The Endowment Effect

by Michael Ervolini

Like all primates we over-value the things we possess. It's called the ''endowment effect'' and it can ruin your portfolio.

Monkeys do it. Chimpanzees do it. Even educated investors do it. But don't you do it, don't fall in love--at least not with assets in your portfolio. Following nature's lead may be, as Cole Porter urges, the right recipe for matters of the heart. Effective investing, however, often requires that you fend off natural impulses and act in ways that reflect more analytic reasoning and less emotion. One impulse to be wary of is the tendency to hype the value of an item merely because it is in your possession. It's termed The Endowment Effect.

The Endowment Effect was first discussed by Professor Richard Thaler of the University of Chicago back in 1980. He noted that people often assign greater values to items when they are owned vs. just prior to ownership. It is as if things suddenly become worth more simply because they are yours--part of your endowment. This extra appreciation for items owned makes it tougher to sell them.

Selling is generally experienced as a loss, even if the sale price is more than was originally paid. Something deep within the brain interprets the sale as your now being deprived--no longer having access or use of whatever is gone. Some theories suggest that before organized markets existed, early man learned to horde. Trading was risky back then and something to be avoided. Remnants from this store-to-survive strategy today drives endowment in humans and other animals.

Your RX for dealing with an endowment …

Sorry Cole, but the best advice for falling in love with investments is don't do it … or at least try to avoid doing it. A strategy that helps is to periodically review your portfolio holdings to make sure they still support your investment plan. Carefully reassess the winners while doing so, and if they have given their best then consider selling them. Much like the old political saw, it's not what the investment has done for the portfolio in the past its what will it do to help returns today and tomorrow.