The Traders Journal

The Endowment Effect

EvolutionInvestors beware or at least be aware.  Over the past two years, I’ve had a number of significant relationships, but that’s changed now – in part because I was reminded of Charles Darwin’s famous quote “It is not the strongest of the species that survives, nor the most intelligent that survives.  It is the one that is most adaptable to change.” 

Academics like to write lots of papers proving that investors ascribe much more value to a position they already own than to one they don’t.  They call this the endowment effect.  I confess – I fell prey to exactly that effect.  I’ve been trading the biotech run profitably for over 2 years.  I knew it was long in the tooth.  I saw the industry begin to underperform the market.  I saw the lower peaks and negative money flows amongst the sister stocks. 

But these biotechs had become good friends and very profitable winners for so long that I failed to embrace a change in the winds.  In essence, I wanted to alter the weather and fueled my emotional sunny visions with hope and a fondness for my biotech friends.  I was in fact chasing unnatural returns.  It had already started to rain, but there I was hoping for more sunshine and refusing an umbrella.

My point is that I diminished my returns (albeit still locking down wonderful gains) because:

  1. I grew too friendly with these biotechs and that is unhealthy.
  2. I began to personally filter what the market charts were telling me.
  3. I stood in the rain getting wet while hoping for sunny skies again.
  4. I got greedy.  I enjoyed the 2 year status quo.  I was slower to change than I should have been.

Now I better understand and embrace what Darwin meant.  The solemn pledge I made to myself is that next time it will be different.  When I see change happening, I will act upon it.

Trade well; trade with discipline!
-- Gatis Roze


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This also happens to me all the time, giving back 1/3, 1/2 even 100% of profits before finally acknowledging that the tide has turned and it is time to move on. But it is tough to do since the previous profits felt so amazing.
Very solid article on the the mental aspect of trading. I can understand how slowly a winner can become a long-term friend, that would avoid the scrunity the magnifiying glass, that a new prospect would come under. Thanks for sharing in a way that all can relate to. I printed & saved for referen
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