The endowment effect is a human bias that places a higher value on what one owns over what one does not own. Merely taking ownership of a stock, a bond, exchange-traded fund (ETF) or any other investment asset does not alter its economic value. The asset is only worth what the prevailing market price is. Yet, the endowment effect can cause us to be averse to selling the object by making us view the investment as being more valuable than it really is merely because we already own it.
“Being a financial advisor is one part portfolio manager and one part clinical psychologist. I’m not sure which part is more important, but the choice architecture aspect resides in framing decisions for clients in a way that enables them to understand the tradeoffs and make sensible decisions.”
Richard Thaler
Nobel Prize Winner in Economics for his Theories in Behavioral Finance
“Daniel Kahneman, Amos Tversky and others convincingly demonstrate that even when all information is available, individuals are highly susceptible to cognitive errors. As Kahneman and Tversky concluded after years of research, human beings are by and large irrational decision makers.”
C. Thomas Howard
Professor Emeritus Finance, University of Denver
“The dominant determinants of long-term, real-life, investment returns are not market behavior, but investment behavior. Put all your charts and graphs away and come out into the real world of behavior.”
Nick Murray. Adviser and Author
2d Quarter Results
Below are the indices we follow.
| Periodic Performance | |||||
| By 06/2018; Default Currency: USD | |||||
| Qtr | 1 Year | 3 Years | 5 Years | 10 Years | |
| S&P 500 | 3.43 | 14.37 | 11.93 | 13.42 | 10.17 |
| Russell 2000 | 7.75 | 17.57 | 10.96 | 12.46 | 10.60 |
| Russell 2000 Value | 8.30 | 13.10 | 11.22 | 11.18 | 9.88 |
| MSCI World ex USA (net div) | -0.75 | 7.04 | 4.87 | 6.23 | 2.63 |
| MSCI World ex USA Small Cap (net div.) | -0.94 | 11.87 | 9.45 | 10.28 | 6.09 |
| MSCI Emerging Markets (net div) | -7.96 | 8.20 | 5.60 | 5.01 | 2.26 |
| Bloomberg Barclays U.S. T Bond 1-5 Years | 0.12 | -0.40 | 0.48 | 0.77 | 1.79 |
| ICE BofAML 1-Year US T Note | 0.40 | 0.92 | 0.64 | 0.49 | 0.77 |
The US equity market posted a positive return, outperforming both international and emerging markets in the second quarter. Large cap value stocks underperformed large cap growth stocks in the US; however, small cap value stocks outperformed small cap growth. There was a positive size premium, as small cap stocks generally outperformed large cap stocks in the US.
I would expect markets will remain volatile for the foreseeable future. Both trade tensions and mid-term elections will most likely cause an increase in volatility. Remember, volatility is not a good predictor of long-term returns, so we counsel clients to ignore the noise and stick with their plan.
Value of a Financial Advisor
Periodically, we get questions from clients or prospects such as “why should I hire you?” We believe we add value in a variety of important areas, such as how we build our portfolios for the long-term using peer reviewed academic research.
However, for this and the next few newsletters, we are going to focus on the psychological/behavioral aspects of the value of a truly “fee-only” independent financial advisor.
As indicated by the quotes above, investor behavior is many times a deterrent to long-term investing success. Daniel Kahneman and Richard Thaler have both won Nobel Prizes in Economics showing that humans have predictable biases that are difficult to overcome without objective third party help and expertise. The common human biases that negatively impact long-term investing success include:
- Overconfidence
- Overoptimism
- Self Serving Bias
- Ownership Bias (Endowment Effect)
- Loss Aversion (Losses are more painful than gains are rewarding)
- Availability Bias (sometimes known as recency bias)
- Media Response
- Anchoring or Confirmation Bias
- Hindsight Bias
- Familiarity Bias (Lack of diversification ensues)
- Herding
According to industry consultant Dalbar, the average equity investor has significantly underperformed the S&P 500 Index over the last 20 years, and this has been a consistent theme over at least the past 20 years. A large part of the underperformance is due to behavioral issues. In this newsletter, I am going to focus on two biases that are currently impacting current clients. In upcoming newsletters, I will address the other biases in more depth.
Ownership Bias/Endowment Effect
Ownership bias places a higher subjective value on what one owns over what one does not own. That item can be an asset, home, stock, stock option or even an idea. The minute after one owns something, the individual normally places a greater subjective value on it than the instant before he or she owned it.
In our practice, we have seen clients place a greater value on individual stocks or stock options they currently own versus other assets they could own such as diversified funds, even though markets are very efficient in pricing. As Mark Riepe, senior vice president of Schwab Center for Personal Research has stated, “once you possess an asset, you tend to place more value on it than you would otherwise.” The problem with that type of thinking is that individual stocks have much more risk than a diversified fund because an individual company has “company specific risk”. This risk can be diversified away by holding the entire asset class while maintaining the expected return of that asset class (and the individual stock that is in that asset class).
How risky is it to hold an individual stock versus a diversified portfolio? According to estimates by economist Lisa Meulbroek, a dollar in company stock is worth less than half the value of a dollar in a mutual fund of the same asset class.
Ownership bias is often complemented by Anchoring and Familiarity bias. We will address Anchoring here, and Familiarity Bias in our next newsletter.
Anchoring
Anchoring is a cognitive bias whereby an individual relies too heavily on an initial piece of information offered or received. That could also include the “highest” price of some asset.
Many investors we deal with tend to “anchor” on the highest price achieved in the past for a particular stock or option as the “value” of that asset even though the true value of that asset is today’s price set by the market. When analyzing investment opportunities, the actual analysis should be looking at prospects going forward from today for that particular asset compared to the investment alternatives currently available to the investor. If one takes Lisa Meulbroek’s analysis above seriously, an investor should sell the individual stock or option almost every time.
Why is diversification important? According to research by Professor Hendrik Bessembinder, “Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages.”
Conclusion
Money is very emotional for clients. In addition, our brains have evolved to create certainty and order, and markets are anything but certain and orderly. Managing emotions so clients can make more rational decisions is vital for wealth accumulation and maintenance. A recent Vanguard study estimates that advisors add about 3% of value annually. Vanguard estimates 1.5% of that is behavioral coaching. (See link https://vgi.vg/2LggikA.) Coaching becomes very important during periods of greed or fear stemming from “irrational exuberance” or down markets. An independent advisor can help clients stick with their investment plan, even when their emotions and biases are driving them to do something else. A great decision is a result of a good process. A good process oriented approach, coupled with systematic reviews, periodic rebalancing, proper asset allocation and financial planning can help clients take the emotion and bias out of investing for better long term results.
Until next time,
Mike and Emily