Wikipedia, also known as the most trustworthy site of all time, defines the endowment effect as “the finding that people are more likely to retain an object they own than acquire that same object when they do not own it.” Not going to lie, I feel instantly less credible quoting Wikipedia for my opening of an article, but it’s really just a definition – and a very fitting one at that.
I always knew that the endowment effect was real, but I never really knew that there was a definition and a term specifically applied to it.
Think about it – how many times will you refuse to sell something because it has some sort of perceived value to you that it doesn’t have to other people.
For instance, maybe someone doesn’t want to move out of their $200,000 house because it’s the first house they ever bought, raised a family there, and retired in that same house.
Now they need to sell the house to downsize, but the problem is that the house is worth $200,000 but they view it as a $300,000 because of all the memories that are tied up into that house. They’ve placed this incremental value on it, without knowing, due to their bias of the endowment effect.
Is there an issue with this perceived value? No – as long as you’re willing to never sell that house.
My favorite part about the endowment effect is that people don’t even realize it’s happening to them or that they’re experiencing it.
I’m Guilty of it too…
For instance, I used to have thousands of sports cards from my childhood. I mean, like 10,000 or more. When I was still in school, my mom was having garage sale. I was very into the value of the sports cards and even bought a book that told me the proper prices of the cards to make sure that I was pricing my cards properly.
My hockey and basketball cards I sold for a very cheap amount. In fact, my book that I bought didn’t even address those values. I just didn’t care how much I got, I just wanted some cash!
My football cards, I tried to price at face value. If I got a fair market price, I was happy. If not, I would prefer just to hold onto them.
Now my baseball cards…those suckers, those were all almost double the actual value. Why did I price them this way? I LOVED baseball cards. I used to sort them by league, then by team, then by player. My favorite team is the Cleveland Indians – I had my own binder with just the Indians in it. I mean, like over 60 cards of just Jim Thome (my personal hero). These Jim Thome cards were not even for sale.
So why did I price the baseball cards so high and not even try to sell any of my Thome cards?
Well, because they meant more to me than the dollar amount. And guess what – I was fine with that! They had a personal meaning to me.
I used to watch SportsCenter for hours on end (this was when it was the same episode that played back to back to back to back) as a kid and flip through pages of pages of sports cards in my binder, recite stats to my dad until he was too annoyed to listen anymore, and show them off to my friends in a bragging sense.
I placed a perceived value on them because it meant a lot to me that was higher than the actual dollar amount.
Academic Study on the Endowment Effect
One of the most common examples of the endowment effect is from a study that was completed by Professors Kahneman, Knetsch and Thaler, which is commonly referred to as the mug experiment.
In this experiment, the scientists had a group of individuals that they either gave a coffee mug to, or they didn’t. If you got a coffee mug, they asked what price you would be willing to sell it for. If you didn’t have a mug, they asked how much you would pay for that mug. The variance between those two was staggering. The average selling price was $7.12, and the average buying price was $2.87, see below:
That is a HUGE difference between the average buying price and the average selling price. The difference is simply the perceived value that the group of people that already have the mug place on already having the mug, vs. what the average buying price would be, which is really what the true value is. As Kevin O’Leary always says, “you’re worth what someone will pay”.
Endowment Effect and the Stock Market
So, how does the endowment effect really impact you when it comes to investing? Well, it’s pretty simple really – holding onto a stock too long can cause you to not only experience lackluster returns, but it can also create an environment for you to experience “opportunity loss” and miss out on opportunities that are currently present and you should jump all over!
A lot of people that I work with, including myself, own stock in their employer – and that’s a good thing! Owning stock in your employer really shows that you support your company and believe in the long-term vision.
But the scary thing is that a lot of those people blindly purchase stock not knowing a single thing about the valuation of the company, or even knowing any sort of financials.
For my coworkers, they’re very happy as they’ve seen 291% returns in the last 8 years. For employers that work as very large, credible employers, such as Chesapeake Energy (CHK) or Transocean Ltd (RIG), who are down 93.2% and 90.1%, respectively, this would be a huge disaster!
These employees might continue to invest because the stock means so much to them, because they work for the company and they see the vision – but in the long run, they’re likely going to regret this decision because they placed a perceived value on the stock – but guess what – you can’t use perceived value to pay for your retirement.
I know this is an extreme, but it’s a very real situation…
I’ve literally had people tell me that they want to sell a stock because they have received bad service at that restaurant. Ok….and? Yes, if the service is always bad, or if you think it’s a cultural thing that can keep them from competing, then that might be one thing to think about when selling a stock – but never let one personal situation keep you from reaping the benefits of a great performing stock.
This is the exact opposite of the endowment effect, but the principle is the same – do not let personal feelings and emotions get in the way of making money.
One thing I absolutely hate is when you hear people ask if they should buy, sell or hold a stock. What the heck is a hold? Why would you ever hold but not also be willing to buy? What does hold even mean? Does it mean that it’s good enough to keep in your portfolio if you have it already but not good enough to buy more? Like….what? That’s just blasphemy to me.
If a stock isn’t good enough to buy, then why is it in your portfolio?
The answer is the endowment effect.
People will hold onto stocks that they own, just because they own them, when that money can be used to invest in a stock that they deem as a “buy”.
MarketWatch went through many of the different analyst ratings by firm and listed them in an article so you could really understand what they all meant. Below is a screenshot from one that really gets me going…
As you can see, Wells Fargo Securities has a “Hold” rating, which essentially means it has upside, but not right now. Maybe you’re different than me, but my opinion is that if I’m comparing two different options, and they’re almost completely equal, but one has upside RIGHT NOW, then I will choose that one – 100% of the time. To me, a ‘hold’ means SELL. Move that money into a high performing stock.
Imagine now that you’re an employee that Chesapeake Energy or Transocean Ltd…if you start to see the writing on the wall, and maybe you start to get fearful that the stock is in the process of making a severe turn for the worst, would you sell the stock, or would you hold?
A lot of people will hold because they feel like since they already own it, and it does assist their company by investing in them, there’s no harm in holding it.
Well, my friends – that is the definition of the endowment effect.
They are holding onto the stock for the sole reason of some perceived value that simply doesn’t exist – and it’s causing them to miss out on potential great returns on other, flourishing companies.
If you get one thing, and one thing only, from this post – please make it be to take your emotions out of investing. Look at things as black and white, matter of fact. There are only facts and numbers when investing – do not let your emotions get in the way of your financial goals, because if you do, then I don’t think your emotions will be very happy.