The Endowment Effect

Deciding when to sell a stock or a mutual fund can be difficult, especially when that unwanted stock or mutual fund resides in a taxable account. To be sure, there are a number of strategic reasons to hold positions you want to sell. This is the time of year, for example, when many investors resist the urge to sell because they would prefer to push the capital gains into the next tax year. But many of the reasons that investors hold onto positions are not so strategic in nature.

In their book, Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich examine a host of psychological mental tendencies that make selling any investment, even a bad one, so challenging. Research demonstrates, for example, that most investors tend to overvalue whatever it is that they already own. This is described, according to behavioral finance, as the “endowment effect,” and its influence is very powerful.

To illustrate the power of the endowment effect, Richard Thaler divided a Cornell economics class in two. Half the class received school coffee mugs as a gift; the other half received nothing. Then Thaler held a coffee mug auction. The students who did not own a coffee mug already, on average, were willing to pay only around $2.75 to acquire a mug. The students who already owned a coffee mug, however, had much greater sense of the value of their mug. On average, these students needed to be offered around $5.25 to sell their mug. This study and others like it, demonstrate that one of the primary side-effects of already owning an asset is the owner values that owned asset as much as twice as much as it is actually worth.

With the endowment effect in mind, it is easy to understand why so many portfolios are littered with positions that should be sold but are not. The psychology behind the impulse to hang onto what you already have is understandable, but it should be kept in mind because it is not always helpful or strategic.

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