Behavioural Finance: The Endowment Effect

I will be honest. I don’t read a lot of books these days. Most of my reading now revolves around blogs, research reports, company annual reports, old articles from the Economist, and newspapers online. The last book I think I read was 4 years ago called The New Dads’ Survival Guide. A while ago, I learned that Richard Thaler, considered one of the pioneers of the Behavioural Economics had published a new book called “Misbehaving: The Making of Behavioral Economics”. It’s a bit of trip down memory lane by Mr. Thaler where he regales us in how he stumbled into what would be a new pillar in Economics with some interesting insights and observations on how and why we make economic decisions. I’ve read about Mr. Thaler’s theories and observations in other publications and never read his previous book, “Nudge: Improving Decisions About Health, Wealth, and Happiness” so I thought it would be worth a dive.

The book is a bit academic at times as a lot of the book refers to studies and papers. It can be a bit dry but Mr. Thaler presents some very profound insights on investor behavior that resonated with me. So much so that I will be sharing some of these concepts in this and subsequent blog posts and at the same time tying them into some of my own personal behaviours and experiences to just give this some colour. The first of Mr. Thaler’s observations revolves around the concept of the Endowment Effect.

According to Mr. Thaler, the things you own form what Thaler calls your endowment. Each of us place a higher value on things we own more than things that don’t own but could own in the future. For example we feel that our house is worth more than another house that may have the same features and design. We think that our location is just a little bit more optimal or because the kitchen was recently renovated and modernized. I’ve personally seen this when looking for houses and running into owners who are stubborn and refuse to sell their properties even though they are being offered more than what they listed the property or what other similar properties within their neighbourhood sold for.

The same mentality can apply to our investment portfolios. We subconsciously feel that the stocks or ETF’s or bonds in our portfolio are worth more than what the market thinks they are worth. If you have spent hours researching and analyzing stocks and made decisions to include them in your portfolio, you have convinced yourself (rightly or wrongly) that you will feel that those stocks carry a higher value and that you have discovered something that nobody else has seen. If I have Apple stock in my portfolio, I am going to feel that my 50 shares are marginally more valuable than someone else’s Apple shares. According to Mr. Thaler, because you have emotionally and financially invested yourself in a stock, you are less willing to give it up, especially at a time that you really need to give it up. We’ve "invested" the time and so we can’t be wrong. If the stock should come under pressure for a negative company activity, we will try to rationalize that it will not impact the stock that resides in our portfolio because we feel our shares are on a higher level.

Earlier in my investment career, I experienced this directly. I bought and owned a batch of shares in the toy company MegaBrands. I did a lot of research and determined that this was a can’t miss stock. The quantitative analysis were all positive and from a qualitative perspective I thought that toys were essentially recession proof and they had recently expanded their product line. It all looked good until several kids ate some small pieces of a Mega Brand toy and died. I dismissed it as an isolated case and in my mind thought that the business model was so valuable that it would be able to overcome. It didn’t. The stock fell almost 90 percent. When I look back, my decision making was clouded because the Endowment Effect enabled me to place a higher value on the stock than it really was. I was too emotionally invested in the stock.

The Endowment Effect builds or formalizes a type of investment behavior that we can become too attached or fall in love with our investments and when we demonstrate that behavior it is often to our detriment. The Endowment Effect feeds into another behavior Mr. Thaler discusses which is called Loss Aversion and I`ll visit this concept in another blog.