Endowment effects and loss aversion psychology and investing

The purchase price for something, be it a house, a car, a stock or basically anything else, becomes irrelevant the moment we exchange funds for the newly acquired asset. The price we pay for an asset goes from being of the utmost importance to completely immaterial (but for tax considerations) the moment the transaction is complete. We have a strong desire to be good stewards of our economic resources. As such, we diligently analyze and often employ the help of experts before deciding what car or house we should buy while carefully evaluating the proper price. There is nuance and distinction between buying assets for use like a home and buying assets for exchange like a stock, but for both types we overly fixate on our original purchase price as we evaluate the things we own. No one wants to feel like they overpaid for an asset. As a professional investment manager, I get to confront this opportunity for psychological pain shortly after I flip the lights on in my office each morning. It's inevitable in my line of work. Let's review two psychological tendencies and discuss how they can work together to cause us to make decisions that aren't entirely rational. First, we have the endowment effect, which explains how we innately assign a higher value to an asset once it comes into our possession. Daniel Kahneman recounts a psychological experiment he conducted decades ago in his book, Thinking, Fast and Slow, where half of participants received a commemorative coffee mug with their university insignia on it. The mugs were placed directly in front of them. The other half of study participants were told they should look at the mugs and decide what price they would pay to purchase a mug from their neighbor. Those who were given mugs had to decide what price they would accept to part with their new mug. The average price the buyer was willing to pay was $2.87, while the average selling price from the mug owners was $7.12. Sellers valued the mug more than twice as high than the average buyer. This type of endowment effect can just as easily come into play with the securities we've chosen for our portfolio. In The Psychology of Human Misjudgment, Charlie Munger talks about the endowment effect's possessory wallop and how you will find a man who has already bought a pork-belly future on a commodity exchange now foolishly believ[ing], even more strongly than before, in the merits of his speculative bet. The second psychological tendency, loss aversion explains how the pain of experiencing losses is worse than the joy of accruing equivalent potential gains. This applies to both the loss of use of a coffee cup and to purely monetary losses. With an investment portfolio our tendency toward loss aversion can cause us to stubbornly hold on to a stock that has declined in value below the price we paid for it. It's difficult for us to admit we were wrong and make the loss permanent by selling, even if faced with objective evidence that circumstances have changed since our purchase in a way that impairs stock's intrinsic value. Tax considerations are the only thing that makes an investment's original cost pertinent to a decision to sell or hold. In the case of a tax-advantaged retirement account, original cost is completely irrelevant to that decision. In an IRA, the only things that matter are what the current price of the security is and based on all currently available information whether the estimated intrinsic value is sufficiently higher than the current price to induce me to continue to hold shares or perhaps buy more. ----- J.P. Szafranski is CEO of Meliora Capital in Tulsa (www.melcapital.com). Published: Mon, Mar 18, 2019