The endowment effect: Value is relative
The endowment effect reveals that ownership, or a lack thereof, plays a critical role in how your clients perceive a stock’s value.
Generational characteristics make Baby Boomers far more prone to the endowment effect than Millennials.
Technology stocks have paced the market’s gains so far in 2018, potentially overinflating their relative valuations.
Given the extreme performance disparity between growth and value stocks this year, consider talking with your clients now about the potential benefits of rebalancing.
Value is more relative than economists once believed. Classical economic theory holds that market participants are rational decision makers who unfailingly attempt to maximize their returns. Embracing this maxim leads to expectations that developed equity markets, as a collective extension of individual market participants, are therefore efficient and rational. However, global equity markets often fall considerably short of such expectations, defying economic theory and reflecting the fact that investors are often predictably irrational, instead.
Behavioral finance: Where humanity and economics meet
Enter the science of behavioral finance, which can help advisors better connect with clients and improve their value propositions. One of the behavioral finance effects likely influencing some of your clients is related to their perceptions of value. During the 1980s and 1990s, a variety of studies were conducted involving groups of individuals that were provided with objects ranging from coffee mugs to lottery tickets to cash, with participants in some studies designated as owners and others not designated as owners. These exchange-based studies demonstrated that ownership of an item materially affected an individual’s perception of value, with owners generally requiring more compensation than potential buyers were willing to pay.
Professor Richard H. Thaler, who won the 2017 Nobel Memorial Prize in Economic Sciences for his efforts to humanize the study of economics, referred to this preference as “the endowment effect.” In this edition of our quarterly behavioral finance insights, we discuss the generational repercussions of the endowment effect and provide actionable guidance to help advisors better connect with clients regarding the road ahead for equities.
Technology has generated more than 65% of the S&P 500® Index’s year-to-date gains in 2018.
Technology still leads the charge
Technology stocks have generated more than 65% of the S&P 500® Index’s year-to-date gains in 2018.1 The same major Technology companies that piqued your clients’ interest in 2017 have remained in the frenzied media spotlight this year, including companies such as Facebook, Amazon, Apple, Netflix, Alphabet (Google’s parent company), and Microsoft. As we discussed in our spring behavioral finance insights, titled “The availability bias,” the prolonged spotlight and relatively recent upbeat performances of Technology stocks may be reducing your clients’ ability to view their Technology holdings objectively.
For your clients who express a strong preference to remain overexposed to Technology, the endowment effect is probably reinforcing their perspective. Specifically, the endowment effect reduces your clients’ willingness to pare exposure to stocks that they already own. These clients may also be overestimating the relative value that these holdings represent. Given that many of these companies have been a prominently featured part of the market’s 10-year bullish run means that conversations about the importance of disciplined rebalancing can be challenging.
Help your clients avoid an undertow
Equity market tides have been turning, as illustrated by the return of equity market volatility chart below. The chart illustrates the performance of the S&P 500 Index, as well as the performance of the Technology and Energy sectors within the index. As demonstrated, this year’s market advance has been filled with ups and downs compared with 2017, when the S&P 500 Index generated a record 12 consecutive months of positive performance. The chart below also points to the relatively upbeat performance of previously out-of-favor Energy stocks since March, underscoring the potential benefits of diversification within a client’s portfolio.
Several factors have driven up market volatility this year. Worries about a possible trade war between the U.S. and China—a substantial threat to global growth—and expectations that the current expansionary period in the U.S. is nearly over have played significant roles. Additional factors have included geopolitical tensions, fluctuating expectations regarding Federal Reserve rate hikes, as well as the ongoing U.S. political drama.
These collective influences argue for a thoughtful approach to asset allocation moving forward. The historically accommodative monetary policies set in place by central banks around the world are quickly coming to an end. Accordingly, the days of relatively straightforward, dependable global economic growth may be numbered.
Baby Boomers, Millennials, and the endowment effect
The equity market’s early year selloff provided an indirect example of the endowment effect in action, underscoring that Baby Boomers are particularly susceptible. Rather than view the market correction as a sign that valuations in select areas of the market had become unsustainable, many Baby Boomers viewed the selloff as an opportunity to double down on their existing growth-oriented stock holdings. This result was not overly surprising, given that Boomers tend toward being slow to sell but quick to buy, and generally exhibit a predisposition toward overconfidence and quick decision making.
Millennials seem far less influenced by the endowment effect than Baby Boomers. Due in part to their data-driven focus, Millennials tend to take longer to make decisions. Rather than purchase additional shares of their Technology stocks, many Millennials appear to have used the market’s early year correction as an opportunity to rebalance their allocations. Many Millennials then turned their attention to an investing opportunity that made far more intuitive sense to them than equities: cryptocurrencies. The recovery in Bitcoin between early February and early March partially reflects this dynamic.
Over the past 12 months, U.S. large-cap growth stocks have outperformed value stocks by more than 15%, an outcome that is approximately two standard deviations below the mean.
Give your clients the value that they deserve
Over the past 12 months, U.S. large-cap growth stocks outperformed value stocks by more than 15%, an outcome that is approximately two standard deviations below the mean. The last time that such a performance disparity occurred was the late 1990s, shortly before the Tech Bubble burst. The chart below illustrates the recent outperformance of growth and may help to better frame the current performance disparity for your clients.2
Although it is too early to tell whether we are at a market inflection point or merely approaching one, consider reminding your clients that sentiment shifts are often dramatic and difficult to predict. Any such market corrections and reversions to the mean frequently reward previously out of favor sectors and strategies with better relative performance, while potentially punishing sectors that have reached unsustainable valuations.
On the horizon
Looking toward the near-term horizon, we believe that there are several points that you should mention when speaking with your clients about the outlook for equities. Specifically, further Fed rate hikes seem likely for now, as does a trend toward historically average market volatility. An end to extreme monetary policy accommodation by overseas central banks is another point worth discussing, as is the potential for tariff-related challenges to fuel market uncertainty. In addition, revisiting your clients’ stock specific concentrations to help ensure that the endowment effect is not unbalancing their portfolios is another way to potentially add value. In the process, consider exploring whether your clients are effectively positioned to benefit from a potential mean reversion among value stocks, which we believe are far more attractively priced at present on a relative value basis.
Omar Aguilar, PhD
Chief Investment Officer, Equities
Charles Schwab Investment Management