In 1990, Nobel Prize-winning economist Daniel Kahneman and two colleagues published a study documenting how we can “overvalue” things we already own (D. Kahneman, J. Knetsch and R. Thaler, “Experimental Tests of the Endowment Effect and the Coase Theorem,” The Journal of Political Economy, December 1990). This “endowment effect” applies to investors who may hold on to assets beyond their strategic relevance, failing to account for true opportunity costs, and missing out on opportunities to reallocate that capital to investments that better meet the needs of the portfolio.
Recent reporting in The Economist magazine also highlights the powerful incentives investors have to stand behind the original return assumptions for their investments (“Interest Rates and Investment Returns,” March 2, 2017). Beyond the resistance to accept a potential error, some make the case that low interest rates have reduced borrowing costs for firms, which increase opportunities for outsized returns in the future. In our view, this argument can strain efforts to support return expectations and hurdle rates, and reinforces the importance of firmly making the best investment decisions given our understanding of current values and opportunities.
When we consider investments, we must look forward. This may require us to adjust our thinking for probable nominal returns.
In forestry, for example, we often struggle with “sunk costs.” When evaluating the current value of our timberland investment against new investment opportunities, we must do so with ice in our veins and clear financial analysis on hand. We, first, ignore sunk costs and, second, evaluate forest investments based on their ability to generate income and returns moving forward. The only time we have complete control over our portfolio is today.
Clear here for key questions to ask as applied to timberland investments.