and it was left on a shelf to gather dust. He wouldn’t use it for years. One day while surfing the Net he found out that the price of his collection had increased by 50 times. Will he sell the collection? We strongly doubt it. And even if he does, he will most likely be belonging for the good old days when he was happy looking at his coins.
- Senior C decided to move to her cottage house so she could make her living by renting out her flat in Moscow. However, she can’t let it for rent at a market price as the flat is furnished with old-fashioned furniture from the 1970s. She doesn’t want to move the furniture to her cottage house nor does she want to get rid of it as this furniture once was in huge deficit.
These cases illustrate irrational behavior. The thing is that people are likely to overestimate something they own because of the emotions that are connected with it.
But what do these cases have to do with the stock market? Surprisingly, pretty much a lot. Beginner investors are more likely to buy stocks of the companies that are in the public eye focusing on the personality of the head of the company, other shareholders, or its positive media coverage.
However, these factors hardly have any link to the return on the asset. When buying an asset its long-run trend, liquidity, volatility, and multipliers should be put into consideration.
Ignoring these rules beginner investors often buy shares in the companies that are hugely promoted by the media but actually have already completed the phase of growth. Eventually, the shares in the newly formed portfolio fall in price.
Then a typical scenario takes place. The investor doesn’t feel like selling the devaluating assets because it is hard to admit being wrong as so many emotions have been put into forming the portfolio. Besides that, nobody wants to lose their money. As a result, the investor either spends years serving a loss-making portfolio in the expectation of future profits or goes on buying devaluating assets using the broker leverage which often leads to getting a margin-call and losing a substantial part of his funds.
And, again, all of these cases are examples of irrational behavior that can only be defeated by rationality. The human psyche would always be against all of the uncomfortable situations and decisions at first glance. But every argument “against” that comes to your mind first should be followed by a rational argument “for”.
Only this rational way of thinking can lead you to become a successful investor.