Would You Buy That Investment Again at Today’s Price?

This is the 16th article in the Behavioral Finance and Macroeconomics series exploring the effect behavior has on markets and the economy as a whole and how advisors who understand this relationship can work more effectively with their clients.

Endowment bias, which is an emotional bias, is inconsistent with standard economic theory, which asserts that a person's willingness to pay for a good or an object should always equal the person's willingness to accept dispossession of the good or the object. In short, people who exhibit endowment bias value an asset more when they hold property rights to it than when they don't.

Here's a simple example of endowment bias in action: A young boy was given a candy bar by his parents with his lunch. At lunch time, a friend asks the child to trade his candy bar for another treat. Often, children in this situation will require the equivalent of more than one candy bar--such as two candy bars of a different type, or three lollipops--to compensate for the fact that they already own a candy bar.

According to standard economic theory, since the child was given the candy bar in the first place, he should be willing to trade it for something of equal value. But, because he already owns the candy bar, he requires additional compensation in order to be induced to make the trade. This type of behavior is the endowment bias in action.

On the investment side of things, investors who hold investments simply because they already own them display the endowment bias--and can put themselves in a position of creating a suboptimal portfolio. Instead of evaluating the costs and benefits of holding or selling existing investments, they may simply decide to do nothing. In these cases, investors typically aren’t following a disciplined plan--or if they are, they are overriding it.

As advisors, we need to justify every position in the portfolio to make sure it has a purpose and is playing a role. Just because a client owns something doesn't mean he or she should continue to hold it.

Generally, endowment bias tends to impact investors in four main contexts:

• inherited securities
• purchased securities
• commission aversion
• desire for familiarity

For instance, investors who own inherited, concentrated stock positions often exhibit classic endowment bias. Take the case of a hypothetical granddaughter who hesitates to sell the bank stock she inherited from her grandfather. Even though her portfolio is under-diversified and could benefit from such an adjustment, because the granddaughter was given the stock, she may be irrationally attached to it. The problem, of course, is that the granddaughter may be unaware of the risk associated with holding an excessively concentrated equity position.

In order to try to combat this bias with clients, I typically ask the client, "If you had received, as cash, the current value of this security, what portion of that cash would you allocate into this specific security?" Often, the answer is none or very little. This is a powerful advisory concept and can be used to great effect to help your clients overcome endowment bias behavior.

Michael M. Pompian, CFA, CAIA, CFP, is the founder and chief investment officer of Sunpointe Investments, an investment advisor to family offices based in St. Louis, Missouri. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. Contact Michael at michael@sunpointeinvestments.com.

The author is a freelance contributor to Morningstar.com. The views expressed in this article may or may not reflect the views of Morningstar.