How the ‘Endowment Effect’ Can Impact Your Portfolio
27 Nov 2017
A friend and fellow advisor from Omaha, NE, Chris, called me recently to ask me about our WMT 600AM and WHO 1040AM radio shows. His question was straightforward: “Our group is thinking about doing radio in Nebraska like you guys do in Iowa, what service do you use when you make market forecasts?” I actually paused for a moment to realize that Chris had never heard our radio shows before, and responded: “We don’t make market forecasts; we just educate Iowans about bad investment behaviors for 2 hours.” Chris replied, “Don’t you run out of material after you talk about the whole greed and fear thing?” I replied, “The radio show’s going on 8 years strong now, and we still have not scratched the service yet!”
The reality is, we could talk all day long about the stock market, but if you are continually making bad investment decisions, what good will that do? Our goal at Premier Investments is to educate and inspire. So, I am writing this today to educate you on one investor bias that can have an impact on your financial life: The Endowment Effect.
The “endowment effect” is a psychology condition in humans that states, “If humans already own something, they think it’s worth more than it actually is.” The great social psychologists (and Noble Prize winners) Professor Daniel Kahneman and Professor Richard Thaler have proved over and over again in their experiments that this effect is a real human response. In one study, involving Cornell University students, Kahneman and Thaler gave Cornell insignia coffee mugs to half of the Cornell students, but left the other half empty handed. The group with Cornell insignia mugs were asked to estimate a selling price and the empty-handed group was asked to estimate a buying price. Would the students that already owned a “Cornell insignia” mug ask for more?
This is exactly what the professors found, “the students with cups were unwilling to sell for less than $5.25, while their empty-handed peers were unwilling to pay more than $2.25-$2.75.” What does the “endowment effect” have to do with your portfolio? Investor’s will always have a tendency to overvalue the investments that they already own, regardless of what the real value is. Here’s an example of a bad investment behavior that is caused by the Endowment Effect; a beneficiary receives 100% of their inheritance in one company stock and does not diversify because…”it’s been in my family for years.” Let’s just hope the company’s name is not Enron! Oh and by the way, 83% of the Cornell students turned down cash and kept their Mugs!