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Investment Bias: Endowment Effect

Investment Bias: Endowment Effect

This is the belief that you own a “winner” and you will keep that winner for reasons that aren’t justified by the return. Owning companies is fun, and investors like to celebrate their victory over the market by stashing great stock picks in their “stock pickers trophy case.” This bias towards the stock you already own keeps you from objectively valuing the company based on its current valuation. And allows the historical performance, and a kinship towards a stock, causes you to underweight the risk of the position. Including an emotional or symbolic significance in the rational for owning a financial asset is always an uncompensated risk. 

The endowment effect causes investors to overlook changes in the market, risk, and broader changes to a company’s costs and shifts in its market share. It’s rooted in the belief the investor is special because of their selection of the stock. Creating this intrinsic value between the investors and the stock, that is no longer justified by the return.

The value of “ownership” doesn’t translate between buyers and sellers. People will value something that they already own more than the exact same item from someone else. One of these psychological examples is demonstrated by this exercise:

Divide a group of people into three. Give one group of people a simple, coffee mug. Have them assign a price they are willing to part with it. The second group is required to buy it, have them assess a price they are willing to pay. Have the third group determine the market, and pick their own valuation. In the aggregate the owners will “endow” the mug with too much value, compared to the group that picks the market price. Both the group that sets the market price, and the group forced to buy the mug will be much closer in their valuation, then the group that currently owns the mug.

It is hard to part with your own successes. The bottom line is that attachment to the personal history we have with these investments contaminates the valuation process. At their best this contamination causes a portfolio to become sluggish, overly risky, or inappropriate. At their worst they see a contraction to lower price points and contraction to the investors net worth over time.

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Other Related Topics:

Definitions: Fixed Income

Fixed Income (or debt) represents your ownership over the repayment of a debt. Usually considered bonds, they are contracts promising the repayment of loaned money. Other forms of debt arrangements include Mortgage-Backed Securities, liens, loans, and CDs. Fixed income is called that because the return is decided on the outset – so the return is fixed from the initial offering. Because the upside is fixed from the start, the change in their pricing is less dramatic. Thus, fixed income pricing becomes less about the asset itself, and more about the prevailing rates for other options (read “current interest rate environment”). Debt is usually priced based on three variables, 1) How likely you are going to get your debt repaid, who owes the borrowed money, and what is the way they will pay it back? (Taxation, revenue, etc.) 2) how long until you are repaid your initial investment, this is called duration and indicates how long the money is at risk for. 3) the rate that the debtor is paying on the borrowed sum, usually expressed percentage as a coupon or yield. There are subcategories based on who the entity requesting the money fall into: Muni’s  – a Districts or Municipalities Debt. Usually issued to fund special projects, schools, or city and municipal improvements. In addition to the yield, these are priced for risk based on cities’ credit history, the source they plan to repay the loan (taxation or toll-based), and any available insurance they put on the bonds. Treasuries – the sovereign debt of a country. This is debt usually supported by the taxing authority of a country and its ability to create (fiat) the money they need. This is priced based on the credit rating of the country, the outlook of its currency, and the yield. Corporate – debt issued by companies and priced based on their creditworthiness. These are divided into investment grade and non-investment grade (called affectionately “high yield”) and then subdivided further. Certified Deposits (CD’s) – debt issued by banks. These are usually issued in small increments and for a short duration. The returns are insured by the FDIC (federal government) Mortgages (MBS) – These are backed by the creditworthiness of the borrower, and usually the risk is mitigated by grouping a pool of mortgages into tranches based on their collective credit rating. Collateralized Debt Obligations (CLOs) – Similar to the mortgages, this is a collection of debts that secure equipment or are backed by specialty financial arrangements.  Often backed by the repossession of accounts receivable or equipment.  

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Definitions: Equity

The term Equity represents any ownership rights over an asset’s cash flow generation potential. As an asset class, there is no guarantee of a return on your investment, it is the most speculative of assets classes and is the only asset class that can have its intrinsic value brought to zero. But because it is ownership without end, and a right to the value in perpetuity, it is also the source of the greatest returns. The math looks like this: The most common sources of Equity are stocks, your home, and other real estate assets. But equities can also include ownership in a business through your own formation, or as the result of a private placement and they also include art, royalty agreements, or leasing agreements.  Other terms for Equity are shareholder value, book value, or stake.

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Definitions: Asset Allocation

Asset Allocation is how we discuss the percent of assets in one of the four main asset classes. It is the balance of risk and reward and is the most reliable leading indicator of the intermediate and long term trajectory of a portfolio. The Asset Allocation is the first place we can adjust to a client individual’s goals, risk tolerance, and investment horizon. Asset allocation is often displayed as a pie chart and discussed in terms of the ratio. For example, the “60/40” is a shorthand reference to a portfolio that is 60% allocated to equities, and 40% to debt. These are used by many firms to place clients into a suitable collection of investments. The four assets classes we define in Asset Allocation are Equity, Fixed Income, Cash, and Precious metals.

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