The dangers investors face from the ‘endowment effect’

Important information -  the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

Steve Bannon, the Elon Musk of the first Trump term, may not have invented the President’s disorientation strategy but he described it well. ‘Flood the zone’, he said, if you want to put your enemies off their guard. His target was the media. But it might just as well have been the financial markets.

The torrent of news, opinion, policy shifts and propaganda is designed to keep us guessing. It may be a deliberate strategy, but it is also a high risk one. This week’s U-turns from the White House on the Federal Reserve and Chinese tariffs show that Mr Market is no pushover. He knows how to fight back.

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Stuck in the middle of this epic battle, investors are in a risky place. Many of the psychological flaws and biases that make investing hard at the best of times are being tested to destruction by the administration’s planned chaos and the forthright response from the equity, bond, currency and gold markets. Here are some of the mistakes that I’m trying to avoid as I navigate this stand-off.

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The first is to avoid the twin illusions of knowledge and control. It is natural to think that more information should lead to better decision-making. But there is plenty of evidence that this is not the case. An experiment in the 1970s, cited in James Montier’s excellent book Behavioural Investing, showed experienced bookmakers a progressively longer list of data points on horses, riders, course conditions and other variables and then asked them to forecast the results of races on the basis of the information they were given. Having more data made no difference to the accuracy of their forecasts. What did rise, however, was the bookies’ level of confidence in their picks.

In an age of 24-hour news and social media, there is no practical limit to the amount of information we can gather to rationalise our decisions. Unfortunately, there is no reason to believe that it will help us to better outcomes. The reverse is almost certainly true. We risk being misled by false or irrelevant data and overwhelmed by its volume. Having all that information at our fingertips increases our sense of being in control, but it is an illusion.

A related myth is to think that big news is necessarily significant. Just this week, we have learned that Russia is considering halting its invasion of Ukraine along the current front line, that the US President has no intention of firing the chairman of the Federal Reserve, and that the tit-for-tat tariffs imposed by the US and China on each other are unsustainable and the two sides are ready to talk. All of these are important stories. But they are not equally significant from a market perspective. It is impossible to know in advance which really matter, and which do not.

The next mistake I’m trying to avoid is succumbing to ‘after the fact rationalisation’. This is the ‘I knew it all along’ fallacy. It is dangerous because it leads us to believe that if we just tried a bit harder we could know in real time what was going to happen in future. What has happened in markets this year should disabuse of that idea.

Roll back to January and the triumphalism and fawning of the early days of the current administration. The business leaders queuing up to celebrate the dawn of a new era of growth, tax cuts, deregulation and prosperity in America. That was only three months ago. It feels like another age as the International Monetary Fund slashes its forecasts and the economic glass looks half empty again.

Investors fell into the same trap, believing that America First would mean Wall Street First too. But making one mistake does not mean you can’t compound it with another. The herd instinct fuelling a flight from US assets today is just as likely to be wrong. America has not suddenly abandoned its innovative gift and entrepreneurial spirit. This too shall pass. And today’s wise-after-the-event sceptics may soon look foolish.

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The flip side of anti-American group think might well be the wishful thinking that has put Europe back on investors radars. It is natural to hope that the silver lining to US isolationism might be a re-invigorated old continent, standing on its own two feet militarily, hosting a new reserve currency, competing with America and China in the industries of the future. But wishing something were true does not make it likely on any realistic timescale. Expectations can be priced in a lot quicker than progress is delivered.

A particularly dangerous version of wishful thinking is what psychologists call the endowment effect. This is the tendency to overvalue what we already own. This bias could become even more important if the rotation out of the US into other regions and out of shares into hard assets like gold continues. Nvidia shares neither know nor care whether you are a holder considering whether to sell or a new buyer looking to take advantage of the more than 30% drop in the price since November. The fact that gold has doubled in three years has no bearing on its value today but if you have owned it since 2022 you will feel very differently than if you have missed the boat and are considering whether to invest now.

The biggest mistake I am trying to avoid in this febrile investing environment is the temptation to do anything at all. As the White Rabbit says to Alice: ‘don’t just do something, stand there.’ When the zone is being flooded, the best course of action can be to let it all wash over you. If you already had a balanced portfolio, matching your tolerance for risk, then fiddling around with it now is unlikely to make it much better.

This article originally appeared in The Telegraph

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