Explore the Impact of prospect theory, Loss aversion, and Recency bias

Part one of this behavioral biases series explored the impact of prospect theory, loss aversion, and recency bias as three of the key factors that explain why the returns of average individual investors have historically lagged the S&P 500® by nearly 50%. Part two examined three other behaviors that lead us to do the wrong things at the wrong time with our money—specifically our propensity for familiarity and framing biases, as well as our tendency to rely on mental accounting. And part three delved into the adverse impact of overconfidence, anchoring, and herding behaviors.

In this last article we delve into three final cognitive biases and psychological influences—the endowment effect, sunk-cost fallacy, and illusion of control—and the detrimental effect each can have on our ability to make rational investment decisions.

Endowment effect

We’re all inclined to overvalue the things that we own—whether due to an emotional significance we attach to the items, or simply because they ‘belong’ to us. Often, it leads us to attach an artificially higher value on specific items compared to what we would reasonably be willing to pay for the same item on the open market if we didn’t own it.

This is the essence of the endowment effect1—a bias which is often confused with status quo bias (an owner’s reluctance to sell). With the endowment effect, however, owners are generally more than willing to sell an item as long as the potential buyer meets or exceeds the value the owner has ascribed to the item.

Example: Let’s consider a situation in which you might attribute a significantly higher value to a particular stock you own (e.g., Tesla) than its market value. Maybe you have a personal affinity for the brand, or some other emotional connection that causes you to disregard reasonable valuation measures.

This bias could easily have a negative influence on your investment decision-making when it comes to holding or selling the stock. And it may also cause you to overlook any negative reports about the company—such as deteriorating fundamentals which could drive down the price—as you seek out information that reinforces your view of unrealized excess value.

To mitigate endowment effect risks, strive to apply a more objective approach to assessing the value of any security, portfolio, or financial market. Your Janney Financial Advisor can offer an unbiased assessment of value based on benchmarks, peer analysis, and third-party reviews. This will allow you to establish a reasonable, unemotional, and objective baseline value without allowing personal feelings to get in the way of making smart decisions.

Sunk-cost fallacy

In theory, how much you paid for an item (its sunk cost) should have any impact on future decisions you make about what to do with the item you purchased. But in reality, that’s often not the case. Instead, the sunk-cost fallacy2 frequently motivates people to make decisions based on how much money they’ve already spent. In regard to investing, the sunk-cost effect manifests itself in several ways:

  • People tend to invest beyond their initial outlay—even when the investment is losing value. This is often referred to as ‘chasing good money after bad,’ in hopes that the investment will eventually turn around.
  • Similarly, investors unwilling to admit that they made a mistake will tend to hold on to a stock far too long, perhaps missing out on better opportunities along the way.
  • And lastly, we commonly look at the value of an investment not in light of its intrinsic value but rather through the prism of what we paid for it—basing our decisions about whether to buy more, hold on, or sell it based on that original purchase price.

Of course, in situations where capital gains taxes may be generated by a sale, the cost basis of an investment has to be factored into any decision. But more often than not, a good rule of thumb is to analyze the investment as if you didn’t already own it. Would you choose the same investment again?

Obviously, this re-evaluation begs the question as to whether the investment offers as good (or better) upside potential than another investment. If the conclusion is that it doesn’t, then perhaps it’s time to sell it and redeploy the proceeds towards an investment with better potential prospects. What’s more, if the investment has lost value from it’s original price, there are losses that can be harvested to offset capital gains elsewhere in your portfolio.

You Janney Financial Advisor will help you conduct this assessment—accounting for the myriad variables that might influence any buy or sell decision. Not only can they inform the process with research that offers various perspectives, they can also help you separate an investment’s cost from both its present and expected future value.

Illusion of control

Every day, we attempt to control our lives—seeking to avoid costly mistakes and cause good things to happen. We like to think we can influence outcomes, even though so many factors are totally beyond our control. Honestly, how many times have you thought or said, “If I could just go back and do X differently, everything would be better?”

This cognitive bias is known as the illusion of control,3 and can be particularly problematic when it manifests in our investing behaviors.

Example: Suppose you purchase the stock of a company with attractive fundamentals and solid long-term prospects. Over the ensuing months, however, the stock experiences a significant decline in value due to a small, unexpected regulatory change. Because of your illusion of control, you might tell yourself that if you had only known that one extra detail, you would have made a different decision and thus experienced a better investment outcome.

On the one hand, this can reinforce a dangerous bias that next time you’ll make a better decision because you’ll know what to look for when evaluating a potential investment. Conversely, it can also lead to blaming yourself for having made an error—something that can adversely impact your ability to make future decisions.

Investment decisions almost always must be made without every piece of available information at your fingertips. It’s about calculated probabilities more so than definitive outcomes. And this is where conversations with an advisor can prove so beneficial—providing a sounding board to discuss new ideas.

Your Janney Financial Advisor can also work with you to develop an ‘investment thesis’ that will guide your decision-making. This can serve as a valuable tool to help filter out extraneous noise, allow you to focus on relevant information (including those external variables which are beyond your control), and become more flexible in letting go of your cognitive biases.

Remember, biases aren’t always a bad thing. But the better we understand how they can slant our perceptions and influence our actions, the easier it becomes to avoid their excesses and keep our financial plan on track.

1 Kahneman, Daniel; Knetsch, Jack L.; Thaler, Richard H. (1990). “Experimental Tests of the Endowment Effect and the Coase Theorem.” Journal of Political Economy 98 (1325-1348).

2 Arkes, H. R.; Blumer, C. (1985). “The Psychology of Sunk Costs.” Organizational Behavior and Human Decision Processes 35 (124-140).

3 Langer, Ellen J. (1975). “The Illusion of Control”. Journal of Personality and Social Psychology 32 (311-328).

 
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