The Eye of the Beholder: Managing the Effects of Endowment Bias

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Have you ever wondered why it seems like every homeowner believes his or her home is worth more than the market says it’s worth?  Over the last decade, with a few brief exceptions, American homeowners have consistently believed that their homes were worth more than their appraised values would suggest (at one point as much as 8% more, on average).

And this is not a new phenomenon. Historical data suggest that this has generally been the case since data have been available on the subject.  But how can it be that we so consistently overestimate the value of our homes, regardless of data to the contrary?  The answer appears to be something called endowment bias, and this insidious emotional quirk can cause significant problems for otherwise conscientious investors.

What, exactly, is endowment bias?  Endowment bias suggests that people assign more value to something if they own it than if they do not.  This bias applies to a number of possessions, including homes, automobiles, stocks, and practically everything else that we own.  In one experiment that was performed on a group of Cornell University students, one-half of the students were given a coffee cup with the Cornell logo, and the other one-half were given nothing

Then those students who had been given coffee cups were asked at what price each of them would sell his or her cup. The median price at which the group agreed to sell their cups was $5.25.  However, when the students who had not been given coffee cups were asked to name a price at which they would buy the cups from the other group, no one in the group was willing to pay more than $2.75.  This sizeable gap seems to indicate that the selling group placed more value on the coffee cups simply because they owned the cups.

Early research on this topic suggested that the origin of endowment bias was actually loss aversion (another dangerous bias that I discuss here).  Because a person selling an item would feel a sense of loss upon the sale, he or she wanted to be compensated for that painful feeling by charging a higher price, even though he or she would never pay that price to buy the item.

However, more recent studies have shown that the endowment bias is even simpler than this. In a modified version of the original coffee cup experiment, it was found that buyers would pay a higher price for a coffee cup if they already owned an identical cup.  This phenomenon indicates that simply owning an item causes a person to assign more value to it.

The investment implications of this bias should be obvious.  An investor may be disinclined to sell assets that have become fully valued because the mere act of ownership impairs the investor’s ability to properly value the asset.  Holding onto assets that have become fully valued on a fundamental basis introduces incremental risk to a portfolio.

For this reason, an investor should not take a position in an investment without having a clear and disciplined exit plan. This exit plan may change over time because of changes in fundamentals, but having a stated plan for when to sell an investment can help to offset or avoid the effects of endowment bias.

Investors should note that securities are merely tradable assets, and one should never have an emotional relationship with any investable asset, lest it become over-valued and increase the portfolio’s risk.

Investing should never be an emotional endeavor, but for many investors, it is precisely that.  Oftentimes, an investment portfolio represent the fruits of a lifetime of hard work and disciplined saving, so eliminating emotion from the equation can be a difficult task.  However, simply being armed with the knowledge of our own emotional tendencies can help to significantly reduce their negative effects on investment decision-making.

In the case of endowment bias, establishing a clear exit strategy before getting involved with a security can help us to make more rational decisions before our emotions have a chance to get in the way.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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Matthew Blume, CFA

Matthew Blume, CFA

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