Last week, we began our discussion about the only “free lunch” in investing with an explanation of compensated versus uncompensated risk, and a list of behavioral errors that can lead investors to assume risks involved with single-stock ownership that could easily be diversified away (with an appropriate mutual fund, for example).

Today, we’ll take on another reason for failing to diversify. It relates to what is called the “endowment effect,” which occurs when a person values something they already own more than something they don’t own yet. This phenomenon can result in a type of financial behavior that causes many investors to hold concentrated positions, often with devastating results.

Put yourself in the following situation: You’re a wine connoisseur and you decide to buy a few cases of a new release at $10 per bottle. You store the wine in your cellar to age. Ten years later, the dealer from whom you purchased the wine informs you that the wine is now selling for $200 per bottle. You have a decision to make. Do you buy more, do you sell off your stock, or do you drink it?

It turns out that when faced with this type of question, while very few people would sell the wine, very few would buy more. Given how expensive the wine has become, they might save it to drink on special occasions. This is not a completely rational reaction. The fact that you own the wine (the endowment effect) should not have any impact on your decision. If you would not buy more at a given price, you should be willing to sell at that price. The logic is simple. If you didn’t already own any, you wouldn’t buy any. Therefore, the wine represents a poor value to you, and thus should be sold.

The endowment effect causes individuals to make poor investment decisions. Investors tend to hold onto assets they would not otherwise purchase, because either they don’t fit into the asset allocation plan or they are viewed as so highly priced that they are poor investments from a risk/reward perspective. The most common example of the endowment effect is when people are very reluctant to sell inherited stocks or mutual funds, or certain assets purchased by a deceased spouse.

I’ve heard expressions like “I can’t sell that stock. It was my grandfather’s favorite and he owned it since 1952.” Or “That stock has been in my family for generations.” Or even “My husband worked for that company for 40 years, I couldn’t possibly sell it.” Another example of the endowment effect involves stock that has been accumulated through stock options or some type of profit-sharing or retirement plan.

Financial assets are like the wine bottles we mentioned previously. If you wouldn’t buy them at the market price, you should sell. Stocks and mutual funds are not people. They have no memory, and they don’t know who bought them or how long ago. They will not hate you if you sell them. An asset should be owned only if it fits into your current overall asset allocation plan. And possessing it should be viewed in that context alone.

Investors can avoid the endowment effect by simply remembering to ask: If I didn’t already own this asset, how much would I purchase now as part of my overall investment plan? If the answer is that you wouldn’t buy any, or you would buy less than you currently hold, then you should develop a disposition plan. Alternatively, if there is a large taxable gain, you might consider donating the stock to your favorite charity. By donating the financial asset in place of the cash you would have given anyway, you can avoid paying the capital gains tax.

Unfortunately, we’re far from done describing all the biases that can lead to the failure to diversify.

The authors of the study “Human Capital and Behavioral Biases: Why Investors Don’t Diversify Enough” offered several other behavioral explanations for this omission:

• The Endorsement Effect: Participants in 401(k) plans are influenced by an employer match made in company stock. They consider the match in stock an endorsement and take it as a positive signal to invest in the company. The same thing is true of stock grants and stock options.
• Cognitive Dissonance: We all want to feel good about our career choices and our employer. That leads to employees choosing to believe that a firm’s prospects are bright. Choosing not to believe this leads to angst and self-doubt. This, in turn, can result in an overly optimistic assessment of a firm’s prospects, and concentration in that firm’s stock.
• Appeal to Authority: Many people tend to automatically obey or believe those who they regard as holding positions of authority. Thus, employees overweight the optimistic statements that executives make about their company.
• Choice Overload: Various studies have shown that participants are often overwhelmed with information regarding the many investment choices in their retirement plans. An easy way out is to take the familiar option, in many cases company stock.
• Commitment Bias: Selling company stock can be seen, or felt, as a sign of disloyalty.
• Confirmation Bias: We have the tendency to overweight evidence that confirms our views and ignore evidence that is contrary to them.
• Herding: Few people have the ability to fight the herd. Most would rather follow it. One reason is that they are concerned about how others will assess their ability to make good decisions. The fact that other employees own large positions in company stock influences their decision to do so as well. Herding is also an excellent reason to avoid what I like to refer to as “water cooler” investment advice. Don’t discuss investments with fellow employees, because academic research has found this leads to poor decisions.
• Regret Aversion: We are concerned about the distress we’ll feel if we make a decision that we come to regret. This leads to employees maintaining concentrated positions in order to avoid the emotion they would feel if they sold company stock and it later rose sharply.
• People make investment decisions based on what they believe is important information, or what economists call “value relevant” information. They virtually never consider that other investors, with far more resources, almost certainly have the same information. Information they have must already be “baked into” prices. Mark Rubenstein, a professor of applied investments at the University of California, Berkeley, put it this way: “One of the lessons of modern financial economics is that an investor must take care to consider the vast amount of information already impounded in a price before making a bet based on information.” Legendary investor Bernard Baruch put it more succinctly, stating: “Something that everyone knows isn’t worth knowing.” The failure to understand this leads to a false sense of confidence, which in turn leads to a lack of diversification.
• Investors sometimes have the false perception that by limiting the number of stocks they hold, they can manage their risks better.
• Investors gain a false sense of control over outcomes by being involved in the process. They fail to understand that it’s the portfolio’s asset allocation that determines risk, not who is controlling the switch.

Next week, we’ll explore some additional reasons for why investors neglect to diversify. Specifically, we’ll address one all-too-common explanation: A lot of investors, I’ve found, don’t understand just how risky holding a concentrated position in an individual stock—as opposed to, say, a mutual fund—can be.