In this month’s edition of “Money Matters,” Scott Oeth talks about the endowment effect and why investors who become emotionally attached to their investments can suffer negative financial consequences that may have been avoidable without that emotional attachment in place.

Money Matters: The Endowment Effect Transcript

0:00:00.0 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals, and he's joining us now by phone. Good morning, Scott.

0:00:22.0 Scott Oeth: Good morning, CJ.

0:00:23.0 CJ: Glad to talk with you today. So you wanted to talk about the endowment effect. What is that?

0:00:32.1 SO: Well, as we've talked about many times in the past, CJ. I think it's very important as an investor to know thyself and to try and understand the little mental tricks or traps that we all fall into to varying degrees. Some people have more issues in one area than another. But this is an interesting idea, and it's that it's been noted, psychologists study these things, that people tend to place more value on something that they already own than if it was just out there in the free market. And I'll get to the investing side of this in a moment, but I was reading some of the research and they use an example, some psychologists are originally studying this, study coffee mugs. And they said that people would tend to need to sell their favorite coffee mug or just a mug that they own two and a half times what they would otherwise pay for it if they had to open up their wallet and buy that same mug. And I was dumbfounded that, holy smokes, just like a week before I was cleaning out a cupboard where I had too many coffee mugs, and I was having a very hard time parting with some of these mugs.

0:01:36.4 SO: But on the financial side of things, we just had a person come in the office a week or two ago, and they had made a lot of money in one of the big name technology stocks. And we see this often where people really get sort of a trap around a certain financial item, a company stock, maybe they work there, maybe they had stock options, or someone in their family like grandparents had worked for this company for a long time where it was something that was gifted. Probably the most powerful examples I've seen are inherited portions of family farms where there's an incredible sentimental attachment. And it's important. It's important to understand the honor and respect those feelings, but I think I also make a clear level-headed financial decision, or at least understand the evaluation you're making and say, "What is the true financial value there?" And then you can set that next to sentimental value or just you like something because you like it.

0:02:38.4 CJ: So what I'm hearing is that people may hang on to things longer than they should, financially speaking, just because they've imbued it with more personal importance.

0:02:50.8 SO: Yeah, it can happen, certainly. Like I say, working with a number of corporate executives, you'll often see that sometimes they have as part of their compensation that they are given essentially a bonus in terms of company stock, it's called "restricted stock." The company says, "Okay, you do a good job. If you stay with us for a certain number of years, you get this company stock." It's taxed just as if they were given a cash bonus. But often there's a real psychological attachment, and they feel this major sticking point or decision point, and whether they should keep that stock or sell it versus if they had just gotten that cash as a bonus, very likely they would not have taken that money and bought the company stock with it, even though it's exactly the same value, same monetary value. It's the same tax treatment. Everything is the same, it's just because it comes in that form they feel an attachment to it.

0:03:45.6 CJ: So what can we do about this endowment effect? Or how can we avoid this sort of mental or financial trap?

0:03:54.1 SO: Yeah, it's interesting. I think it's tough to completely avoid these. And a very interesting field of study where psychologists started looking at how people make financial decisions. And the field of behavioral economics was actually Nobel Prize awarded in this field, and there's a number of noted heuristics or behavioral traps or mental models that they've identified that people commonly fall into. And I think, studying these, being aware of these, maybe talking it through with an outside person is always everything we talk about here is just general ideas. We recommend people to get their own individual advice, I think that can help a lot. Talking through with someone who's outside of yourself, your own emotions, your own mind, and that can be of significant value. But the endowment effect in particular, and where it can cause people to maybe get hung up on really having an overly exaggerated position and a concentrated maybe potentially risky stock when they should be more diversified. Some of these things could be really damaging financially, or stuck emotionally on some type of financial assets or a piece of land that might really be under-performing, maybe it's not risky, compared to what someone needs to have their portfolio do for them. So it seems to be tied to this concept of loss aversion. And when people own something, they fear giving it up.

0:05:22.3 SO: I think they also really fear making a mistake. It feels like a bigger decision to say, "Well, should I sell A, B, or C stock, or X, Y or Z?" And they fear that regret. "What if it continues to skyrocket and go up? I'll be like a fool." Even though they might not have taken that same money and bought that one company stock. So I think, as always, I'm a big fan of really laying out your financial goals and the timeline and prioritizing them. And that's sort of the heart of the financial planning side of things. And doing that, I think, can help allow for better decisions as opposed to just viewing your portfolio in isolation and benchmarking it against what the market is doing, really tying it to your personal timeline and goals. I think that can help a lot.

0:06:11.3 SO: And the simple question, CJ, "Would you buy it again?" So when I'm sitting there, I'm struggling to get rid of some of these coffee mugs that are falling out of my cupboard. I should probably take a look at it and say, "Okay. Yeah, I like this mug. How often do I use it? Would I pay $5 for this coffee mug again?" And you can do the same thing with a piece of property or a stock. And often what you find is they're gonna say, "Well, boy, I had really great gains in this one company stock, and it's a stock I hear about a lot in the news. And it's gotten to be a significant part of my portfolio." But would you take cash and buy an equal amount of that? Very often, the answer is no. I think that type of test can help challenge the thinking and maybe reset your thinking on that position.

0:07:00.1 CJ: That sounds reasonable. Anything else we should know about this?

0:07:04.2 SO: Well, I think it's a super fascinating field. And I think these types of things are certainly as important, if not more important to success in personal finance and success investing than crunching numbers and analyzing financial statements in trying to determine fair market value. The human emotions can really, it drives the fear and greed cycles in the markets and can really trip people up in terms of buying and selling at the wrong times. And so studying the human side of investing is critically important, and I really encourage people there again to seek some quality advice that they can trust. I've written quite a bit more about this on my blog. I have a whole piece on behavioral finance where I sort of note a number of these mental traps that we need to be aware of and watch out for.

0:07:53.5 CJ: And how do we find that blog?

0:07:56.8 SO: The blog is called Intrinsic Value, but the easiest way is just, if you type in my name, scottoeth.com, O-E-T-H, it's there.

0:08:04.4 CJ: Alright. Well, thank you again, Scott, for some great advice. We're talking with Scott Oeth. And we'll be talking finances with Scott on the first Wednesday of the month on North Shore Morning. And we really appreciate it and happy holidays to you.

0:08:18.5 SO: Well, thanks CJ. I love the opportunity, and always enjoy our chats. Thank you.

0:08:22.0 CJ: Alright. Bye-bye.