The Endowment Effect: A Mind-trap Among Investors

The cognitive tendency among investors to get caught up in the endowment effect -- a mental roadblock that can cause investors to hold onto something too long -- applies to shares, bonds, and funds in a portfolio, a newly released report by Morningstar concludes. 

(January 27, 2012) — Investors must scrutinize both what they own and what they don’t in order to overcome the endowment effect – one of the first cognitive biases to violate standard economic theory — according to a newly published article by Morningstar. 

The article — titled “Investors Behaving Badly: Endowment Effect” — explains that the cognitive tendency to ‘love what you own’ applies to the shares, bonds, and funds in a portfolio. In other words, the article asserts that investors often overvalue what they already own. 

“We’re trying to raise awareness about the type of research in the behavioral economics field,” the article’s author Lee Davidson, an ETF analyst with Morningstar, told aiCIO, adding that the aim of studying the field is to raise investor awareness, highlighting the tendance among investors to hold onto losing investments longer than they should.

The danger then, among investors, is that they fail to evaluate securities on a level playing field, failing to focus on the question that actually matters:  How will my investments perform in the future? 

“We naturally exhibit a tendency to be lenient on evaluating the performance of what we own. If the market says our stock is worth £10, we naturally think its worth more even before we perform any analysis whatsoever. Not surprisingly, this cognitive bias does us a disservice,” the report states. 

The report continues: “For every type of investor, therefore, it is important to be cognizant of the endowment effect and judge the various products impartially as best as possible, especially when you already own one or more of them.”

The report by Morningstar follows another critical report published in May. According to Andrew Ang, professor of business, finance and economics at Columbia University, endowments around the country need to do a better job at figuring out how to allocate money among liquid and illiquid assets.

“For Harvard, the main problem during the financial crisis was that about 1/3 of the university operating revenues came from the endowment. In 2008, that endowment, like every university portfolio, had large losses,” Ang told aiCIO following the release of his research report, explaining that the four ways to fill the hole is to cut expenses, liquidate the portfolio, issue debt, or increase donations.

Ang’s paper draws attention to the central question — which he describes as a philosophical one — among endowment heads: How should you be allocating your money when you have liquid and illiquid assets in your portfolio? “Harvard’s endowment fell and they couldn’t meet their cash requirement because they tied up a majority of their portfolio in investments that were illiquid. They couldn’t sell at short notice or raise cash when required,” Ang says.

According to Ang, most endowments completely ignore illiquidity risk on asset allocation, largely due to the increasing percentage they have devoted to alternatives, most of which are illiquid. The increased allocation to alternatives, Ang believes, is due to institutional investors aiming to emulate the investing approaches of Harvard and Yale’s endowments. “Endowments largely achieved high returns till 2008, but if you chase returns without taking into account illiquidity, that risk really bites.”