A wise man should have money in his head, but not in his heart. —Jonathan Swift
This week we are going to examine what is known as the Endowment Bias.
According to a paper published in the Journal of Econimic Perspectivesby Daniel Kahneman, Jack L. Knetsch and Richard H. Thaler titled Anomalies: The endowment effect, loss aversion, and status quo bias, endowment bias occurs when we overvalue something that we own, regardless of its objective market value (Kahneman, Knetsch, & Thaler, 1991). It is evident when people become relatively reluctant to part with a good they own for its cash equivalent, or if the amount that people are willing to pay for the good is lower than what they are willing to accept when selling it. Put more simply, people place a greater value on things once they have established ownership. This is especially true for things that wouldn’t normally be bought or sold on the market, usually items with symbolic, experiential, or emotional significance. The endowment effect is an illustration of the status quo bias and can be explained by loss aversion.
So how does Endowment Bias effect investors? Let’s see what Michael M. Pompian, author of Behavioral Finance and Wealth Management: How to Build Optimal Portfolios That Account for Investor Bias has to say.
- Endowment bias influences investors to hold onto securities that they have inherited, regardless of whether retaining those securities is financially wise. This behavior is often the result of the heirs’ fear that selling will demonstrate disloyalty to prior generations or will trigger tax consequences. 2. Endowment bias causes investors to hold securities they have purchased (already own). This behavior is often the result of decision paralysis, which places an irrational premium on the compensation price demanded in exchange for the disposal of an endowed asset. 3. Endowment bias causes investors to hold securities that they have either inherited or purchased because they do not want to incur the transaction costs associated with selling the securities. These costs, however, can be a very small price to pay when evacuating an unwise investment. 4. Endowment bias causes investors to hold securities that they have either inherited or purchased because they are familiar with the behavioral characteristics of these endowed investments. Familiarity, though, does not rationally justify retaining a poorly performing stock or bond.
Let us help you eliminate this bias. Professional advisors with disciplined systems of investing tailored specifically to your investment goals will allow you to overcome many of the obstacles inherent in our very nature. At DWAM, we can help.