How To Stop COVID-19 From Derailing Your Retirement
Justin Kuepper
|
Let’s take a look at a few key pieces of advice to stop...
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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.
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.
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.
Receive email updates about best performers, news, CE accredited webcasts and more.
Justin Kuepper
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Let’s take a look at a few key pieces of advice to stop...
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Find out why $30 trillon is invested in mutual funds.
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Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
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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.
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.
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.
Receive email updates about best performers, news, CE accredited webcasts and more.
Justin Kuepper
|
Let’s take a look at a few key pieces of advice to stop...
News
Iuri Struta
|
Most equities have continued their rally these past two weeks, along with investment-grade...
Aaron Levitt
|
While tax-gains harvesting takes some planning to implement, it can help save investors...
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
Download our free report
Find out why $30 trillon is invested in mutual funds.
Mutual Fund Education
Justin Kuepper
|
Let's take a closer look at how ESG investments have outperformed during the...
Mutual Fund Education
Daniel Cross
|
While CITs and mutual funds share many similarities, there are some key differences...
Mutual Fund Education
Sam Bourgi
|
The phrase ‘bear market’ has been thrown around a lot lately, but it...