European equities
10 May 2016 | By Liam Nunn

The Ikea effect

'We’re going to IKEA,’ my wife announced sternly. I’d been living in fear of these words ever since we moved into our new place...

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’We’re going to IKEA,’ my wife announced sternly. I’d been living in fear of these words ever since we moved into our new place; and before I could even protest I was being frogmarched through an endless maze of cheap furniture and unpronounceable products. The great thing about IKEA is the fun doesn’t stop when you leave the shop. Afterwards I got to spend the entire weekend assembling a variety of flat-pack furniture (while supressing the frequent urge to end the misery through a merciful hammer blow to my own skull).  

I’m not a big fan of DIY. But even I admit to feeling a satisfying sense of pride whenever I walk past our newly constructed bookshelf. Yes it’s not perfectly straight and it wobbles around when you touch it; but if you ask me it looks pretty good, and I certainly wouldn’t relish the idea of tearing it down and replacing it anytime soon.

This emotional attachment I’ve formed to my self-assembled furniture was the subject of a fascinating 2012 study; in which Harvard psychologists coined the term ‘IKEA effect’ to describe our tendency to value a product of our own labour much more highly than an independent third-party would[1]. A close cousin of the more widely-known endowment effect, this quirk of human psychology should be of significant interest to anybody who invests a substantial amount of time and effort in stock picking.

By the time we decide to add a new company to the portfolio, a lot of cognitive effort will already have been invested in the stock. We’ll have scoured the annual reports, met with management and convinced ourselves that the shares are a mispriced opportunity. And while we firmly believe in the importance of diligent analysis; the effort that goes into this process also has the potential to distort our view of reality. Just as I look at my wonky bookcase through rose-tinted glasses, investors are naturally inclined to see the contents of their carefully constructed portfolios in a pretty favourable light. 

This can have a highly detrimental impact on performance. Firstly, because the ‘IKEA effect’ is yet another reason why it’s psychologically difficult to sell overvalued ‘darling’ stocks. But secondly, and perhaps less obviously, this bias can lead to a particularly damaging form of loss-aversion. In a study of mutual funds spanning over twenty years, Andrea Frazzini found that the average fund manager was 1.2 times more likely to sell a stock that had gone up in price than a stock that had declined in price since purchase[2]. And while this standalone observation may not seem particularly surprising, the performance impact of this behaviour was striking. As shown in the chart below, fund managers that showed greater willingness to sell loss-making positions outperformed those managers that were most reluctant to exit positions at a loss[3]:

Source: Frazzini, 2004

Clearly we need to be careful in interpreting these findings. Frantically rushing to sell a company solely because it’s declined in price isn’t a smart strategy; and having the conviction to stick to your guns in the face of market overreaction is a crucial tenet of active management. But what these results clearly illustrate is that it’s a very fine line between justified conviction and blind stubbornness; and that it’s absolutely crucial we retain both the humility to recognise that we will make mistakes; and the courage to address them promptly when we do. No matter how carefully we analyse a business, we have to accept that we might be wrong. That we might be clinging to a fundamentally poor investment because we’re reluctant to write-off our initial hard work, that we might be seeing a beloved-bookshelf where everybody else, quite rightly, sees an accident waiting to happen.

The Old Mutual European Smaller Companies Fund has an equal-weighting strategy, partially to combat the malignant loss-aversion that Frazzini identified. All our ~50 holdings start-out as a ~2% weight in the portfolio; and if a stock subsequently declines to a weight of ~1.5%, we reassess the position. If, after challenging our assumptions with a critical eye, we decide the investment case remains intact; we’ll return our holding to a full 2% weight. But if we find that something fundamental has changed, or there are flaws in our initial analysis; we won’t hesitate to exit the position even if that means recognising a loss. If we lack the conviction to buy more when the position has declined to 1.5%; we tend to think we shouldn’t be holding the shares at all.

The equal weighting process isn’t a panacea. But by systematically testing our conviction in underperforming positions; we aim to create an environment in which the recognition of mistakes is seen as a courageous virtue rather than a cowardly sin. The process is designed to emphasise that the only valid reason for us to continue to hold a stock is that we deem the current market price to be incorrect; and it’s important our judgement in this regard isn’t distorted by the price at which we initially bought the shares or by the effort we’ve previously expended in our analysis.

Like a five-hour slog around IKEA, selling at a loss is something that nobody actively relishes. But recognising our hardwired tendency to avoid it – and the negative impact this can have on performance – may be one of the most valuable lessons in the art of investment. 

[1] Norton, Michael I., Daniel Mochon, and Dan Ariely. ‘The IKEA Effect: When Labor Leads to Love.’ Journal of Consumer

Psychology 22 (3) (July 2012) 

[2] Frazzini, Andrea. ‘The Disposition Effect and Underreaction to News’, The Journal of Finance 61 (4) (August 2006)

[3] Montier, James. ‘Part Man, Part Monkey.’ Behavioural Investing, (Wiley, 2007): 34-35

 

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