ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?

Andrew Stotz 00:02
Hello risk takers this is your worst podcast host Andrew Stotz, from a Stotz Academy, and I'm here today continuing my discussion with Larry swedroe, who is head of finance and Economic Research at Buckingham wealth partners. You can learn more about his story in Episode 645. Larry deeply understands the world of academic research about investing, especially risk. Today, we're going to discuss a chapter or two chapters from his book investment mistakes even smart investors make and how to avoid them. Today, we're gonna be talking about Mistake number 11. Do you let the price paid affect your decision to continue to hold an asset? And Mistake number 12? Are you subject to the fallacy of the hot streak? Larry, take it away.

Larry Swedroe 00:49
Yeah, there's one of the more common mistakes discovered, if you will are uncovered by behavioral financial economists who combine the field of psychology with investing is something called the endowment effect. The endowment effect is where we tend to value something more, if we own it, then if we were to purchase it. So for example, let's say that somebody and they've done lots of tests like this, there's a gift that you get, that's a Yankee t-shirt, and it's worth, you can go buy it or whatever, for $10. But if you own it, and you're asked, how much would you sell it for, you won't sell it for $10, it would be 15, even though you would never pay 15 to buy it. So we tend to value things more when we own them. So what I try to teach people the meaning of this endowment effect is through an example that someone has explained to me. So Andrew, let's take this example. I imagine you like to enjoy a good glass of wine now and then. So let's assume you know you've decided somebody has offered you a great opportunity to buy this new wine coming up. It's, you know, all the characteristics are great. And everyone's writing about this year is going to be a fabulous year for Cabernets, and you're offered a chance to buy the Cabernets at $10 about a bottle. Now that's kind of in the price range that you might normally buy for a table wine, you're not going to be able to drink it for a couple of years. So you know, maybe you might buy bottles 1215 box, and that's an ordinary day, five years go by and now that bottle is selling for $200 A bottle. Clearly it was a great investment a good decision to buy. The question is now you have this case, it's ready to drink. And would you drink in that case those 12 bottles of wine that you normally only willing to pay maybe a maximum of $15 for? Or would you sell them and get $200 in gold by 12 Nice bottles of wine for 15 bucks. What would you do? Andrew? What do you think the right answer is from an economic perspective? And what do you think your emotional self would tell you to do?

Andrew Stotz 03:33
I think the first thing is that in the beginning, I kind of bought it for drinking. Right. So my first reaction is, hey, I should drink this, what's any different about drinking it at this point. But then on the other hand, I look at the price I paid, which was pretty low now relative to the very high price that it's out. And I think to myself, Wow, I can make some cash. And so I think I would think about it very differently in that case. And I may take that cash and buy because I can drink a $10 bottle of wine, not that I drink wine. But that would be kind of my thinking on it. But tell me what you

Larry Swedroe 04:13
know, what a lot of people do is they may say, Well, I'll keep one or two bottles to drink to enjoy it and then sell the rest because I would never pay $200 A bottle for a bottle of wine to sit nav every night at dinner with my tuna sandwich. You know, whatever you happen to be eating for dinner, right? Well, the economic logic is the price you paid for it should be irrelevant to the decision whether you buy or drink it. It should only be what you pay for that price today, or would you avoid not paying it because there's too much and in fact you would make the decision since you would never pay $200 A bottle you should sell All of them. But we have this endowment effect, which causes us to make non economically rational decisions. Now, so what does that have to do with investing? So Andrew will create an example. Let's say your father worked for General Electric. And it's 1999, your father happens to pass away, and he leaves you 10,000 shares of GE stock, that's I'll make something up, it's only got $100 A share. What should you do with those 100 chairs?

Andrew Stotz 05:37
I'm gonna appreciate the gift value of those shares, and shares them and hold them for as long as I can. Because they were given to me by my father.

Larry Swedroe 05:50
And he wanted, you know, you know, he wanted you to hold those shares, right? In effect, or at least that's the thing. There's this endowment effect. Now, let's say you had 100 shares, or 1000, shares of stock trading at 100 to $100,000, would you have invested $100,000 in GE stock? If you father, I gifted you the $100,000, instead of the shares of stock,

Andrew Stotz 06:21
there will be 1000s of stocks I could look at, I would be asking the question which stock is going to go up over the next, let's say, five or 10 years? Which one do I think if I'm going to put it down on one, do I think it's going to have the best opportunity over the next five or 10 years? That may or may not be GE but there's no reason to think that it would be right.

Larry Swedroe 06:42
Roughly at that time, there were 8000 stocks, why GE and it turned out GE would have been a horrible investment. The stock has done very poorly over the last couple of decades, well, that another option might have been, hey, if I had the $100,000, I ought to just own the total stock market fund and be much more diversified. But yet many people that I come across, I can't sell that stock dad, you know, owned it for 50 years, you know, that's not gonna hate you, he's gone, he doesn't know worth it, you're gonna, you know, own that stock enough. But the endowment effect causes us to put an extra value either emotionally, or otherwise on it. And we end up making decisions based upon this endowment effect, which is completely irrational. From an economic perspective, it may be somewhat rational from a psychological perspective, we're trying to satisfy that some psychological need, I love my dad, he wanted me to own the stock. But that has nothing to do with whether your father was smart. And you know, wanted to tell you on the GE stock, right. And they have been that, you know, he said, I got this huge capital gains, I don't want to sell the stock and leave you on your grant, you'll get a step up and basis in the US, you pay no tax on that, then you sell it when I gifted to you, and I can go build a diversified portfolio. But we have this endowment effect, we tend to place value on things that we already own, rather than thinking of them is if I didn't own it, and I had the equivalent amount of cash, would I take that cash from buy that one particular stock? And the answer is obviously, almost 100% of the time, you shouldn't own that stock for that reason. So that's a big problem that investors make, they get gifted stock from a parent, a husband, whatever. And then they hold on to this concentrated risk when diversification is the only free lunch and invest.

Andrew Stotz 09:06
When I think about the word endowment, I think that someone's given me something, or I've been gifted something. But I guess the endowment effect also applies just you could call it ownership, you know that you own something. There's a couple of things that it made me think of I have a new client right now that I'm working with. And one of the challenges that he's facing is that it's his father's business. It's been built over decades. But it's a completely different environment now. But he can't close it down. Or he can't liquidate parts of it because of that endowment effect that he just doesn't want to betray what he believes was the interest of his father. Yeah.

Larry Swedroe 09:51
The best advice that I would give is to say, look, there are clearly psychological issues. There's an emotional attachment you love If your father, you want to fulfill his wishes, but there's also an economic rationale that your father, I assume, would want you to do what's in your best economic interest? So here's the core, the question you should ask from a rational economic perspective. And then you could decide later, whether there's the psychological value, put a price on it, and say, is it worth, you know, keeping this asset, that's, I could sell for a million, but it doesn't make sense to hold, but I do place the psychological value. So the question would be, okay, let's look at what the price you can get for selling it. And if you have the cash, instead, let's just make a number up, it's a million dollars. If I gave you a million dollars, would you invest it in this business? The answer is no. Then the economically rational answer is clearly you should sell it again. Or you could decide for other reasons, hey, look, I love my dad, I know he would have wanted this, I can afford to lose the million dollars, the business goes flat. It's not the end of the world. But on the other hand, what is that million dollars was important, that would allow you to send your kids to have a good education, or allow you to retire and sleep well at night. And to me, the answer becomes an obvious choice, you have to be able to find a way to separate the psychology and the emotion from the economic rationale.

Andrew Stotz 11:35
Yeah, it's interesting, because he came to me with his brother, and his brother had a very different opinion of it. Like, you know, Dad wouldn't want us just to go down with the ship on this thing. And so you can see the value of an advisor. In this, I want to explain another story that's very similar to what you described. And that is, my father worked for DuPont, all of his life. And he didn't know much about finance, but he knew it was free money coming from DuPont, when he could buy a share that was worth 100 in the stock market. And he could buy it at 85. So he just loaded up on all of the DuPont stuff that he could buy over the last 15 years of his career or so. And that basically gave him a great, you know, return. So my mom and dad retired in North Carolina, and basically the they got a financial advisor there. And the financial advisor is the name of it's called Larry Carroll. And that's the firm and my mom heard Larry Carroll on the news and on us on talk shows. And she really liked him. So she said, Let's go down meet him. So basically, they started working with him and his team, and what they said and said, Look, 60% of your portfolio, or whatever that was at that time was DuPont stock. And they asked what would happen if Doosan DuPont stock went from, let's say, 500? Where it was at that moment, down to 50. What would happen? What if it was Enron? Yeah, exactly. And my dad said, it's impossible. And my mom tells the story, you know, and we talk about it, my dad said, this is impossible, it would go down from 500 to 50. So the guy just eventually convinced them that they need to start selling it. And they started to sell it and diversify that money into a much wider diversified until they got it down. I don't know, maybe 10% of the portfolio. And over time, my dad, you know, didn't feel that attachment as they were selling it. But my mom tells a story that sure enough, after a few years, that share price hit the number that that advisors said, you know, in this case, from 500 to 50, or what is my hypothetical, but it was a massive fall. And the advisor had gotten them out of it and diversify that. And so that's a really great example of how you as an advisor, a financial professional, you can help people get over that endowment effect. Yeah.

Larry Swedroe 13:56
Here's another example. This is a perfect example of another mistake covered in my book, which is confusing the familiar with the safe. We tend to think things are safer if we're familiar with that. So we overweight for example, for US investor US stocks, if you're a Japanese investor, you overweight Japanese stocks or a French investor. He thinks French stocks are the highest performing and safest investments. And if you lived in St. Louis, for most of your life, you thought Anheuser Busch was a great stock and it but if you lived in Atlanta, guess what stock you thought was? Right. Is it any safer to own Coca Cola if you live in Atlanta than St. Louis? And is it any safer to own butt and eyes or Bush if you lived in St. Louis, then Atlanta, it makes no sense. But we do that. So here's a great story to fit yours. I met with an advisory firm that was aligned With our firm in Atlanta, they paid us as a consultant to help them with their clients. And I met with an Intel executive in around 1999. And the guy had the vast majority of his assets in Intel stock was trading in the mid 60s. The start and he was fairly senior executive. And I said, This is crazy. It makes no sense. You're making these mistakes, confusing, the familiar with the safe concentrating all your risk in one risk basket. And oh, no, but I know what's going on, could not convince him. Within a few years, the stock was at 10. And that was devastating. And I tried to point out them that if he sold the stock in the 60s, his life was secure. He could sleep well, it didn't matter whether he can own 20 to 30% equities, and sleep well enjoy the rest of his life, it didn't matter couldn't convince him to sell, because it could never happen. And if it did happen, he would know.

Andrew Stotz 16:10
Yeah, and one of the one of the he was still holding the stock. One of the great ways of getting over the endowment effect is, you know, help someone to just sell 5% Just sell a little bit, and let that kind of sink in. And sometimes that can get people you know, through it. I wanted to say that. Occasionally, Larry, people asked me about relationship advice. And they mistakenly asked me that because I'm nearly 60 and still single. So you know, I warned them in advance, you know about it, but I say, Look, I don't know much about relationships. I know my mom and dad had a good one. So I observed that one. But what I will do is just I only have one question for you. And it's a yes or no answer. And it will resolve all of your confusion. And they say okay, what's the question? I say? Well, you know, your boyfriend really well right now, right? Yeah, yep. No, I'm really well, okay. And you didn't know him when you first met him? Right? No, I didn't know him at all. I just thought he was good, whatever. Now, imagine that. You didn't know this guy. And he walked up to you and wanted to start a relationship? Would you start that relationship with him now? And they said, Well, you know, I said, Look, just give me yesterday. Right? And they say either yes or no. And I said, there's your answer. If your answer is yes, then you need to double down and invest more time and effort in the relationship to try to make it work and may not work for various reasons. But if your answer is no, it's time to take action. So

Larry Swedroe 17:45
sunk costs the problem of the knob, considering some people stay in relationships, because I've been with them five years, you know, I don't want to have wasted that. The same thing with a stock you may have bought at 60. And now it's 30. I got to hold it and least until I get even, that's a sunk cost. The only question is, would you buy the stock at 30 today and take that money and buy it? And if the answer is no, then you should get rid of it. That's another common mistake. The Fallacy of the sunk cost.

Andrew Stotz 18:19
You know, I one thing before we go on to the next mistake is just how do you handle I mean, like when I was looking at the most common mistakes that people were making, on my podcast, as I'm interviewing people, one of the mistakes is like they're making behavioral mistakes, emotional mistakes, thinking mistakes. And I I started like thinking, Okay, I could classify this in some way. But man, once you start getting into behavioral mistakes and that type of thing, it's, it's overwhelming, like you've talked about familiarity. And then there's also recency bias, right? And they're not exactly the same. And you just talked about sunk costs, and then there's endowment. And I'm just curious, like, how do you sort through all of the, or you just have to just know all of these?

Larry Swedroe 19:07
Yeah, I wrote the book so people, one could get a good laugh at themselves. I know. I've made most of the mistakes, that's our new them is very Wardman stakes. So the key is education and providing that with people and showing them that why what's the logic given them analogy to something that's outside of the world of investing, so they can figure out okay, I get the concept, and then apply that concept to investment. Because once you get the concept you can then make hopefully, a rational decision. The information is power and allows you to make a better informed, less emotional decision. And that's really where a good adviser or friend can, you know, play a role by opening somebody's eye So make sure that thinking about it in an economically rational way, rather than in a psychologically or emotionally satisfying way. The problem is, we're human beings. And we're subject to all kinds of biases that are hard to avoid. They're ingrained in our system. And you know, we're not computers, we are emotional. So that's one of the biggest values of a good advisor is to educate, show the people the rational economic decision, and let them make that an informed decision. Do you want to let your emotions dominate for whatever if you place a lot of value, and you can accept those risks, then that's fine. You said I'm willing to pay that price. People buy lottery tickets all the time. We know the expected return is minus 50%. It's completely irrational. And the sad part is, the people who buy the most lottery tickets are the people who can least afford to do it.

Andrew Stotz 21:05
Yeah. Tragic. Before we go on to mistake number 12, I just want to tell you about my first and only time that I went into a casino in Las Vegas and I went to a craps table and I got to the dice and just as I was about to throw it, I yelled, yatse. Okay, I made that up. Anyways, mistake number 12. Are you subject to the fallacy of the hot streak?

Larry Swedroe 21:33
Yeah, this is another common fallacy a problem, very related to recency bias, which we have discussed in the past, where we place an overwhelming amount of value on what has happened recently. So a hot streak. So for example, you know, LeBron James, let's just say he's a Korea 50% shooter overall. And but LeBron James is hit five shots in a row. Okay. So people are willing to bet boy, he's hot, he's gonna make the next one. Turns out studies have been done, career 50% shooters shoot 50% On the next shot, regardless of whether they missed their previous 10 or made their previous 10. That's a great example. You sure? Yeah. That's the data, we can look at the empirical evidence, not the theory. Now, in the short term, it might be somebody is hot, because he's got a lousy defender, and no one can got him or he's being, you know, guarded by a superior defender. And it's a little tougher, but on average, there is no such thing as a hot streak. A team that wins 70% of the games, is after losing three in a row is just as likely is a 70% chance that they will win the next game. And so we unfortunately, place too much evidence, particularly on investment managers or stocks on whatever is on that hot streak. So the example that I use to help people is the story of a mathematics professor, who is teaching a class in statistics. And he comes into the class and he tells this class of 100 kids to lecture hall class says, I want everybody in this room to write down T or H heads or tails, imagining that they're flipping the coin. And write out the 100. Number, the T's are the ages. And I'm gonna leave of one coin on the desk, and I want one student to pick it up and actually flip the coin. Okay, and I'm going to come back in 30 minutes or whatever. And I will identify when, you know, in the next class, when we hold that, I will tell you which student flipped the real coin. So everybody's gonna sign their name. Just don't put whether you flip the imaginary coin, right, or you flip the real coin and most of large majority of the time, the professor was able to identify which person flipped the real coin. So, how do you think he did that? Diandra? How could he figure out out of 100 students, which one is flipping the real coin and which one is flipping the imaginary coin and writing down that T and the H

Andrew Stotz 24:53
Well, you know this goes to the issue of how they find tax cheats sometimes By looking at the final digits of numbers that they submit, they're not randomly selecting them. Yeah. So in that case, you would say that they may expect a hot streak through in the number in the heads or tails that they're putting down when in reality, it may just be randomly up and down. But what so

Larry Swedroe 25:23
how does the professor find the person who's got the hot? Whereas who actually flipped the real coin? What is he looking for?

Andrew Stotz 25:33
He's looking for? Well, the first thing, the first thing I would say is that you're going to have streaks that naturally occur, right? And so, and students

Larry Swedroe 25:46
just stop right there. Because that's the answer, I, when we flip an imaginary coin, we don't think there'll be more than maybe three or four heads or tails in a row. So but the fact of the matter is, the odds are pretty good that somewhere in a flipping of 100, you'll get six or seven heads or tails in a row. So he just looks for the person who had the longest streak of six or, you know, whatever, the most heads or tails in a row, and he predicts that person is the one with the real coin flip. And it turns out that he was right most of the time. That's the problem. It's very hard to distinguish luck from skill. So for example, if you have 10,000 money managers, which is about how many mutual funds we have, what are the odds randomly that you would expect, if even if the markets were perfectly efficient? What are the odds that somebody could before costs anyway? Right could outperform the market? It's about 50%. Right? So 5000, at the end of two years, you would expect randomly 20 503 years, 554 years, 625, five years, 312. And on and on, if the 10 years, you might expect that randomly, you'd have 10 people would have flipped those 10 minutes in a row. That's the equivalent of beating the s&p 10 years in a row. Now, would you put your money on someone winning the next round of flipping coins saying heads wins every time?

Andrew Stotz 27:30
Of course? Of course I would. Because I just saw in the news that this guy flipped 10 times in a row. And that's photobook how I flip 10 times in a row? How could I not believe that? Alright, so

Larry Swedroe 27:43
that's the problem. It's very hard to distinguish love from scale, when you have large databases, and so many people competing, you need huge amounts of data to do that. And we confuse skill with luck, often. And so that's what leads us to this fallacy of a hot streak, you have to do statistical tests to see did we have more than randomly we would have expected active managers, for example, outperforming the s&p. So for example, over a 20 year period, you would expect, you know 2%, to outperformed just randomly. So if the actual numbers 1%, then we know that fewer outperform than randomly expected, so we shouldn't attach any value to the ones who did. If we got a lot more, outperform them randomly expected. Maybe then we have a clue to help us identify what traits did those outperformance have that was consistent and different than the ones who underperform? No one has yet figured that one out, unfortunately, or fortunately. And therefore, we have no way to identify who are the future winners. And we cannot rely on past performance.

Andrew Stotz 29:09
And those darn losers study the winners to say how do they do it and all of a sudden, you get a self correcting mechanism in the market.

Larry Swedroe 29:19
The sons agree you get that but actually what happens is this more likely the outcome is this. Let's say you have 5000 Winners after one year and 12 150 after three, so people wait three years. They see these 12 150 Really bad managers of whether or not 1250 You know, the other 8700 And you know, whatever the numbers, right? So we kicked them out. If we had money with them, we sell and we put the money with some of those 12 150 winners. So now what's happened is some of those losers, those 8875 Losers, some of them had skill, but never got a chance to just had bad luck randomly, over a three year period, maybe their investment strategy was out of style, or whatever. But they never got a chance. So money flows out, and they have to shut down their funds. Now the remaining people who were either skillful or lucky, right, let's say half of them that skill half as long. The next round, the ones who were lucky are gonna disappear. Which means over time, the competition is getting tougher and tougher, because only the skillful remaining, which makes it harder and harder to outperform. And that's why, as we explained in my book, The Incredible Shrinking alpha, successful active management is a loser's game anyway. Because if you win, you get a lot more dollars. And now you either have to diversify more. So now you look more like the market. And it's very hard to outperform. Or you have huge market impact costs. Because every time you're trading, the small number of stocks in illiquid markets, your trading costs go up. So they tend to fall off because of their own success. And let's they cap may be it, depending on the fund may be a 1 billion if it's small cap, or five or 10 billion or launch cap, unless they actually cap their assets under management, they'll fail because success breeds seeds of its own destruction, because most of them will not turn down the chance to earn fees on the bigger assets, very few will shut down taking room on

Andrew Stotz 31:51
except for one of my guests, Richard Lawrence, who has the fun called overlook in Hong Kong. And what he basically did is set limits of how much he would take in from the clients at peaks and bottoms also, with the idea being that he tried to keep his fun at a certain size, knowing that in the end, that would be, you know, the best,

Larry Swedroe 32:14
the rare act of manager who was thinking in the interests or the best interests of his clients. And they do exist, but there aren't many of them.

Andrew Stotz 32:25
And his book is somewhere, I misplaced it. But he's written a book that's really great about explaining that. And just let me check one thing on this. And also, while I'm looking for that, I just wanted to mention that there was a story I saw on the internet that I want to go through about this in August 1913. I can barely remember that day. But that month, but in August 1913, a group of gamblers lost a ton of money betting in the Monte Carlo Casino. They watched as the roulette ball kept falling on black, which it did 26 times in a row. Well, that is a one in 66 million chance outcome. THE GAMBLERS kept losing as they bet that the longer the black streak win, the higher probability of breaking and landing on red, but

Larry Swedroe 33:33
that's wrong. It's still 50, a little less than 50%. Because you have the zero and the 00. It's like 48%, or whatever the number is, right? Each time. It's a random event. It's a mistake.

Andrew Stotz 33:49
And it's the gamblers fallacy, or also called the Monte Carlo fallacy, and it's when you believe that past or most recent outcomes, rather than randomness drives the next outcome of a random process. And that's really about in this.

Larry Swedroe 34:05
Yeah, my favorite story about this hot streak is about David Baker, who ran the fund called 44 Wall Street. Now, if yes, if I asked you who was the best, most famous money manager of the 70s, only one name should come to mind running mutual funds. Peter Lynch, Peter Lynch, for Peter Lynch was not the best manager in that period. He was only second best. Now. You know, Andrew, why would you give your money to the second best manager when you give it to the number one manager so David Baker's 44 Wall Street the next decade when Lynch went on to continue to have strong returns. David Baker's 44 Wall Street while the stock market was soaring, every dollar invested turned into 26 have incense losing 73% of its value. There's the best example I know of the fallacy of the hot streak happened 10 years be locked that added the skill. It's noise when you have so many people playing the game.

Andrew Stotz 35:17
Yep. And for the audience, Episode 687 is Richard Lawrence's episode. And the title of it is avoid the stock. That's the hype of the day. And his book is called the model which I have on the other side of my bookshelf over there. It's a great book where it describes his methodology of what he did over the years. So gives you some idea, anything you want to add to this discussion before we wrap up there.

Larry Swedroe 35:43
The only thing I would add is relevancy to today using Richard Lawrence's analogy, the hot stocks or the AI stocks, not all of them can be super winners, but they're priced as if each and every one of them will go on to be a winner. Yet, maybe one or two of them will actually dominate and the rest will go bankrupt or disappear or provide mediocre returns. So you want to avoid FOMO this fear of missing out just build a diversified portfolio. Avoid picking individual stocks that has far more to do with speculation than it does with investing.

Andrew Stotz 36:27
Great advice. Larry, I want to thank you for another great discussion about creating growing and protecting our wealth for listeners out there who want to keep up with all that Larry is doing. Find him on Twitter at Larry swedroe in at LinkedIn. This is your worst podcast host Andrew Stotz saying I'll see you on the upside.