Thursday, November 11, 2010

Faced With the Decision of Selling an Inherited Asset?

Thanks to my favorite writer Larry Swedroe, I thought it might help to provide an explanation of the right way to consider whether you should buy, hold or sell investments. No, I am not advocating to try and time the market.

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.

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