Blogs | October 28, 2010

It’s mine, so it’s worth it

Conscientious investors are particularly prone to a thinking trap known as the “endowment effect”.


Off the field
One feature of the saga surrounding the 2010 sale of United Kingdom football club Liverpool FC was the reluctance of owners Tom Hicks and George Gillett to sell at a loss, even though the club is now worth less than when they bought it. This is a common phenomenon.
Economists call this phenomenon the “endowment effect” – our tendency to over-value what we have simply because we have it.

Is resisting it a mug’s game?
A well-known experiment by economist Richard Thaler at Cornell University in the United States in 1988 demonstrated how the endowment effect works. Thaler handed out free coffee mugs at random to students, and asked those who had received mugs how much they would sell them for, and those who hadn’t how much they would pay for them. The typical recipient of the mug demanded $4.75 (€3.43) but the typical buyer offered $2.25 (€1.62).
Mere possession of the mug – which arose only by accident – caused people to value it highly.

We over-value what we have – be it shares or a job
The principles highlighted by Thaler can do real damage to our wealth. For share owners, they can leave us vulnerable to what fellow academics Meir Statman and Hersh Shefrin called the disposition effect – the tendency to hold onto losing shares or mutual funds in the hope that their price will return to the one we paid. This can be dangerous because there is little evidence that share prices do mean-revert, with losses followed by gains. Quite the opposite. It’s increasingly thought that, if anything, shares have momentum.
A paper on the Social Science Research Network suggests, for example, that over periods of a few months losses tend to lead to further losses. The same endowment effect can lead us to stick with poorly-returning bank accounts, high-interest credit cards or expensive utility suppliers. In all cases, we over-value what we have. More generally, this “better the devil you know” attitude causes us to carry on working in jobs we merely tolerate or living in places we don’t much like, simply because we over-value the few merits they have. The endowment effect leads us into the status quo bias.

My house is my castle – and it’s worth a right royal amount to me
Such behaviour is also seen in the housing market.
Economists at the University of Pompeu Fabra in Barcelona have estimated that homeowners over-estimate subsequent selling prices by, on average, between five and 10%. This has two pernicious effects.
First, it contributes to the tendency for housing transactions – and not just house prices – to fall in a recession as homeowners refuse to sell at what they wrongly consider to be unreasonably low prices. As a result, housing markets can take many years to adjust to bad economic times. In their study of banking crises, This Time is Different, Carmen Reinhart and Ken Rogoff estimated that after the average banking crisis house prices fell for six years.
Secondly, if we over-estimate the value of our homes, we are apt to spend and borrow too much. This is good for society, as it helps to dampen the effect of recession. But it’s bad for the individuals who do it, because if they are using their house as part of their pension fund, they might be in for a nasty shock when they come to sell.

Take a step back from your investments to combat the endowment effect
One particularly horrible aspect of the endowment effect is that hard-working people are especially vulnerable to it.
In a recent study of investors’ psychology, Robert Durand of the University of Western Australia found that conscientious investors were more likely to hold on to losing stocks. The harder we work for something – researching a company before buying a share, or doing a house up – the more likely we are to over-value it.
So, how can we protect ourselves from the endowment effect? It’s tough. But try to step back. Ask yourself: if I didn’t own this share, would I buy it? If I didn’t have this account, would I open it? If this job were offered to me, would I accept?
We all make bad choices. But perhaps trying to answer these questions honestly might at least prevent us from being trapped by our past bad choices.

InvestingSociety

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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