Ever heard of the phrase ‘a bird in the hand is worth two in the bush’?
At its most basic level, this is the ‘endowment effect’ and is based on the finding that people will often place greater value on things once they have established ownership – be that a tangible object, such as a painting, or something less tangible like a stock market investment.
It leads to a situation where people will demand more money to sell an item that they own than they, or other people, would be prepared to pay for it, writes Rob Smith, head of behavioural finance at Barclays Wealth.
Emotional biases may have an impact on your investments, particularly if you’re holding onto loss-making assets in the hope they’ll ‘come good’
Experts believe it’s down to human nature and our deep-rooted aversion to feeling a sense of loss.
For example, we feel loss when we give up something we own, but we do not have that same feeling when we choose not to purchase something.
We are keener to avoid losing the item than we are to acquire it, and so put a higher value on it.
To bring this to life, the most well-known study on the behaviour found that participants wanted $7.12 to sell a mug that they owned, which had no sentimental value, but would only pay $2.87 to buy the same mug when they didn’t own it.
Closely related to the endowment effect is the ‘disposition effect’, where investors hold onto loss-making assets longer than those that make gains – in the hope that they will ‘come good’ eventually.
These emotional biases towards things we already own can have a real impact on investors, as it can lead them to value their existing investments higher than what they would be willing to pay if they did not already own them.
Signs you’re a sufferer
Feeling an emotional connection to your investments, whether this is to the company itself or its past financial performance, will increase your chances of suffering from the endowment effect.
This doesn’t always mean that feeling a connection to your investments is a bad thing, but it does mean you need to be conscious of how your feelings might be influencing your judgement.
For instance, if you don’t actively compare your investments with other potential opportunities, you might be falling prey to these effects and be missing out financially.
A sure fire way to tell is to pretend you don’t currently hold your investments, and ask yourself ‘would I buy this at its current price if I didn’t already own it’?
If the answer is no, then you are certainly suffering from these effects and should consider selling.
Practical ways to fight it
Rob Smith: Consider whether you’d buy an asset at its current price if you didn’t already own it
There are a couple of ways that you can try to overcome your emotional biases and work out if you’re attaching too much value to your investments – potentially losing out on good market opportunities:
1. Think about an investment very similar to the one you own, but that’s not in your portfolio.
Try to establish what you would view as a reasonable price for the investment were you to buy it today.
If the value is less than that of your current investment, then you should think about selling.
2. Consider the opportunity cost, as in the money you could be losing out on, by holding your investment – if there are other options that provide better risk-adjusted returns, then you should be looking to sell.
A gain of 5 per cent in isolation may seem attractive, but if this is considered against an 8 per cent gain from another investment with similar risk, then it becomes easier to overcome the bias.
3. Take a look at your portfolio and work out whether you hold any emotional attachments to your investments, and why.
It could be that you’ve inherited them from a close family member, that you used to work for the company in your youth, or that they’re a sustainable investment addressing issues that you care about.
Whilst these are all sound reasons, and very understandable, the reality is that any emotional attachment to your investments can harm your decision making ability – so try and limit your emotions where you can.
When it comes to investing, it’s fine to be led by motivations other than just financial returns, particularly when it comes to ESG investing – but even these investments should be judged as dispassionately as possible and on their merits.
By understanding your emotions, you can try to manage them – giving yourself the best chance of creating a portfolio that is fully diversified and set-up to take advantage of market opportunities, whilst weathering any market storms.