Flat-pack investing might ruin you

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

No moving day is complete without back ache, a selfie in front of the new door and the conquering of the Billy bookcase. It’s a perfect kind of torture to have to rebuild a few IKEA beds, knowing there’s a full day of cleaning and construction ahead before you can collapse into one.

There’s nothing like admiring your own handiwork when it’s all done, though. It might not stand up to master craftsman scrutiny but who cares? You built it with your own two hands and that’s what counts.

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It’s not immediately clear how all of this can scupper our investing skills but it turns out the ‘IKEA effect’ can really skew our perception of value.

In 2011, Harvard Business School discovered that building our own furniture warps our idea of what it’s worth when we’re done.

“In a series of studies in which consumers assembled IKEA boxes, folded origami, and built sets of Legos, we demonstrate and investigate the boundary conditions for what we term the “IKEA effect” – the increase in valuation of self-made products. Participants saw their amateurish creations – of both utilitarian and hedonic products – as similar in value to the creations of experts, and expected others to share their opinions.” [1]

Amateurish? Charming. Looking beyond that personal attack, though, it rings true. It’s why negotiations can get frosty on Vinted, with a bargain hunter haggling with you over the shoes you wore when you graduated or the chunky knit jumper you made yourself. Both have a bit of you in them somewhere that raises the items’ worth in your eyes, and certainly not in theirs.

Swap the screwdrivers and wrenches for hours spent poring over balance sheets and you get an investor convinced their stock is a winner simply because of the effort they put into researching it. From there it’s an easy step into falling victim to the endowment effect (or ‘divestiture aversion’ which sounds like an episode of the Big bang Theory) which describes our tendency to think something is worth more simply because we own it.

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We’re vulnerable to experience both behavioural biases because we’re so eager for our hard work to pay off and sometimes let that morph into thinking it should pay off for us. That’s a problematic route to go down because we’re inserting ourselves into the equation when really we have no bearing at all on the outcome.

When we start to think we bring some of the value to the table (sturdy or not) our actions can really start to suffer. We can end up ignoring warning signs like ebbing sales volumes etc. because we are anchored to the effort we put into finding a stock, not the value we found. It can stop us selling because we don’t want to feel like all that research went to waste or we can start investing in a company simply because we now know more about it. In short, we use our own egos to blur the lines between hope and reason.

As with the behavioural heuristics we’ve looked at in the past, it’s not enough to just remember to avoid them. Their very nature means they often kick in when we aren’t watching and when we’re especially vulnerable to emotion taking over - like making money decisions under pressure.

If we can’t rely on ourselves to stay calm or logical in the moment, it means we need to do a lot of the work beforehand and mitigate our twitchy selves’ influence ahead of anything happening.

First, always look for counter arguments. It’s not wrong to back yourself - if you didn’t you’d never buy anything. But, to stop any type of stockhold syndrome kicking in, active seek out the opposite view to make sure you’re not missing anything and to give balance to your thinking. You never know, it might start to make a bit more sense or it might strengthen your conviction. Either way, it will have added value and you will have challenged the IKEA effect instead of feeding it.

Second, compile a checklist of simple questions, designed to highlight any flare-ups in your decision-making process. A few could be:

• Am I choosing to ignore or downplay recent bad news? Why?
• Have I factored the latest data into my valuation models?
• How might the severity of recent news updates affect the business in various scenarios?

The latter offers a good way to simulate a good, neutral and bad outcome given new information so you can plainly see what could happen. This can be particularly helpful if the wider context (inflation, interest rates, geopolitics) allows you to assign a probability to each outcome.

Third, automate your process. This could either be by using limit orders to buy/sell at a given point or through adhering to a specific set of trade criteria you’ve decided before getting into the trade. The goal here is to reduce thinking on the spot, when bias might pop up. Make it clinical instead.

In the end, remembering the stock doesn’t know you own it and doesn’t owe you anything is as useful a reminder as any. Stay sensitive to valuations and set your entry and exit criteria before you’ve begun. At the very least, these prevent the “What was I thinking?” moments because you’ll know exactly what drove your decisions and what to take from this trade into the next.

Sources:

[1] The “IKEA Effect”: When Labor Leads to Love, Harvard Business School, 2011.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.