The Endowment Effect – Messing with your mind.
Consider the following scenario: You have the option to buy a particular stock, which you are told by a reliable source may increase in value 20% at some point in the next month, the source can not tell you why, but you trust this source. You decide to invest some cash that you have lying around not earning much interest, say $10,000 in this stock at $1.00 per share. Over the next few weeks not much happens and your source then informs you that his expectation did not materialise.
Assuming you can sell the shares for $1.00 and therefore suffer no loss (Ignoring any brokerage fees). – What would you do?
A). Do you just sell the shares? Let’s face it; you never had much interest in that company in the first place.
Or
B) Do you hold on to them? Now that you own them perhaps they are a good company after all, they may not have had the big rise that was predicted, but they may still turnout to be good value.
So what do you do?
In reality it should be a no brainer. – Prior to the recommendation, you had no interest in owning the shares; you bought them for one reason only, because you thought there was going to be a quick buck to be had. Thus the rational thing to do would be to go back to putting your money into cash until a good investment opportunity comes along. However, there is a chance that in reality you select option B; now that you own the shares you personally attach a higher value to them, and would rather wait for someone to pay you a higher price for you to sell them. This of course is a highly irrational way to think, but unfortunately as humans we have a tendency to be swayed from acting in a rational way at times, and it should be no surprise that many of those times are when money is involved. It is not truly known why we are prone to act in irrational ways at times, however it is known that this irrational decision making part of the brain lurks just below the level of our consciousness, acting silently to hijack our rational thoughts and causing us to see and perceive the world in ways which are not always beneficial to us.
In the above example, choosing option B would be an example of a pattern of behaviour termed ‘The endowment effect’ by one of the godfathers of ‘Behavioural Finance’ Richard Thaler. Thaler had identified that people were willing to demand more to give up an object that they owned, than they would be willing to pay to acquire it. The endowment effect can be seen at work all day and everyday in trading and investing, as well as in many other aspects of our life. Let’s look at a theoretical example taken from day-trading.
Two traders – Trader A and Trader B are day-traders in the FX market,
The following chart shows a particular day’s trading action in Spot EURUSD FX.
The entire day’s trading, until the late afternoon, has been bouncing within in a range between the high 1.3130s and the mid 1.3170s. Both traders decide to execute a long position in the late afternoon on the approach to the low of the range at 1.3140. For a short while the EURUSD starts moving higher, but the move soon fades away, and the currency pair starts to decline and breaks down through the low of the range. - Both traders typically take the same approach to trading; however trader A sticks to the method religiously and is rarely distracted from it, whereas trader B is prone to being side-tracked. – Normal application of their method would see them cutting out the long position on a break below the days range, and going short. This is the action Trader A carries out, which results in a profit of 28 ticks over the course of the trades. However Trader B had allowed himself to be compromised by succumbing to the endowment effect. - Thus when he was went long of the EURUSD FX spot in the afternoon, he adopted a belief that it should have a higher value, when it broke the support level, which would signal that he should be abandoning the position and going the other way, he maintained this belief and not only held on to the position, he also decided to buy more, in this case he doubled the size of the position. – By the end of the day, in accordance with the trading rules of his firm, he had to be out of all positions; thus he had to sell the position out pretty close to the low of the day ultimately resulting in a loss of 74 ticks over the course of the trade.
Whilst this is a hypothetical example it is representative of what happens in many real situations, across many markets and across all time-frames.
Going back to the EURUSD example, the close of the day’s trading should ensure that Trader B’s worries are over. However the danger may not necessarily be over for Trader B, having gone home and possibly dwelt on the events of the afternoon, he may well be feeling a touch aggrieved and angry. He may be asking himself, why the hell he was caught holding onto the long position and doubling up rather than following the normal rules. At this point a new danger is getting ready to present itself: - Readers of some of my other articles on biases may be familiar with the bias of ‘cognitive dissonance’, they also may also have heard me mention how one of the dangers of decision/judgement biases, is that one sometimes they can lead to a string of damaging and dangerous decisions and judgements.
Getting back to this example, what we may have is a ‘cognitive dissonance’ at play here. In this case the dissonance is this; on the one hand Trader B believes that he is a good smart intelligent trader who knows what he is doing, and on the other hand he did something stupid and foolish. Accepting our own foolishness and fallibility is not a comfortable thing for many people; hence in this case Trader B chooses to resolve the dissonance by believing that the right course of action was to go long he was just unlucky, and that next time in the same situation he would do the same thing. Hence dissonance is resolved by an ‘erroneous self-justification’, and subsequently Trader B gets a good night’s sleep. - What this means however, is that the next time he is faced with a similar situation he may follow a similar course of action to that he took above, he may get lucky next time and it turns out right, but he will no longer be following his system or method which has proven successful in the past, and eventually this could turn out to be the first stages of a long period of under-performance.
The endowment effect can have repercussions in many ways some of these are as follows:
- It can cause traders to hold on to trades too long, eventually giving back most or all of a profit.
- Traders may not cut, or even increase losing positions.
- Traders can suffer from distortions in perceptions, leading to them not objectively assessing incoming news or data.
- A trader or investor may develop an ‘entrenched view’ which causes them to make poor decisions and choices and to fore-go opportunities elsewhere.
Identifying and recognizing when traders succumb to the pull of biases and other irrational and self-defeating behaviours is incredibly difficult, as I mentioned earlier, they tend to sit just below our level of consciousness. Nonetheless traders should be on the lookout for these behaviours, and there are certain courses of action you can undertake to help identify when we are falling victim to them, and to then try and focus our attention in order to reduce our vulnerability to these behaviours.
One step I always advocate is keeping a trader's journal of one's actions, behaviours, thoughts and feelings around their trading. As part of the journal process one should be reviewing their actions and double-checking their thinking and reasoning.
Trader's should also try to to question their actions; are they in a trade for the right reason? are they thinking rationally? If they are in were not in the trade they are in, would they get into it now? If they feel uneasy about a trade, look back to the original rationale for the trade, and crucially try and distance themselves a little from the trade, thus allowing a more objective assessment.
Discipline and planning are crucial; in the first example had the investor written out a plan pre-committing to sell if the share price fails to rally as expected he may be more likely to take option A, the rational course of action. In the second example, if Trader B had remained disciplined and focused he would have booked a profit instead of a significant loss, and would not have been thrown off-course on his trading plan.
To see and learn more about the psychological and behavioural aspects of trading, including further information on biases and irrational trading behaviour, follow the link to the 'Trader,Trading & Risk Psychology' website.
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