There are many mental traps an investor or trader can fall into.  Unless these are understood, the investor may not even realize she is under the command of the mental trap.  Her performance will suffer.  One of the worst mental traps for which a trader or investor is likely to be unaware is the endowment effect.

Endowment

When someone owns something, they attribute more value to it than they otherwise would, simply because they have possession of it.  That’s the endowment effect.  In one of the earliest studies on this mental trap, people were given an unremarkable coffee mug and then given the opportunity to sell or trade it.  As the study progressed, it became apparent that ownership of the mug significantly affected its perceived value.  When not already owned, people willingly paid the going rate for the mug, say $5.00.  Once owned, however, they were unwilling to sell it for less than $10.00 — twice the market value.  The only thing that changed was ownership.  Mere ownership dramatically inflated perceived value.  Since that initial research, numerous studies across different populations buying and selling various items demonstrate the endowment effect. 

One Investor’s Experience with Endowment

One investor owned Apple Corp (AAPL) a few years ago (2012) and was in a very profitable position, having earned on paper a hefty return on his investment.  He was also a savvy technical analyst and knew AAPL had become considerably overbought.  Although the chart pattern forecasted a significant decline, he held onto his stock.

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As an owner of AAPL, he believed that the stock was worth more, much more.  He was trapped by the endowment effect, unable to see clear indications that further upside for AAPL at that time was limited and the risks of ownership had dangerously increased from a technical perspective.  He continued to be bullish on the stock, however, even as it slid lower and his returns evaporated.  Eventually, he sold the stock at substantially less profit than he once had had.

Endowment Overrides Sound Decision-making

Investors mentally locked into a stock often focus on the attributes of the company and see them as reason the stock will rally higher.  The AAPL investor knew all the latest information about the wonderful Apple Corp products—from all the features of the latest iPhone to breaking news on the iPad.  Although excellent products, it is important to understand that appealing product features—no matter how enchanting—do not mean the market will send the stock higher.  Revenue, earnings per share, earnings growth, business strategy, competition and the like outweigh product features when valuing a stock.

Dealing with the Endowment Effect

Here are a few tips on dealing with the endowment effect:

  • Be aware of your tendency to want more for the investments you own.  It may seem reasonable to think the stock is worth more, but this may be a clue it’s time to sell.  If other data is telling you the stock is ripe for a down move or the stock is trending down, be willing to override the arguments your mind is telling you that the stock “deserves a higher price.”  Accept reality and move on.  The practice of mindfulness is a useful skill in this regard.
  • Be wary of bulls touting stocks.  Many would-be stock pickers overvalue stock features such as products or management (e.g., “The CEO is a rock star”) and fail to conduct sound stock evaluation.  We see many on social media outlets.  They are often caught in their own mental traps.  Avoid them and do your own analysis.
  • If you are using fundamental data to select investments, know what sound fundamentals really are.  Understand the criteria that makes a stock a good investment.  While managers may be ‘rock stars’ and the company makes exciting products, these alone don’t make the investment a sound one. 
  • Develop technical skills and use them.  When a market continues to fall, putting in lower highs and lower lows, it’s in a down trend.  Although the market may find a bottom at the next low, that’s not a good enough strategy to keep your money invested. 
  • Have a point at which you cry uncle by setting a stop.  Stops are used to take yourself out of a position when wrong about the trade or the investment has turned down.

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Dr. Gary Dayton

Founder

TradingPsychologyEdge.com