Why It's So Hard to Let Go (Hint: It's all in your head)

Another brilliant new study from the SPAN lab at Stanford elegantly describes the neural predictors of the endowment effect. If you recall from some of our past blog posts, the Endowment effect describes the tendency for people to overvalue what they own, and value less what they don't.

A classic example of the Endowment Effect is playing out in the housing market. In a normal housing market, people value their own houses more than is justified by what the market will pay (often about 12% over the market price). During a market downturn, the normal homeowner tries to sell their house for an average of 33% over market value (per Hersh Shefrin on NPR, March 30, 2008).

So what could drive people to cling to what they own and demand a higher price for it? It turns out that we are hardwired for "scarcity," and we don't want to let go of something we already have.

It even appears that we fear losing something we think we are going to get, and we'll chase it with a higher price at an auction (such as Ebay). This is seen in an insightful study by James Heyman, Yesim Orhun, & Dan Ariely called : AUCTION FEVER: THE EFFECT OF OPPONENTS AND QUASI-ENDOWMENT ON PRODUCT VALUATIONS).

Brian Knutson, Elliott Wimmer, Scott Rick, Nick G. Hollon, Drazen Prelec, and George Loewenstein demonstrated in a study published by Neuron tomorrow, called Neural Antecedents of the Endowment Effect, that activation in the anterior insula (appearing in the top image), predicts the strength of the Endowment Effect.

Importantly, there are "individual differences" in the intensity of the Endowment Effect. That is, the activation in any one person's right anterior insula predicted how much value they assigned (and how much money they would demand from a bidder) for a consumer product. Each individual is different in this regard. And I imagine (though I have not seen it shown experimentally) our own propensity to the endowment effect changes over time depending on recent events in our lives.

Remember, the anterior insula often activates when someone is afraid of losing something, when they are in physical (and imagined) pain, and when they are experiencing disgust. So the idea of giving up a product is actually painful, and so we assign a higher value to it - to avoid the pain of loss.

Maybe that's another reason why it's so hard to let go of a sagging stock, especially one with a great story that is a former high-flyer. It's actually painful! More on this study and its implications later...

Happy Investing!

Richard

Emotional Baggage: When it's so hard to let go...

Selling a losing stock shouldn't be hard. Yet many investors find that as bad news begins rolling in, they are in disbelief. The stock they loved has turned on them.

Take Starbucks (SBUX) for example. Last year the announcement that hot creamy drinks weren't selling as well as anticipated during the summer was a shocker to many star-struck (pardon) investors. I could hear the disbelief from investors in slow-motion withdrawal: "Starbucks can always keep growing and raising their drink prices, they just need to serve faster, colder drinks, fresher coffee, expand to Bhutan, etc..., can't they?" Yet, after Starbucks appeared on nearly every street corner, it should have seemed natural that growth had to begin slowing.

The Onion even noted in 1998 that Starbucks had begun opening Starbucks outlets in the bathrooms of existing Starbucks (see article here). To continue growing, Starbucks had to begin cannibalizing itself.

For most investors, the stages of coming to terms with a "Stock Gone South" are like those of someone dealing with other sad events in life. I cou;d even speculate that such stages might follow the logic of the Kubler-Ross model of the "Five Stages of Grief."

First, investors look for reasons why the bad news isn't really true or was maliciously fabricated by outsiders (DENIAL). If the bad news continues, then they feel ANGER (and maybe blame the management or "evil" short-sellers). Next they begin to negotiate (BARGAINING) with themselves, "I know this has been a great stock, but maybe I need to let her go for a while - I can always buy some shares again later." Unsentimental investors then sell, while the more sensitive types become indecisive - paralyzed with disappointment (DEPRESSION). If they make a habit of wallowing in self-pity, then they are likely to end up at the fifth stage of grief called ACCEPTANCE, whilst still owning the Stock as a hopeful "comeback kid" (though in reality it is likely to be sunburned pink (sheets) and panhandling for change somewhere near the equator).

At risk of jeers and taunts from those still in DENIAL, the same as is happening to SBUX might be happening to (drumroll please).... Google (GOOG)!!! Truth be told, GOOG actually looks relatively inexpensive under $450/share ... or am I too emotionally attached to see clearly? (Disclosure: I don't own GOOG shares...yet).

It might seem like an easy decision to cut GOOG loose and re-invest the money elsewhere. Unfortunately for investors there is an innate human tendency, called "the endowment effect," which unconsciously compels them to cling to familiar, fun, or long-held stocks. Associated with the endowment effect is a thought process that justifies continuing to hold a weak stock ("It's just a temporary setback;" "I'm a long-term holder;" "It's actually a good time to buy ... if only I wasn't already holding too many shares..."

We got some great evidence for the endowment effect at a training we ran for financial advisors last week. In our experiment we give out fancy "MarketPsych" pens to half the attendees (because we "forgot" to bring enough, oops!). We then decide to redistribute the pens using a market mechanism - for fairness sake. We ask those who received a pen to write down a price at which they would sell their pen (the ask), and those who did not receive a pen write down how much they would pay for one (the bid).

At our meeting last week there were NO transactions for pens among audience members, The average bid was $1.35 (which approximates the actual value of the pen). Remarkably, the average asking price was $8.80 (ranging from $3 to $15). The sample was small, and we usually see asking prices around $5, which is still remarkably high.

The high asking prices are a testament to the power of emotional attachment and its ability to cause overvaluing of those things we like (and those that are scarce). One way to increase the endowment effect, and widen the bid-ask spread, is to ask those who received a pen to describe the things they like about the pen, and to ask those without a pen to describe objective aspects of the pen. When we do that, the spread is even bigger.

So how can you fall out of love with SBUX, GOOG, or any other stock that is disappointing you? (And it usually is true that these stocks will continue underperforming going forward). Think of the objective aspects of the investment, not the ones you love to love. Don't think about how tasty frappuccinos are, think about the price to book value. Instead of remembering the pleasure you got the first time you Google'ed yourself, think of declining profit margins and ad revenues. It requires deliberate action, but it is definitely possible to toss aside your emotional baggage and learn to see stocks more rationally. It's just not very fun...

Happy Investing!
Richard