Irrational decisions by investors not to sell are costly own goals

olleague of mine is fond of saying that investors make no money when they buy an asset. Even if the market price of the asset rises after buying it, they make money only when they sell it. This statement of the seemingly obvious holds profound insights for investing.

Consider the experience of the many technology investors who bought shares and sat on unrealised profits up to the peak of the Nasdaq in March 2000, only to watch those profits evaporate and often turn into big losses. Investors in Irish property and bank shares suffered a similar fate during the financial crisis.

All investment ultimately boils down to two separate and distinct decisions: to buy and to sell. We are hard-wired to systematically treat the decision to sell in a fundamentally different way from the decision to buy, and there can be significant costs to not understanding this. From the vantage point of conventional economics, however, this makes no sense.

Before making the decision to buy, a rational investor is assumed to consider the probability-weighted options available and dispassionately choose the one offering the most attractive risk-adjusted return. The decision to sell is arrived at by the same rationally consistent process. So the decision to sell is simply the inverse of the decision to buy, and arrived at by an identical process of logical decision-making. While this economic analysis is mathematically elegant and undeniably rational, it is an almost useless description of real-world behaviour.

Behavioural economics is a relatively modern discipline that grapples with the seemingly systemic irrationality of decision-makers in many environments.

While distinguished economists such as Keynes and Minsky were interested in such behaviour, its transformation into a modern discipline can be traced to a 1974 paper called Judgment Under Uncertainty: Heuristics and Biases, by psychologists Daniel Kahneman and Amos Tversky.

Richard Thaler, the US economist regarded as the father of behavioural economics, was inspired by Kahneman. Thaler’s book Misbehaving: The Making of Behavioural Economics is a wonderful account of the evolution of the discipline. Thaler recounts the story of Richard Rosett, a professor at his university, to illustrate his “endowment effect”.

Rosett, a wine collector, told Thaler he had bottles bought long ago for $10 that were now worth more than $100, and that a wine merchant named Woody was willing to buy some at current prices. Rosett said he occasionally drank one of those bottles, but would never pay $100 for one, nor would he sell any to Woody.

To Thaler, this was illogical. “If he is willing to drink a bottle that he could sell for $100, then drinking it has to be worth more than $100. But then, why wouldn’t he be also willing to buy such a bottle? In fact, why did he refuse to buy any bottle that cost anything close to $100?” he wrote. Thaler concluded that as an economist, Rosett knew such behaviour was not rational “but couldn’t help himself”.

In conventional economics, Rosett’s decision-making makes no sense. His choice not to buy a bottle of wine for anything close to $100 is logically at odds with his refusal to sell an equivalent bottle for the same price. The endowment effect is swamping all else in determining the outcome.

Put simply, the fact Rosett already owned the wine changed his behaviour, even though rationally it should make no difference. His decision to buy is being driven by something fundamentally different from his decision to sell.

For investors, replace bottles of wine with stocks of companies. Thaler’s understanding of the endowment effect, and that we are hard-wired to systematically treat buying and selling in a fundamentally different way, likely make him a better investor.

We should follow the seemingly obvious advice of my colleague and take heed of this crucial effect. Combined with an awareness of this and other insights from the growing canon of behavioural research, we will likely end up richer.