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It’s my mug

This article, by Justin Baiocchi, was originally published in The Northern Daily Leader on 30 July 2016.

People are becoming increasingly aware that our emotions and psychological biases play an important role in how we approach investment decisions. The relatively new field of behavioural finance attempts to explain how these biases influence our actions and decisions, usually for the worse unfortunately. Instead of being calm and rational when confronted with complex decisions regarding risk and return, we instead tend to let our base instincts and emotions take over. The end result is generally an unpleasant one from a financial perspective.

One of my favourite psychological biases is called the endowment effect. This is one which most people can relate to and is simple to understand. The endowment effect was illustrated by an experiment conducted by three researchers, Kahneman, Knetsch and Thaler, in 1990. In the experiment a number of volunteers were divided into two groups. The first group were given a coffee mug and told it was theirs to keep. They were then asked what price they would accept to sell the mug. The second group of volunteers weren’t given the mug, but were shown the same mug and asked what price they would offer to buy the mug. As you might expect, the first group who ‘owned’ the mug expected an offer to buy the mug that was on average much higher than the price the second group, who didn’t have a mug, thought was a reasonable price for the mug. Remember, this is the same mug, with a random bunch of volunteers. The only difference was that the first group, the owners of the mug, felt that it was worth much more simply because they owned it. In essence, value is ‘endowed’ on the mug (hence its name, the endowment effect) simply through the act of ownership.

The endowment effect translates very easily to the stock market. If I owned Telstra shares, for example, the endowment effect suggests that I’m likely to think they’re worth more than they really are, or the price that buyers are prepared to pay for them. So instead of selling at an appropriate price, I’m likely to hang on, waiting for my unrealistic price to be reached, which may never happen. And so another bad investment decision gets added to the tally. The emotional feelings associated with ownership have outweighed the rational decision-making process we all like to think we follow. If this has happened to you, don’t feel too bad, you wouldn’t be the first and certainly won’t be the last to feel like a mug.