Two Concepts That Can Affect Your Returns

Two concepts often left out of conversations about investing are opportunity cost and endowment effect. Though different, they do overlap and can have implications for your portfolio.

Opportunity cost is what you forfeit by taking a certain course of action, even if the action is a decision not to act. Every dollar you allocate to a specific investment is a dollar not allocated to some other investment or purpose. If you allocate, say, $5,000 to stock A and stock B outperforms, your opportunity cost is the excess return you would have realized by buying stock B instead. At the same time, the money you invested in stock A costs you the opportunity of doing something else. By investing the money, you give up the chance to, say, spend it on a vacation or make a donation to your favorite charity.

The endowment effect holds that we value the things we own more than things we don’t own. In one oft-cited study, some participants were given a coffee mug for free while others were not. When the owners were asked how much they would be willing sell the coffee mugs for, they gave a price that was approximately double what those who did not receive the mugs were willing to pay for them. The mere ownership of a free coffee mug increased its value in the eyes of those who were given it. This behavior applies to many other assets as well, including investments. Combined with other biases, such as the disposition effect (an aversion to taking to a loss on a stock) and confirmation bias (seeking out information that supports your viewpoint), investors can end up holding onto investments that an objective third party would otherwise view as candidates for selling.

The only ways to completely avoid opportunity cost are to make the best decisions all of the time and to have perfect foresight. Since neither is possible, the best a person can hope to do is to reasonably limit opportunity cost. The endowment effect can be partially countered by asking a simple question: If your investments were sold while you were sleeping, would you buy them back after you wake up? If the answer is no, then they are probably not as valuable as you currently think they are.

The overlap between the two concepts should be coming more into focus. By holding onto an investment simply because you already own it, you are both being overly optimistic about its prospects and missing out on the potential returns of allocating your money elsewhere.

As effective as it can be to ask “would I buy this today,” care needs to be taken to avoid excessive trading. Constantly seeking to eliminate or, at least limit, opportunity cost can actually have the opposite effect. In seeking higher returns, investors often end up with lower long-term returns due to performance chasing. It’s a pattern that has been repeated throughout history and will continue into the future.

So, if constant performance chasing is not the answer, what is? Having defined rules that govern your investment decisions. Even if you don’t have clear cut rules, simply writing down the reasons you are buying an investment and what would cause you to sell it—before you buy it—can help. You are more likely to be objective before you purchase the investment (when the endowment effect is less powerful), and you’ll have an identifiable set of criteria to determine if the characteristics that made the investment attractive still apply. If those traits no longer apply, consider whether it is time to sell.

None of this will completely eliminate the opportunity cost of not having a bought a different investment. Over any given period of time, there will always be an investment with a higher return (unless you are really, really lucky). What having clearly defined rules will do is reduce the opportunity cost caused by an undisciplined approach and behavioral biases such as the endowment effect.