Getting attached to stocks – the Endowment Effect

Changes in stockmarket direction are hard to deal with.  Assessment of new information is just part of the problem.  Imperfect mental accounting means assessment of risk is slow to change.  Investors realise they should be adjusting their portfolios, but psychology gets in the way.  Some defensive sectors, like telecoms, look attractive now, but what should investors sell?  It is not so easy to take profits in banks and miners.

 How investors react is not always fully explained by the early models of behavioural finance.  Certainly, investors can be averse to taking losses, and tend to sell winners too soon.  But, the current background noise, and lack of consistent indicators on the health of the global economy, has encouraged inertia.  Trading volumes are low, and many investors have stuck with higher beta areas like resources through the two year bull market.  It seems that lack of realistic alternative investments has discouraged premature profit-taking.  Those who moved into defensives –  like pharmaceuticals – have lost out.  Over the past two years, Glaxo has underperformed the FTSE All-Share by 30%.  Utilities have been almost as disappointing. 

 But, the toughest psychological challenge is the endowment effect.  Investors become attached to what they already own, prizing stocks in the portfolio more highly than alternatives.  Working unconsciously, it is an emotional effect that can distort rational comparisons.  And, why should a fund manager not feel good about miners and banks that have performed well over the past two years?  It would be a shame not to be able to still show those winners in a portfolio.  Few clients would criticise a failure to exit at the top, when a holding is still showing good gains.

 In a classic psychology experiment, people demanded a higher price for a coffee mug that had been given to them, but put a lower price on one they did not yet own.  This endowment effect – an emotional attachment to ownership –  is often seen in share price inertia. Companies can deliver successive misses on earnings before finally reaching the right valuation.  For over-owned and much loved stocks, relative price momentum will often lag earnings momentum. 

 The endowment effect might be controversial, but most investors will recognise the emotion that can attach to winning shares.  Adverse sentiment can make an impact, too.  Sometimes, “bad” shares are sold at the end of a quarter, as they can attract disproportionate client attention. 

 Investors who bought mining stocks two years ago have made big gains.  The sector as a whole is 70% ahead of the market averages over that period.  Investors might not consciously recognise it, but these stocks will give them a warm feeling as they look at their portfolios.  And, while performance is evident, liquidity is less clear.  For smaller mining companies, capital raising for mine development has involved share placings at discounted prices.  Day-to-day dealing activity has not grown at the same rate as market capitalisation.  This could be tested in any widespread withdrawal from the sector.

 As an emotional bias, the endowment effect is tough to deal with.  Reverses lasting months, within what many view as a multi-year uptrend, can also be hard to react to tactically.  Initially investors can feel confident of riding through the setback, but later decide they can get back in lower down.  The coming weeks might test investors’ nerve – they may need to work hard to get the right balance between feelings and rational response.

 This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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