Through his pioneering work with children, famed psychologist Jean Piaget uncovered a profound truth about human nature: Our sense of ownership develops extraordinarily early. But why do we feel such inherent attachment to things? A brief exploration of the psychology of ownership helps answer this question and gives us confidence in the investment approach we take at the Oakmark Funds.
The Endowment Effect
There is a well-established phenomenon in psychology called the endowment effect, which shows we assign more value to items as soon as we own them. In a classic study, students were offered the choice between two giveaways: a coffee mug and a chocolate bar. Approximately half of participants chose each item, but when given the chance to switch objects, students were surprisingly reluctant to relinquish their possessions despite no strong initial preference.1 This tendency to cling is so deep-rooted that neurologists have found the brain responds the same way biologically when thinking about items labeled “mine” as it does when thinking positively about “self.”
In an investment context, the endowment effect manifests as falling in love with stocks that are already owned, which can skew perceived value and impede objectivity. The fear of being wrong, or of not realizing full value on an investment, fools even the most seasoned analysts into holding tight to value traps when their talents would be better utilized seeking out new stocks. Portfolio managers are not immune to this phenomenon either, as research estimates the average cost of the endowment effect in institutional portfolio construction is about 100 basis points annually.2
Although feelings of ownership emerge early in life and are deeply engrained, culture also plays a role. Psychologists have identified an isolated population in Africa that does not exhibit the endowment effect due to the fact that they live in an egalitarian society where most things are shared.3 While our office in downtown Chicago looks quite different from the bushland of northern Tanzania, there are some commonalities in terms of group approach and collective accountability that help us similarly mitigate the endowment effect.
For example, when a new stock is brought to our investment committee, the idea is subjected to a rigorous peer review. To initiate this process, a detailed new idea write up is distributed to the entire research team, and analysts are assigned to prepare the negative case against the stock. A formal presentation is conducted at the Stock Selection Group meeting, during which the analyst who brought the idea must defend the name before all of the investment professionals of the firm. The format is intended to incite healthy debate and provide opportunity for any member of the group to voice concern or support. This process aims to prevent analysts from becoming anchored to a view of the business and to provide a sense of shared ownership around the decision to accept or reject the new idea.
We employ a similar process to evaluate existing holdings that have underperformed. Stocks that have not met expectations are re-pitched to the Stock Selection Group, and actual results are reviewed relative to the analyst’s initial assumptions. Risks to the investment thesis are highlighted in an attempt to avoid value traps and override any deep-seated attachment felt by the analyst. In select cases, the stock will be reassigned to a different analyst to conduct due diligence on the name as if it were a new idea.
As investors, we are subject to the same psychological tendencies that impact all human beings. Michael Steinhardt, one of history’s most successful money managers, has discussed his own battles with attachment in an investment context. Although relatively extreme, Steinhardt’s mitigation strategy was to sell his entire portfolio and begin with a clean slate, allowing him to literally “start over, all in cash, and build a portfolio of names that represented [his] strongest convictions.” While Oakmark might employ this technique as a hypothetical exercise, by establishing awareness of our natural predispositions and designing a culture and process to challenge them, we hope to achieve better investment results for our clients.
1Knetsch, Jack L. The Endowment Effect and Evidence of Nonreversible Indifference Curves, 1989. (http://econweb.ucsd.edu/~jandreon/Econ264/papers/Knetsch%20AER%201989.pdf)
2Cabot Research via The Financial Times, November 2015. (https://www.ft.com/content/f9b17740-9205-11e5-bd82-c1fb87bef7af)
3Apicella, Azevedo, Christakis and Fowler. Evolutionary Origins of the Endowment Effect: Evidence from Hunter-Gatherers, 2014. (https://www.aeaweb.org/articles?id=10.1257/aer.104.6.1793)
The discussion of the Funds' investments and investment strategy (including current investment themes, the portfolio managers' research and investment process, and portfolio characteristics) represents the Funds' investments and the views of the portfolio managers and Harris Associates L.P., the Funds' investment adviser, at the time of this letter, and are subject to change without notice.
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