Last Updated Nov 8, 2010 5:57 PM EST
Put yourself in the following situation: You're a wine connoisseur and purchase a few cases of a new release at $10 per bottle to store in your cellar to age. In 10 years, you learn the wine is now selling for $200 per bottle. Do you buy more, sell your stock or continue to hold it?
Faced with this type of decision, very few people would sell the wine, but very few would buy more. (Of course, given the appreciation in the wine's value, you might choose to save it to drink on special occasions.)
The decision not to sell or buy isn't rational. This is known as the "endowment effect." The fact you already own the wine shouldn't impact your decision. If you wouldn't buy more at a given price, you should be willing to sell at that price. Since you wouldn't buy any of the wine if you didn't already own any, the wine represents a poor value to you. Thus, it should be sold. The same thing is true of any investment you currently hold: In the absence of costs, the decision to hold is the same as the decision to buy.
The endowment effect often causes individuals to make poor investment decisions. For example, it causes investors to hold assets they wouldn't purchase.
The most common example of the endowment effect is that people are often reluctant to sell stocks or mutual funds they inherited. I have heard many people say something like, "I can't sell that stock, it was my grandfather's favorite and he'd owned it since 1952." Or, "That stock has been in my family for generations." Or, "My husband worked for that company for 40 years, I couldn't possibly sell it." Another example would be stock accumulated through stock options or some type of profit-sharing/retirement plan.
Financial assets are like the bottles of wine. If you wouldn't buy them at the market price, you should sell them. Stocks, bonds and mutual funds aren't people -- they have no memory, they don't know who bought them, and they won't hate you if you sell them. An investment should be owned only if it fits into your current overall asset allocation plan. Thus, its ownership should be viewed in that context.
You can avoid the endowment effect by asking this question: If I didn't already own the asset, how much would I buy today as part of my overall investment plan? If the answer is, "I wouldn't buy any," or, "I would buy less than I currently hold," you should sell. That is true of a bottle of wine, a stock, a bond or a mutual fund.
The lesson is simple: In the absence of costs, if you wouldn't buy the asset you are currently holding, you should sell it. For investors in mutual funds in tax-advantaged accounts, the costs of trading are either zero or insignificant. (However, for taxable accounts, the impact of taxes must be considered.)
If you're faced with disposing of an "endowment asset," and there will be substantial capital gains taxes involved, you might consider donating some (or all) of the stock to your favorite charity. By donating the financial asset, you can avoid paying capital gains taxes. Alternatively, you can place the stock in a charitable trust and then sell it, again avoiding the payment of taxes. And finally, keep this important point in mind, there's only one thing worse than having to pay taxes -- not having to pay them. I have seen many large fortunes turned into small ones due to the unwillingness to pay taxes.
More on MoneyWatch:
Why the Concern over Negative TIPS Yields Is Overblown TIPS Update for October For Bonds, Yield Doesn't Always Equal Return Refinancing Your Home Might Cost You in the Long Run Why Buy-and-Hold Isn't a Good Strategy
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.