There is a tendency to fall in love with your portfolio and then think up all the reasons why to hold what you already own. Take this example from The Economist:
Some recent work should at least help. It explores the “endowment effect”, one of the chief tenets of prospect theory. Put simply, this means that people place an extra value on things they already own. Think of a favorite sweater, or your house: would you swap either for something of equal market value? Over the past decade, prospect theorists have found support for the endowment effect in scores of experiments. In one of the best-known, researchers at Cornell University began by giving university students either a coffee mug or a chocolate bar, each with identical market values. First the experimenters confirmed that roughly half the students preferred each good. After the goodies were handed out, they let the students trade: those who had wanted mugs but got chocolate (or vice versa) could swap. With barely 10% of students opting to trade, the endowment effect seemed established (you would expect 50% to have swapped, given the random allocation of gifts). Even after a short time with things of little value, ownership had overwhelmed the students’ prior tastes. Dozens of other tests have produced similar results, and have produced a wave of criticism of neoclassical economics. The criticism has been taken seriously, as it should be: if the endowment effect is real, people’s economic decisions are fundamentally different from what economists have assumed.
Of course the Endowment Effect is real! Trend following profits are rooted in all the elements of what has become known as behavioral finance. While economists may debate away the concept of the Endowment Effect, trend followers simply accept the reality — and follow trends.
What the Endowment Effect Means for Traders
The Cornell mug and chocolate experiment is a precise laboratory version of what happens in trading portfolios every day. An investor buys a stock. The stock falls 20%. Rational economic theory says the investor should evaluate the stock on its current merits, with no preference for it simply because they own it. What actually happens is the opposite: ownership creates attachment. The investor begins generating reasons why the position will recover. They remember the analysis that led to the purchase more vividly than the evidence that the thesis has failed. They would not buy the stock today at the current price, but they hold it because selling means crystallizing a loss that feels personal.
This is the endowment effect in a trading account. It produces exactly the behavior that trend following is designed to exploit: irrational holding of losing positions by other market participants, which means that when a trend develops downward, there are participants who should be selling but are not, extending the trend further than rational models predict. The losing positions that the endowment effect keeps alive become the fuel for sustained downtrends. Trend followers on the short side capture precisely this dynamic. They are not predicting that the endowment effect will cause holders to delay their selling. They are reacting to the price trend that the delayed selling produces, following it for as long as the rules say to hold.
The same mechanism works in reverse for uptrends. Investors who sold too early, having overcome the endowment effect on a winner they held and then watched rise further, represent buying pressure that re-enters as the trend continues. Every participant who chases a rising trend because they regret their early exit contributes to the trend’s continuation. Trend followers already in the position capture that continuation. For the full framework of how behavioral finance underpins the trend following edge, see the behavioral finance page and the trend following overview.
Frequently Asked Questions
What is the endowment effect?
The endowment effect is the tendency for people to place a higher value on things they already own than they would place on identical things they do not own. In the Cornell experiment, students who received a coffee mug were unlikely to trade it for a chocolate bar of equal market value, even though before receiving the mug they had no particular preference for it. Ownership itself created additional perceived value.
How does the endowment effect hurt investors?
By causing them to hold losing positions longer than is rational. An investor who would not buy a stock at its current price continues to hold it because selling means accepting a loss on something they own. The ownership bias overrides the rational evaluation of the current situation. The result is a portfolio of deteriorating positions held for emotional rather than analytical reasons.
How does the endowment effect create opportunity for trend followers?
By producing sustained price trends. When large numbers of investors irrationally hold losing positions rather than selling, the selling pressure that rational models predict is delayed. When that selling eventually arrives, it arrives in waves, producing the sustained directional price movements that trend following systems are designed to capture. The endowment effect does not create trends directly but it extends and amplifies them by delaying the rational response that would otherwise contain them.
Why do trend followers accept the endowment effect rather than debate it?
Because the debate is irrelevant to the trading decision. Whether or not economic theory accepts the endowment effect, the price trends it produces are observable and tradeable. Trend followers do not need a theoretical explanation for why trends exist. They need the discipline and rules to follow them. The behavioral finance research confirms what the performance records already showed: markets behave irrationally enough, consistently enough, to support a systematic reactive approach.
Trend Following Systems
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