Endowment Effect

Endowment Effect is the tendency to fall in love with what we own and makes us resist change.  Or in other words, this is the tendency to consider something you own to be worth more than it would be, if you didn’t own it.

golem-692573-1To illustrate, here is an example from Nassim Taleb’s book  “Fooled by Randomness” : If you are to buy a painting at $20,000 and market conditions cause it to increase to a value of $40,000 a month later, would you still buy it at the current market price?

Many of us would say no because we could have bought it for half the price a month early, but this is absurd because if we wouldn’t buy it for the current market price, then there is no logical reason for keeping the painting.  Only emotional reasons would exist.

This effect is seen all too often in the stock markets.  People will buy a stock at a price of x, only to have it double in the next month.  They hang on to the stock, thinking that they got it cheap, but then tell themselves that they won’t buy any more at current market prices.  This is a cause of our irrationality; Logic says that we should sell all our holdings in a given stock, if we would not purchase it at current market prices.

How does one overcome this bias then?  By already defining a target exit price the moment you buy the stock.  Once that target price is reached, and in order to enjoy the maximum ride of an uptrend as well as to avoid selling too early, enter a Trailing Stop Loss.  This results in two beautiful options, either the uptrend continues and you stay invested or the tide has turned and the “system” unemotionally liquidates your position, without giving back too much of your hard earned profits.

THE KEY to making money in the markets lies in how you EXIT the market.

 

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