Behavioral Finance (part 5 of 5): Looking at the Way Your Thinking and Behavior Affects Your Investing
Part 5 in a series of 5.
The last three items in our list of problematic behaviors are what I would refer to as the three negative effects. They are the House Money Effect, the Snake Bite Effect, and the Endowment Effect. The three of them are very closely related, and so we will consider all three together.
Problem: The Three Negative Effects
Of all of the behaviors we have studied, the three negative effects are by far the most reactionary. They are born more out of instinct than anything else. What is truly amazing about these three effects is that most people who are guilty of them don’t even realize it.
The first of the three is the House Money Effect. This was given its name because of the similarity in thinking to gambling. Consider a person who takes a seat at a blackjack table. He wins a few hands early on and feels very good about his luck. He pockets his original seed money and then begins to play only with his winnings, also known as the ‘house money’. The problem here is that this individual begins to take risks that he never would have with his original cash. Note carefully that nothing fundamentally has really changed. All of the money is truly his and he is still sitting at the same table, but even so his behavior pattern has changed. If in the end he loses it all, he can play it off and say “It was only the house money”. This type of behavior is seen quite often in investing, and it can be one of the most damaging in terms of maximizing our future wealth.
The second effect is the Snake Bite Effect. Everyone has experiences that cause them to become suddenly more cautious than they normally would. The saying “fool me once shame on you, fool me twice shame on me” is good description of this behavior pattern. An investor may put their money into a stock that, through unexpected and unanticipated circumstances, suddenly realizes a large loss. This investor now runs the risk of becoming overly cautious with their next investment in an effort to avoid that same feeling of loss. By doing so, they may well compound the loss by diminishing any future returns.
The third effect is known as the Endowment Effect. This effect occurs most often when someone inherits an investment but can also occur as a result of a merger or corporate spin-off. In any case, the person receives something from an outside source, and has an unexplainable attachment to the item. Many times, the attachment is due to the value that a previous owner had placed on the item. Other times, it is a result of having received something as a gift and not wanting to part with it.
It is not hard to imagine a person who receives a gift of an old car from a loved one that has died. The person who received the car may be unwilling to part with it at a reasonable price simply because of the emotional attachment to the vehicle. In the end, the person may never be able to bring themselves to sell the car, and therefore never realizes the value of it. The same can easily be true of any such gift.
In all three of these effects, the resulting problems are similar. Each of them causes us to act in a manner very different from how we normally would. For example, the House Money Effect causes us to take on excessive risk. This can lead to losses that we would not otherwise have faced. The reverse is true of the Snake Bite Effect. This effect causes us to alter our behavior so that we become too cautious and thereby miss out on gains that we would otherwise have captured. The Endowment Effect is a sort of hybrid of the first two. In the end, it causes us to hold on to an asset far longer than we should and thus realize losses or forego the gains that we would otherwise have made. It is often difficult to realize just when these effects have a hold on our behavior. However, it is important to be aware of them in order to ensure we are making the correct decisions where our wealth is concerned.
Throughout this series, we have looked at different patterns of behavior that negatively impact our investment making decisions. Profitable investing is not an easy task, and in many ways, it runs counter to our own nature as emotional human beings. Studying behavioral finance helps us to understand where the problems lie, and also how we can counter those limiting behaviors.
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