Welcome to the fourth installment of our 'Investors Behaving Badly' series. Thus far, we have covered a lot of ground, introducing some central tenets of the burgeoning field of behavioural economics and their applications to investing (in part 1). We have examined Prospect Theory in some detail (in part 2) and discovered how to frame our investing decisions based on risky and riskless alternatives. We also introduced the concept of loss aversion (in part 3)--our natural tendency to feel worse after a loss, than we feel good after a gain. Throughout the series, we have seen that exchange-traded products (ETPs) can offer an advantage over actively managed vehicles as we attempt to properly frame our investment choices and overcome our aversion to losses. However, ETPs are not cure-all vehicles. In fact, today, we want to introduce another behavioural bias called the "endowment effect" and discuss why investors--regardless of whether they use passive or active investment vehicles--have difficulty overcoming this bias.
First postulated by Richard Thaler in 1980, the endowment effect is one of the first cognitive biases observed to violate standard economic theory. The endowment effect states that 'people often demand much more to give up an object than they would be willing to pay to acquire it' (Thaler, 1980). Since 1980, this effect has been demonstrated innumerable times in laboratory and real-world settings, most often with a coffee mug. Imagine I had an inventory of coffee mugs and offered to sell you one, but you were able to name the price. For argument's sake, let's say you offered £2 and I obliged. Now, suppose I immediately asked to buy it back from you at the previously agreed upon price £2. Most people refuse this offer and instead counter with a higher price in the range of £3-5. Why is this? Thaler hypothesised that once property rights to a product are established, there is a cognitive tendency to value that good more than before you possessed those property rights. Stated another way, your willingness to pay for a good or service is less than your willingness to accept. This violates standard economic theory, which assumes equality between your willingness to pay and your willingness to accept.
The endowment effect has immediate implications for investors. Simply put, the cognitive tendency to 'love what you own' applies to the shares, bonds, and funds in your portfolio. We naturally exhibit a tendency to be lenient on evaluating the performance of what we own. If the market says our stock is worth £10, we naturally think its worth more even before we perform any analysis whatsoever. Not surprisingly, this cognitive bias does us a disservice. In order to overcome the endowment effect, we need to equally scrutinise both what we own and what we don't.
I hesitate to tout the benefits of ETPs in relation to the endowment effect because you own an ETP just like any other stock or fund. However, the argument could be made that the endowment effect has less of a subversive effect on ETPs due to the homogeneity of alternatives. Consider a scenario where the endowment effect is especially pronounced for one of your ETP holdings following the STOXX Europe 600 Index. You like this ETP and would not be willing to part with it unless someone offered you a price 10% higher than what it currently trades for. An investor who is not as influenced by the endowment effect may be able to see opportunity in another ETP tracking the same index that boasts lower fees and better tracking than yours. Odds are that he/she will have a higher investor return than you by a few basis points by failing to be fooled by the endowment effect. However, the consequence of your inaction as a result of the endowment effect will not likely be significant. The reason primarily has to do with the homogeneity of the indices. You both still track the same holdings and will likely experience near equal returns in most cases.
However, in the case of index heterogeneity, the endowment effect can become a significant issue for the ETP investor and can be equated to any other investor's experience. One only needs to gaze at Morningstar's Large Blend category to know that each actively managed fund is not created equal. The same applies to ETPs that track different indices in different fashions. In short, if you chose to invest in a product because it is constructed differently than its peers, then you will likely have a natural inclination to value it more than its nearest comparables. Otherwise, you wouldn't have bought it in the first place. Now, I am not advocating that individuals choose an investment solely because it has very similar alternatives. Quite the contrary, it's vital that investors do their due diligence and choose investments for sound fundamental reasons. But recognise, that in doing so, they will have a natural, documented tendency to overvalue their final selection.
For every type of investor, therefore, it is important to be cognisant of the endowment effect and judge the various products impartially as best as possible, especially when you already own one or more of them.
In the next installment of this series, we will discuss overconfidence. Why is it that 80% of drivers, when polled, respond that they are above average? That's mathematically impossible! In our search for an explanation, we will cover two other important cognitive hurdles: outcome bias and confirmation bias. All three of which can have profound implications on our investing activities.
Lee Davidson is an ETF analyst with Morningstar.
