The Endowment Effect: Do You Overvalue Your Investments?
In a 1990 experiment, coffee mugs were distributed to half the students in a university class. Those with the mugs were asked to set a selling price, and those without the mugs were asked to set a buying price. As it happened, the buyers and sellers had wildly different price expectations: The sellers wanted nearly twice what the buyers were willing to pay.
This tendency to overvalue your possessions simply because you already own them is known as the endowment effect. When it comes to investing, the endowment effect can cause you to hold on to assets that no longer make sense for your portfolio and ignore new investment opportunities.
“Once you possess an asset, you tend to place more value on it than you would otherwise,” says Mark Riepe, senior vice president at the Schwab Center for Financial Research.
Mark says investors show a natural tendency to put money into what they already own rather than researching new investments. “Often, they are passing up an investment that could be a better fit,” he says.
While the endowment effect has its benefits—you won’t incur a lot of trading fees if you’re not jumping into and out of investments—they’re generally outweighed by the costs.
Mark suggests asking yourself three questions when evaluating your current investments:
- Would I buy it today? Look at each investment in your portfolio and ask yourself if you’d be willing to purchase it at its current price. If the answer is no, consider selling.
- What was my rationale for buying? Remind yourself of the reasons you bought each security in the first place. If those conditions no longer apply—a company with international growth aspirations ended up sticking to its U.S. strategy, for example—consider selling.
- Are there better options? List three compelling ideas you have for new investments—and compare them with your current holdings. If your current holdings pale in comparison, consider reallocating the money to the new investments.
The bottom line: Don’t fall in love with your portfolio. Unload holdings that no longer fit your investment strategy—even if you’ve owned them a long time.
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