The Endowment Effect

The Endowment Effect is a phenomenon where people value something they own more highly than something someone else has. Keeping sentimental value out of it, how much would you sell your computer for? How much would you buy one exactly like it?

Most people tend to value something they have far more highly than something someone else has. There is a tendency to fall in love with your portfolio and you'll try to think up all the reasons why you should hold these stocks. If you ever come to replace a stock, you will need the new one to be hugely better value than the one it replaces. There is probably some sense in this, capital gains tax and other transaction costs, but it goes way beyond this.

Most people will demand enormously better prospects if they are going to get rid of a stock, but become very tolerant of the stocks they already own, willing to ride the ups and downs after becoming comfortable with an issue. This is not rational. A rational investor should be as ready to sell a stock as to buy a new one to replace it, provided that an analysis (taking into account taxes and transaction costs of course) shows the newer stock is definitely a better buy.

There are significant opportunity costs for becoming too tolerant of stocks in your portfolio - and too critical of stocks that are not. Not only can you lose the necessary vigilance to protect you from losses in your portfolio, but you may miss out on wonderful opportunities if you apply an unreasonably strict criterion for replacement of investments.