“For most things are differently valued by those who have them and by those who wish to get them: what belongs to us, and what we give away, always seems very precious to us.”— Aristotle, The Nicomachean Ethics book IX (F. H. Peters translation)
The share of equity investments is 8% of the total household financial assets in India. This is low by international standards (40% as per Ned Davis Research). However, the passion that Indian investors have towards equity investments is no less than international investors, especially towards investing directly in stocks.
As we get to see more and more equity portfolios from investors who want us to do a portfolio diagnostic analysis, we are shocked at some of the rubbish stocks that are part of their portfolio. Their passion, sadly, has not resulted in efficient portfolio management in most cases.
Everyone makes faulty investment decisions. Coming up with a faulty investment thesis is excusable. However, it is inexplicable that the investors do not sell losers in the portfolio even after realizing that they have made a mistake. As a result, over a period of time, typically at least one-third of the portfolio consists of stocks that have no hope of coming back to their purchase price. In fact, many stocks are either suspended from trading or close to it.
Theory of loss aversion has been propagated as the reason why investors refuse to cut their losses. It basically says that the pain of loss is twice the pleasure of gain. However, this is only part of the answer and also violates the standard economic theory that a person’s willingness to pay for a good should be similar to his willingness to accept compensation for selling the similar good. There is broader and more efficient explanation for this strange behavior of investors. It is called the Endowment effect.
There are two ways to look at Endowment effect. In a valuation-based scenario people expect to be paid more for something that they own than what they are ready to pay for the same thing.In an exchange scenario, people with a good are reluctant to trade it for another good of similar value.
Pros. Kahneman, Knetsch& Thaler conducted a study to see how the endowment effect influences our decision making.Participants were randomly divided into buyers and sellers.Sellers got coffee mugs as a gift. Sellers were asked for how much would they sell the mug and the buyers were asked how much would they pay for it.
Results showed that the sellers were willing to sell a mug for $7.12 while buyers were willing to pay $2.87 (median prices).
This experiment brings out the stark difference between Endowment effect and loss aversion. Sellers here got the mugs for free. There was no possibility of incurring a loss. Even then they placed a higher value on them just because they owned it.
Investors would do well to be aware of this Endowment effect (bias) and not let it get in the way of periodical cleaning of the portfolio. A professional advisor /planner may be better suited to do the spring cleaning of the portfolio since she would not get biased by the Endowment effect.
The writer of this blog is Abhay Agarwal MD & Portfolio Manager, Piper Serica. Piper Serica is a SEBI registered provider of Portfolio Management Services (PMS). It has generated industry beating returns. The objective of the PMS is to grow wealth over a long period of time by investing in LEADERS in sectors that COMPOUND earnings for a very long period of time with very little business volatility. To learn more get in touch with him at email@example.com or visit www.piperserica.com