We've all felt it. An undervalued stock you bought a few years ago has since doubled, or even tripled. But now you have a problem. Your star performer has moved from a conservative 5% portfolio weighting to a 15% position. You can feel the risk building … but this stock is making you rich! You don't want to let go.
It's the classic Cinderella story. You fall in love with a stock, tell yourself 'I'll dance just a few minutes more' … then the clock strikes 12 and suddenly you're knee-deep in pumpkins and mice. Why do we fall in love with our best investments and what can we do to protect ourselves from heartbreak?
In one experiment, people were given either a mug or a pen at random. They were then offered the chance to trade their item for the alternative. Bizarrely, almost no one wanted to trade. Furthermore, when asked how much the mugs and pens were worth, those participants who received mugs thought mugs were twice as valuable compared to those who received pens, and vice versa.
This effect is exploited by infomercials offering a '100% money back guarantee' – as soon as you have that set of steak knives in your possession, you'll start to feel they're worth more than your initial outlay and so be reluctant to swap back.
And the same goes for shares. Once a stock is in our possession it becomes 'our' stock and we perceive it as special. Consequently, we'll usually feel it's more valuable than the current market price so always want to hold on a little longer, especially if we've owned it for a long time and it has done particularly well for us.
So how do we combat the endowment effect to make better investment decisions?
A good place to start is to come to your portfolio periodically and pretend you have 100% cash, then ask yourself whether this is the set of stocks, at these weightings, you would want if you had to buy everything from scratch at current prices. Doing this exercise won't completely eliminate the endowment effect, but it should help to minimize your commitment to previous decisions.
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