Why the “Endowment Effect” Makes You Overvalue Your Investments
Stop loving your portfolio just because it’s yours.
In this article, we’ll cover the disposition effect, one of the most common mistakes I see among beginner investors.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
The Endowment Effect — What is it?
The endowment effect is the tendency of investors to value stocks they already own as more valuable than they really are.
How does the endowment effect apply to investing?
Investors sometimes have a tendency to “fall in love” with stocks they own.
There are several reasons why this happens, but the bottom line is they become attached to their stocks and hold them longer than they should.
Let’s look at a few examples of how the endowment effect plays out in investing.
Sometimes an investor will fall in love with a stock because it’s been good to him. Imagine an investor who bought Apple (AAPL) back when the iPhone first debuted and now he’s sitting on a huge paper profit.
Over the years, he has become emotionally fond of Apple stock because it has performed so well. Every time he logs into his brokerage account, he sees Apple with a big green gain and he smiles.
The problem is he may have become blinded by love.
Regardless of whether Apple stock remains a good investment, he’s likely to keep holding it because he has a personal attachment to the stock.
This endowment effect is similar to the “status quo bias,” which is the tendency to prefer that things stay the same rather than change. An investor influenced by the status quo bias would prefer to hold their current portfolio, even if it’s not great, rather than change things up and upgrade their stocks.
The status quo bias is similar to the “default effect,” which says that given the choice between several options, investors are likely to choose the default choice. For many investors, the default choice is whatever stocks they hold in their account today.
Finally, another driving force behind the endowment effect is something known as “effort justification.” This is the tendency for people to place unjustly high value on things they put significant effort into creating.
This is also called the “IKEA effect,” which observes that people who build IKEA furniture tend to value it higher than others do, simply because they built it themselves.
Similar to the IKEA effect, investors will sometimes overvalue a stock they’ve spent a long time researching simply because they’ve invested so much time and energy into understanding the business.
All these variations point to the same bottom line:
Investors can get attached to stocks they currently own, which makes them slow to recognize when there are better stocks available.
What should you do instead?
Instead of falling in love with your stocks, ask yourself:
“If I woke up today and had to invest this money in the stock market from scratch, are these the stocks I would choose? Or, are there better options out there?”
Try to detach yourself from the fondness you may feel towards your current portfolio and constantly ask yourself if there are better investments available.
It’s totally fine if the answer is, “No.” You can keep holding your stocks.
But it’s important to at least consider the question.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.