Capital Perspectives: Countering status quo and endowment biases

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Regular readers of this column know behavioral finance topics feature prominently because learning about cognitive errors and emotional biases, eliminating them where possible and accommodating them where they are not can be an investment edge.

Cognitive errors (e.g., illusion of control bias, hindsight bias and confirmation bias) are primarily due to faulty reasoning and can often be corrected or mitigated with better training. Emotional biases are not related to conscious thought and stem from feeling, impulses, or intuition. Therefore, while cognitive errors are important, since emotional biases are harder to coach out of our humanity, it behooves us to acknowledge their presence and structure investment processes designed to neuter them. While philosophies can be adopted in the abstract, the specific processes used must be customized to the individual given we all have a unique psychological makeup.

Recent columns explored ways to counter the loss aversion bias and the overconfidence bias in an investment process. Today we continue a series on emotional biases as defined by Kaplan. Below the definition of the biases, I offer ideas on how to structure an investment process to mitigate their harmful impacts.

Status quo bias – occurs when comfort with an existing situation leads to an unwillingness to make changes. If investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out, status quo choices become more likely.

Endowment bias – occurs when an asset is deemed special and more valuable simply because it is already owned.

In terms of an investment process, these biases are most closely tied to a sell-discipline. Perhaps setting a price at which one is willing to sell as a percentage up from where one would be willing to buy with new capital if the position were not already owned could prove a useful tool to counter the status quo and endowment biases. This ties the sell-discipline to the buy discipline, which itself should have been constructed to circumvent other psychological shortcomings.

For example, let’s say an investor follows a policy of only purchasing the shares of conservatively financed and well-run mega-cap U.S. companies that have historically increased their earning power at a rate exceeding the average of American businesses if the shares can be had for 75 cents on the dollar or less after making a conservative estimate of intrinsic business value. Further assume this investor follows a policy of only selling stock positions when they reach a price 67% higher than where he would be willing to buy, as adjusted for changes in intrinsic value over time. Since 67% up from 75 cents is $1.25, the implication is that the investor is demanding an obvious overvaluation before parting ways with a very high-quality company.

In the above example the decision to sell is linked to the decision to buy. This may result in a more objective process that mitigates the impulse to indulge one’s status quo and endowment biases.

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

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