Wednesday, March 05, 2008

Cross-Talk: Once You Own It, It Owns You

Dr. Richard Peterson, in a recent post, provided an excellent example of the endowment effect: how we lose our objectivity once we take ownership of an asset. He brought pens to a seminar, but only had enough for half the audience. He then asked the group that received the pens to indicate how much they'd be willing to sell them to those who did not receive them. He also asked the group without pens how much they'd be willing to spend for one of the pens. The audience members without pens were willing to spend an average of $1.35 for a pen (which is close to the pen's intrinsic value), but the members who received pens insisted on a selling price averaging $8.80.

Once the audience members owned the pens and considered them their own, they systematically overvalued the pens' worth. Similarly, once we take a position in the market, it becomes *our* position and we value it simply because we have made it our own. That makes it extremely difficult to take a loss on our position, even when that is what our trading plans call for.

It's a bit like houses in the current weak housing market: many owners are unwilling to reduce the selling prices of their properties because they value their homes too much. Once we own the asset, it can own us by coloring our perceptions and actions.

I've noticed over the years that, when I'm trading well, my eye is on the stop-loss points for my positions, not on the potential price targets and profits. Explicitly spelling out how much I'm willing to lose on an idea and then staying focused on that scenario forces me to accept the possibility of loss, rather than fight it. It is a psychological trick that keeps me from getting married to my idea. By the time I put the position on, I'm already mentally prepared for it to fail.

That might sound like twisted logic to some: how can you feel confident about trading if your focus is on losing? But confidence doesn't simply come from winning; it comes from knowing that you can handle losing. By embracing the possibility of loss, we make sure that when we own a position, it won't end up owning us.


Psychological Risk Management