Larry Swedroe’s new book, Investment Mistakes Even Smart Investors Make and How to Avoid Them
Mistake 11 in Swedroe’s catalogue goes like this: “Do You Let the Price Paid Affect Your Decision to Continue to Hold an Asset?” This error is what behavioural economists call the endowment effect. It’s what makes us place a greater value on something just because we happen to own it.
Imagine that you want to attend a hockey game. You don’t yet have a ticket, and you decide that you’re willing to pay no more than $100 for one. The next day, you win a ticket to the game in a radio contest. If a friend offers to buy that ticket from you, for what price would you be willing to sell?
If you were purely rational, you would accept any price over $100, since that’s the maximum value you placed on the ticket before you had one. But if you’re subject to the endowment effect, the ticket is likely to be worth much more to you now that you’ve got one. In one famous experiment, subjects said they were willing to pay a median of $150 to buy a ticket, but their median selling price was $1,500. Somehow simply owning the ticket increased its value tenfold.
Too cheap to sell, too expensive to buy
I recently spoke to an investor I’ll call Stephanie, who provided a perfect real-life example of this odd behaviour. Her advisor had purchased a small-cap energy company in her portfolio, and the stock had since lost over half its value. She wasn’t just bothered about the loss—she was angry that the advisor had purchased the stock in the first place, since she wasn’t interested in speculating on junior resource companies.
“Why don’t you sell the shares and buy something more suitable?” I suggested.
“I think the stock might come back a bit,” Stephanie replied. “I’ll give it another six months or so.”
I thought about that for a second. “If you didn’t own this stock already, would you buy shares today?”
“Of course not,” she said. “Why would I do that? I just told you that risky stocks like this aren’t part of my strategy.”
You can probably spot the irrational thought process here. If she thought the stock was incompatible with her investing strategy, then she should have been prepared to sell all of her shares immediately. The fact that she already owned shares in the company should not have had any bearing on the decision. Indeed, if she truly thought the stock was going to go up in the next six months, why not buy more shares?
To avoid falling prey to the endowment effect, Swedroe suggests asking yourself: “If I didn’t already own the asset, how much would I buy today as part of my overall investment plan?” If your answer is “none” or “less than I currently own,” then you should sell the asset now and replace it with something that suits your long-term strategy.
One caveat, which Swedroe acknowledges: the decision to dump an inappropriate investment is not so simple if you’d face a large tax hit on the capital gains.
I can’t be smug about Stephanie making Mistake 11—I admit I’ve fallen prey to this cognitive error myself. But in the future, I hope I’ll be less likely to fall victim to the endowment effect. Now it’s time to start working on the other 76 mistakes.
I sometimes get some flack for saying this on CMF, but anyone who uses the phrase ‘averaging down’ is making this mistake.
Sounds like an interesting book, though, as it lies at the confluence of two subjects that interest me: behavioural economics and cognitive bias, and personal finance/investing. Of course, humans didn’t evolve to make rational decisions about entirely abstract concepts such as stock investing, so perhaps it is unsurprising that we are left with these heuristics that let us down.
@Andrew F: If you’re interested in behavioral economics and investing, I’d definitely recommend the book. An even better choice is this one:
https://canadiancouchpotato.com/2010/04/17/review-why-smart-people-make-big-money-mistakes/
Regarding the idea of “averaging down,” I suppose it depends on the context. If you hold an asset that you believe has a positive long-term expected return, I don’t think it’s a mistake to buy more of it if the price falls. On the contrary, I would ask, if you bought X for the long term at $20, why would you not buy more if it fell to $18? This is a key concept behind rebalancing a portfolio. I wouldn’t call this “averaging down” but the idea seems similar. Is this what you mean?
By averaging down, I mean specifically the idea of buying an asset because you bought it previously at a higher price. By this I mean people who buy more of an asset because they are trying to fix a previous trade or ‘rescue a loss’. The very idea of averaging down implies a backward looking approach to investing. The decision to purchase should be independent of previous price behaviour.
I think this is dangerous because it can lead to people not managing risk in their investments appropriately and increasing exposure to badly performing assets by ‘averaging down’.
@CCP: Is “Why Smart People Make Big Money Mistakes and How to Correct Them” a better book for behavioural economics or better in general?
Our psychological biases have developped over millions of years and for the most part have put us in good stead (afterall, here we are!). Stehanie’s mistake is okay in a barter system. If humans were perfectly rational, there’d be no religions, etc.
@Sterling: Both books deal with the same general material. “Why Smart People Make Big Money Mistakes” is a bit more broad, in that it doesn’t just deal with investing, but also things like buying decisions. I also found it to be extremely well written.
@Cory: You make a good point. Meir Statman often makes the point that cognitive biases don’t make us stupid, they just make us human. Unfortunately, what saved us on the savannah doesn’t work so well in investing, and we really do have to work hard to avoid these mistakes.
Great post Dan!
I remember when Nortel Networks fell to $40 per share. My investment club owned shares, but some of the investors wanted to hold on, to see if it would recover after previously hitting a high of $124 per share.
One of our members presented the right question:
Would we buy it at $40 per share if we had fresh money? Nobody agreed that we would. We eventually sold it, but it was an interesting case in human psychology.
Yes, but if you replace the words ‘averaging down’ with ‘dollar cost averaging’ or ‘asset reallocation’ and it’s one of the most prudent things an investor can do.
But DCA at least buys regardless of whether the price has moved up or down. It is not just averaging down, it also averages up. DCA is also a mechanical strategy, whereas the typical averaging down scenario is done without much forethought, planning, or on an ad-hoc basis, meaning it is likelier to be an emotional decision.
@Andrew H: Thanks for stopping by. This really does seem to be a powerful urge—it’s related to another cognitive bias that prevents us from selling losers because that would be admitting that we made a mistake.
@Dale: DCA is really an unrelated idea, if you’re talking about systematic contributions. People typically use DCA because they receive a regular paycheque, and so it it makes sense to simply make long-term investing easier and more practical.
It seems like the endowment effect is a popular topic :) I was just reading Daniel Kahneman’s new book recently (which is also great for background information on financial decisions) and learning more about the endowment effect and the general fear of losing what we’re familiar with. It inspired me to write a bit last week about the “fear of success” that comes up once you have a large portfolio to look after and you don’t make decisions the same way you did when you had a smaller portfolio.
Well, Stephen Stills says that if you can’t be with the one you love, you’re supposed to love the one you’re with!
In Stephanie’s case, that indomitable human urge to hold out hope of correcting the original “mistake” might provide her greater psychological utility then recognizing the loss and moving on. If holding the stock provides her with greater psychological utility than she would otherwise experience in dumping the stock, then I’d argue that it is rational behavior on her part. It’s just not very sound investment practice.
The two concepts sometimes come into conflict with each other in the short run. That is what make human decision making so very interesting to observe.