Endowment bias is an emotional bias in which people value an asset more when they actually own it than when they do not. Endowment bias is inconsistent with standard economic theory, which asserts that the price a person is willing to pay for a good should equal the price at which that person would be willing to sell the same good.

However, psychologists have found that when asked, people tend to state minimum selling prices for an asset that exceed minimum purchase prices that they are willing to pay for it. Effectively, ownership ‘endows’ the asset with added value. Endowment bias can affect attitudes toward items owned for long periods of time or can occur immediately when an item is acquired. Endowment bias may apply to inherited or purchased securities.

Investors may irrationally hold on to securities they already own, which is particularly true regarding their inherited investments. For example an investor may hold an outsized inherited stock position because of an emotional attachment, despite the risk of a sizeable loss if the stock stumbles.

These investors are often resistant to selling even in the face of poor prospects. Again using the example of an inheritance, an investor may hold an inherited portfolio because of an emotional attachment when a more aggressive asset mix may be more appropriate.

Consequences of Endowment Bias

This bias may lead investors to do the following:

• Fail to sell off certain assets and replace them with other assets
• Maintain an inappropriate asset allocation. The portfolio may be inappropriate for investors’ levels of risk tolerance and financial goals.
• Continue to hold classes of assets with which they are familiar. Investors may believe they understand the characteristics of the investments they already own and may be reluctant to purchase assets with which they have less experience. Familiarity adds to owners’ perceived value of a security.

Overcoming endowment bias

Inherited securities are often the cause of endowment bias. In the case of inherited investments, an investor should ask such a question as ‘If an equivalent sum to the value of the investments inherited had been received in cash, how would you invest the cash?’

Often, the answer is into a very different investment portfolio that the one inherited. It may also be useful to explore the deceased’s intent to leave the specific investment portfolio because it was perceived to be a suitable investment based on fundamental analysis, or was it to leave financial resources to benefit the heirs? Heirs who affirm the latter conclusion are receptive to considering alternative asset allocations.

When financial goals are in jeopardy, emotional attachment must be moderated; it cannot be accepted and adapted to. Several good resources are available on ‘emotional intelligence.’ Investors should familiarize themselves with the topic so they can help themselves or their clients work through emotional attachment issues.

An effective way to address a desire for familiarity, when that desire contradicts good financial sense, is to review the historical performance and risk of the unfamiliar securities in question and contemplate the reasoning underlying the recommendation.

Rather than replacing all familiar holdings with new, intimidating ones, start with a small purchase of the unfamiliar investments until a comfort level with them is achieved.

This article was issued by Kristian Camenzuli, Investment Manager at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article is being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.