The endowment effect is an emotional bias that causes people to value something they own higher than they otherwise would. Much like other behavioural biases people often don’t even realise that they are doing it until it’s explained to them.
Let’s look at an example, you’re a lifelong Pokémon fan. You’ve collected every card including a few rare ones but one in particular sticks out. This card is one of your oldest and by far your favourite. One day an acquaintance offers $50 for the card, do you sell?
Now let’s consider a different circumstance. You’re the same lifelong Pokémon fan and one day when walking past a card shop you spot your favourite card (same as the one above but you don’t already own it this time). It’s available for purchase for $40. Do you buy it?
There’s a good chance you didn’t sell the card in the first setting and didn’t buy the card in the second. That makes no sense, by not selling the card you are saying it is worth more than $50. By not buying later, you are saying that it’s not worth $40. This is the Endowment effect.
How Does This Effect Investing?
By owning the card, it had more significant value to you than it overwise would have. The same is true for stocks. People will often buy a stock and months later forget why they bought it. When bad news hits a random share, most investors can rationally determine if that will have a positive or negative impact on the business. If the story is terrible, you will likely stay away from the stock. However, most investors who already own the stock will in their head find a reason that the stock is a good buy. This enables them to value the security above its actual worth and leads to many investors holding losers longer than they should.
How to Avoid Falling Victim to the Endowment Effect
I find the best way to avoid the endowment effect is to journal my investment thoughts. Before buying a stock, I will run a valuation to determine what I believe the company is intrinsically worth and then I will combine it with a brief report. In this, I will run through the aspects of the company I like, what I see having a positive impact on the share price and general things that have already been priced into the stock. The reason I do this is that in 6 months when I otherwise would have forgotten why I bought the stock, I can look back on what I wrote. If something has changed and I no longer feel my valuation is accurate, I can adjust and sell if necessary. Without your thoughts from before the purchase, you may find it very hard to make an unbiased assessment when news comes to light.