You are a wine connoisseur. You purchase a case of a new release at $10 per bottle and store the wine in your cellar. Ten years later, the wine is selling for $200 per bottle. Do you buy more, sell your stock or drink it?
Faced with this decision, few people would sell - but few would buy more. And given the appreciation in value, many might choose to save it to drink on special occasions. The decision not to sell, but also not being willing to buy, is not completely rational. This decision is being influenced by the "endowment effect." The fact you already own the wine (an endowment) should not impact your decision. If you would not buy more at a given price, you should be willing to sell at that price. Not being willing to buy wine at the $200 price demonstrates that it represents a poor value to you and thus should be sold.
The endowment effect causes individuals to make poor investment decisions. It causes investors to hold on to assets that they would not purchase, either because they don't fit into the asset allocation plan, or they are viewed as so highly priced that they are poor investments from a risk/reward perspective.
The most common example of the endowment effect is that people are very reluctant to sell stocks/mutual funds that were inherited from a deceased relative. I have heard people say, "I can't sell that stock. It was Grandpa's favorite, and he'd owned it since 1952." Or, "That stock has been in my family for generations." Or, "My husband worked for that company for 40 years. I couldn't possibly sell."
Another example of the endowment effect is stock that has been accumulated through stock options or some type of profit-sharing/retirement plan.
Financial assets are like bottles of wine. If you wouldn't buy at the market price, you should sell, not hold. Stocks and mutual funds aren't people - they have no memory, they don't know who bought them, and they won't hate you if you sell. An investment should be owned only if it fits into your current asset allocation plan. Its ownership should be viewed in that context, and only in that context.
You can avoid the endowment effect by asking this question: If I didn't already own the asset, how much would I buy today as part of my overall investment plan?
If the answer is, "I wouldn't buy any," or, "I would buy less than I currently hold," then you should either immediately sell the asset (my recommendation) or at least develop a disposition plan.
There is another consideration when disposing of an "endowment asset." There may be substantial capital gains taxes involved. If so, consider donating the stock to a charity. By donating the asset in lieu of cash you would have donated anyway, you avoid the capital gains tax.
Tax avoidance is another reason investors become subject to the endowment effect. They hate paying taxes. But there is only one thing worse than having to pay taxes - not having to pay them. For example, do you think that investors in once great companies such as Polaroid or Xerox would have been happy to pay the tax, rather than holding on and eventually not having to pay it because the stock price plummeted?
The endowment effect is one of the many ways that emotions lead to investment errors. The best way to avoid such errors is to have a written investment plan to which you adhere. Do you have a written plan? Do you adhere to it?
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455.