“Economics,” as I was told early in my undergraduate career, “is really just common sense, codified.” This seems true enough. Economics is fundamentally concerned with scarcity and opportunity costs — the intuitively obvious, yet often overlooked ideas that that there is no such thing as a free lunch, and that if you spend your money on one thing, you can’t spend it on something else. It gives us the tools to understand and measure these concepts in the world around us.
One of the newest branches of economic research is behavioral economics, which includes behavioral finance. Behavioral economics deals with how and why we make the decisions that we do. It sets aside one of the assumptions that underpins standard economics — the idea that humans are completely rational decision makers — and tries to understand the biases and heuristics that often lead us to make irrational decisions. By better understanding these biases, we can make active attempts to avoid the biggest pitfalls of irrationality, and in some cases, exploit it.
There are few areas where irrationality can be more damning than finance and investing. It is almost impossible to be unaffected, cold, calculating, and completely rational when investing. But it is possible to correct for some of our cognitive biases, and make ourselves better investors in the process.
One of the basic concepts of behavioral economics — one that can be particularly harmful to investors, particularly those with less experience — is the “endowment effect.” Put simply, when something is part of our “endowment” (i.e., when we consider it ours) we value it more. And this isn’t just true for the watch your grandfather gave you when you graduated high school, or for your wedding gift. The original study on the endowment effect was conducted by economists Kahneman, Knetsch, and Thaler (he of Nudge fame) at Cornell University in 1990. In their experiment, a class of forty-four undergrads were randomized into two groups, with one group “endowed” with a mug, which was placed on their desk. The “market” for mugs was then opened up, and students were allowed to buy and sell the mugs. After repeating their experiment a number of times, and including a trial group using tokens that could be exchanged for money, the economists conducting the experiment discovered a large difference in the willingness to pay (WTP) of those without mugs and the willingness to accept (WTA) of those endowed with mugs. The fundamental idea that WTP equals WTA at the equilibrium price forms the basis of classical supply-and-demand; that they are not equal demonstrates plainly that people are irrational.
The ramifications of the endowment effect on investing are obvious. The existence of the endowment effect is often explained by the fact that humans are loss-averse: we want to avoid a loss more than we want to achieve a gain, even if the expected value of the two is the same. Such irrationality can wreak havoc when investing. It leads to panics and sell-offs by investors (who fear loss of their “endowment” of wealth) due to temporary downturns, despite strong fundamentals. It also leads investors to hold onto assets because they psychologically overvalue them compared to the market, even if a dispassionate analysis would lead one to sell.
The key to overcoming irrationality and our personal biases is to recognize them and attempt to correct for them. The market does not care that you value a stock more just because you own it. Rather, you need to factor your personal biases into your analysis. The next time you make an investment decision, be sure that your decision is unaffected by irrational psychological value of ownership or the irrational fear of a loss. Your personal analysis should be honest, brutal, and above all, rational.