The Endowment Effect: Why we Hold Assets we Ought to Sell
May 18, 2021 – Larry Swedroe
The issue of holding or selling an asset is one of the more frequent risk management problems I am asked to address. I hope the following will help you address the problem from the right perspective.
Put yourself in the following situation: You are a wine connoisseur. You decide to purchase a few cases of a new release at $10 per bottle, and you store the wine in your cellar to age. Ten years later the dealer from whom you purchased the wine informs you that it is now selling for $200 per bottle. You have a decision to make. Do you buy more, sell your stock, or drink it?
Faced with this decision, very few people would sell the wine — but very few would buy more. Given the appreciation in the wine’s value, many might choose to save it to drink on special occasions.
When holding is irrational
The decision to not sell, while not buying more, is not rational. The wine owner is being influenced by what is known as the “endowment effect”. The fact that the wine is something you already own (an endowment) 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. Since you wouldn’t buy the wine if you didn’t already own it, the wine represents a poor value to you. Thus, it should be sold. The same is true of any investment you currently hold: In the absence of costs, the decision to hold is the same as the decision to buy.
The endowment effect often causes individuals to make poor investment decisions. For example, it causes investors to hold assets they wouldn’t purchase if they didn’t already own them — either because they don’t fit into the asset allocation plan, or they are viewed as so highly priced that they are no longer seen as the best alternative from a risk/reward perspective.
Emotional attachement
Perhaps the most common example of the endowment effect is that people are often reluctant to sell stocks or mutual funds that were inherited, or were purchased by a deceased spouse. I have heard many people say something like “I can’t sell that stock; it was my grandfather’s favourite and he’d owned it since 1952.” Or “That stock has been in my family for generations.” Or “My husband worked for that company for 40 years; I couldn’t possibly sell it.” Another example of an investor subject to the endowment effect is stock that has been accumulated through stock options or some type of profit-sharing/retirement plan.
Financial assets are like the bottles of wine. If you wouldn’t buy them at the market price, you should sell them. Stocks, bonds and mutual funds are not people — they have no memory, they don’t know who bought them, and they won’t hate you if you sell them. An investment should be owned only if it fits into your current overall asset allocation plan. Thus, its ownership should be viewed in that context.
Ask yourself this question
You can avoid the endowment effect by asking this question: “If I didn’t already own the asset, how much would I buy today as part of my overall investment plan?” If the answer is “I wouldn’t buy any” or “I would buy less than I currently hold”, you should sell. That is true of a bottle of wine, a stock, bond or a mutual fund.
The lesson is simple: In the absence of costs, if you would not buy the asset you are currently holding, you should sell it. For investors in mutual funds in tax-advantaged accounts, the costs of trading are either zero or so small that they can basically be ignored. However, for taxable accounts, the impact of taxes must be considered.
The charitable option
If you are faced with the decision to dispose of an endowment asset and substantial capital gains taxes would be involved, you might consider donating some, or all, of the stock to your favourite charity. By donating the financial asset in place of cash you would have donated anyway, you can avoid paying capital gains taxes. Alternatively, you could place the stock in a charitable trust and then sell it, again avoiding the payment of taxes.
And finally, keep this important point in mind: there is only one thing worse than having to pay taxes — not having to pay them. I have seen many large fortunes turned into small ones due to the unwillingness to pay taxes.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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