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Stocks — Science Tells us When to
Hold ’em & When to Fold ’em

January 2008
Two new sciences shed light on an old problem of financial risk

With the stock market off to its worst first week of the year in history, investors are scrambling to decide whether or not to get out of the market. In my new book, The Mind of the Market, I describe the problem this way: our decisions about buying or selling things we value are heavily weighted by three psychological phenomena: the endowment effect, the sunk cost fallacy, and loss aversion. Understanding these will help you decide what to do with your investments.

Consider the following thought experiment. If you owned a coffee mug valued at $6 what is the lowest price you would accept to sell it? By contrast, if you were a potential buyer of a coffee mug of the same value, how much would you be willing to pay for it? In an experiment in which subjects were given this choice, the average price owners of the mug were willing to sell it for was $5.25, whereas the average price potential buyers were will to pay was only $2.75. Why the striking difference of nearly double the perceived value? Because of a psychological phenomenon called the endowment effect, in which ownership endows value by its own virtue, and nature designed us to hold dear what is ours.

This is one of countless studies in the new sciences of behavioral economics and evolutionary economics that has revealed how irrational and emotional we can be when it comes to money, investments, and especially stocks. Once we invest in stocks, especially in companies whose products we may value in personal use, we exaggerate the value of the stock simply by virtue of owning it. In our evolutionary past this makes perfect sense. Before humans domesticated other species, they had to forage and hunt, sometimes in conditions of severe scarcity, or the threat of it, in order to survive. Those who survived most likely exhibited a strong predilection for hoarding as well. Nature endowed us with the desire to value, and dearly hold on to, what is ours. Of course, by putting so much value on what we already have, we can also overvalue it — to the point that the cost sunk into it blinds us to the value of future losses that we will sustain if we do not switch to something that we do not already have.

This is another peculiar psychological effect known as the sunk cost fallacy and it can be a serious impediment toward our thinking clearly about whether to hold or sell stocks. For example, imagine that your child’s private school tuition bill of $20,000 is due and the only source you have for paying it is selling some of your stock holdings. Fortunately, you invested in Apple before the iPod boom, purchasing 200 shares at $50 each, for a total investment of $20,000. The stock is now at $200 a share. Should you realize your net gain by selling half of your Apple stock and paying off your bill? Or, should you sell off that loser Ford stock you purchased ages ago for $40,000, at its current value of $20,000?

Most of us would sell the Apple stock and hang on to the Ford stock in hopes of recovering our losses. Financially, this would be the wrong strategy. Why would we sell shares in a company whose stock is on the rise and hang on to shares in a company whose stock is in the dumpster? Because of another psychological effect called loss aversion, in which our brains are wired to pay more attention to losses than to gains. In fact, it turns out that losses hurt twice as much as gains feel good.

For example, imagine that I gave you $100 and a choice between (A) a guaranteed gain of $50 and (B) a coin flip in which heads gets you another $100 and tails gets you nothing. Do you want A or B? Now imagine that I gave you $200 and a choice between (A) a guaranteed loss of $50 and (B) a coin flip in which heads guarantees you lose $100 and tails you lose nothing. Do you want A or B? The final outcome for both options A and B in both scenarios is the same, so rationally it does not matter which option you choose, so people should choose both equally. According to “Rational Choice Theory,” which forms the foundation of a species of human known as Homo economicus, we maximize our utility when we make decisions. That is, when faced with a choice, we consider the value of the outcome and make a rational decision about the most efficient course to take to get to that end.

But loss aversion leads most people to choose A in the first scenario (a sure gain of $50) and B in the second scenario (an even chance to lose $100 or nothing). Even though there is no difference between having $100 and a sure or potential gain of $50 and having $200 and a sure or potential loss of $50, emotionally there is a difference, a big difference, between the two choices.

Research in these new sciences demonstrates precisely how risk averse we are — on average most people will reject the prospect of a 50/50 probability of gaining or losing money, unless the amount to be gained is at least double the amount to be lost. That is, most of us will accept a 50/50 chance to gain $100 if the risk of losing money does not exceed $50. When the potential payoff is more than double the potential loss, most of us will take the gamble.

So the next time you are thinking about holding or selling some of your stocks, remind yourself of the endowment effect, the sunk cost fallacy, and loss aversion before making your decision, because none of us are nearly as rational in our choices as we like to think we are.

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7 Comments to “Stocks — Science Tells us When to
Hold ’em & When to Fold ’em”

  1. Peter Says:

    I don’t buy the notion that a 50% chance $100 has the same value as a 100% chance of $50. Risk comes at a premium.

    If you really believe it then you should be willing to bet your entire wealth on the outcome of the flip of a coin if the coin is weighted in your favour 51 to 49.

    On the other hand, if you didn’t have to bet everything in one go but could bet $1 repeatedly with those odds you have a completely different story.

    As for the Apple vs Ford example, this is also bogus – it doesn’t contain enough information. Perhaps someone might choose to sell Apple on the basis that its an over valued castle in the sky that cannot sustain that price and now is a good time to unload it on a sucker before it falls.

  2. Eamonn Says:

    Peter, you are presenting your theory on how people would behave and trying to use it to counter the way that studies have shown people do behave. Nobody is claiming that everyone is the same, all that is being said is that the tendency towards risk aversion is there.

  3. David Says:

    … and who honestly believes that Ford’s stock is going to rally anytime soon and start beating Apple? Methinks the Peter doth protest too much…

  4. GH Says:

    Methinks Peter is short AAPL. ;-)

  5. Claudio Says:

    It seems to me that Peter, when he quite correctly states that not many people would be willing to bet their entire wealth on the outcome of the flip of a coin even if the coin is weighted in their favour 51 to 49, but they would bet repeatedly $1 at a time just proves what the article states about risk aversion. I can cope with losing $1, but losing all my wealth would be intolerable.
    I believe Warren Buffet also pointed out to our tendency to keep bad stocks (just hoping. . .) while selling the good ones (to make te gains), behaviour which, from the point of view of a Martian would be irrational.

  6. Broughton Says:

    I am a big fan of evolutionary biology, but I am skeptical as well. Statements like “Nature endowed us with the desire to value, and dearly hold on to, what is ours.” have to meet the same standard as any other scientific hypothesis. How do you test such a hypothesis? Surely skilled and rational traders would survive and attract fit mates.

    Perhaps it would be easier to test theories of evolutionary biology using current populations than conjecturing about past populations of which there is scant archaeological record. What are the Darwinian implications of the welfare state that ensures the survival of all human offspring regardless of the fitness of the parents?

  7. Victor Says:

    Hello,

    I think the description of the first experiment is rather inaccurate as it takes the perceived value as if it was the same thing as the market price, and they are not.

    And it is somewhat misleading to ask someone how much he would pay for a mug of market value $6 when he is not searching for a mug. It does not reflect how market prices are formed, because only the valuations of potential costumers matters.

    It is like taking random people in the street and asking how much they would pay for a Ferrari priced at $300k. I think the average would be way bellow that price.

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