Behavioral Biases in Investing: Ignoring the Noise

By Shelburne, Vermont Financial Advisor Josh Kruk

One of the most widely discussed concepts in behavioral finance is “loss aversion”. It stems from a landmark 1979 study1 by Daniel Kahneman and Amos Tversky which demonstrated that for most people, the negative feelings generated from incurring a loss outweigh the positive feelings generated from realizing an equal-sized gain. Therefore, people may bias their decisions, sometimes irrationally, to minimize the probability of a loss.

This concept has clear ramifications for investing. For example, loss aversion may cause investors to take too little risk in their portfolios or to avoid selling an investment for less than its original purchase price even if the sale would be advisable otherwise. The importance of the subject has led to a number of subsequent studies and variations on the theme.

Myopic Loss Aversion

Among the most interesting of those is a concept known as Myopic Loss Aversion (MLA). The theory behind MLA is that investors who are loss-averse look at markets and their portfolios too frequently, which causes them to over-emphasize short-term dips and recent bouts of market volatility. This in turn causes them to invest too conservatively for their risk profiles, sacrificing wealth along the way.

MLA and Investor Stock Allocations

The first significant examination of MLA was done by Shlomo Benartzi and Richard Thaler in 19952. They were interested in understanding why investors were demanding such a large additional return premium to own stocks instead of bonds. They calculated that an investor using a 5-year evaluation period should be indifferent between owning stocks and bonds when the expected return on stocks was 3% higher than bonds. In other words, an additional return of 3% a year on stocks sufficiently compensated investors for the extra risk associated with owning them over the 5-year horizon. An investor with a 10-year evaluation period would require just a 2% premium on stocks to be indifferent. This is because the likelihood of absorbing a cumulative loss in stocks progressively decreases with longer holding periods.

However, the authors noted that the actual premium observed in the market at the time of the study was much higher at 6.5%. This implied an investor evaluation period of just one year, and was happening despite the fact that most market participants have investment horizons far longer than one year. They concluded that, by evaluating results over a time frame that is too short and by over-emphasizing near-term events, investors were on average much less willing to own stocks than they should have been based on their investment horizon.

A number of other studies3 have supported the idea that loss aversion combined with frequent evaluation of market and portfolio conditions leads to under-investment in stocks and therefore, lower asset accumulation over the investing horizon.

MLA and Professional Investors

Unfortunately, it does not appear that professionals are any less susceptible to the MLA bias. A 2016 working paper4 issued by the National Bureau of Economic Research provided an intriguing real-world example of how information flow can impact decision making and economic outcomes. Currency traders were invited to test a new trading platform, with the opportunity to earn future trading credits based on the profitability of their test trades. The participating traders were divided into two groups. The first group received updated market pricing and portfolio information continuously (i.e. every second), while the other group received the information every four hours.

Three important observations were made. First, investors who received less frequent information were willing to accept market risk at a rate 40% higher than the group who received continuous information. Second, because of that willingness, the group with less frequent information achieved average profits that were more than 50% higher. Finally, these results were consistent regardless of how much professional experience the traders had.

A separate study found that a group of 50 financial advisors in Norway actually exhibited MLA biases to a greater extent than a group of students.5

Implications

There are a number of significant implications to the concept of MLA which could have a material outcome on wealth accumulation over time.

Discipline is Key

In an era of smart devices where information is flowing constantly and where sensationalism may distort the relative importance of a given piece of information, it may be prudent to actively avoid checking market and portfolio information on a frequent basis. Since the investing timeframe of most investors is measured in years or decades, this also helps better align an investor’s mindset and behavior with that timeframe.

Patient Investors Are Beneficiaries

Investors who exhibit MLA by overweighting the importance of recent information are likely to be overly conservative in their asset allocation (i.e. overweight bonds) and therefore sacrifice a portion of the return available to them. In doing so, they effectively provide a subsidy to the investors who do not exhibit this behavior. This represents a tremendous opportunity for patient and disciplined investors, who are essentially able to earn more than their equilibrium required return without taking additional risk.

MLA May Favor Passive Solutions

Because MLA has been shown to impact the behavior of even experienced professional investors, it may also play a role in the debate between active and passive fund options. Regardless of the average investment horizon of a fund’s shareholders, the performance of active fund managers is evaluated over a fairly short time frame. Results relative to the benchmark are typically published quarterly and manager performance is judged over 1, 3, and 5-year windows. Additionally, professional fund managers are bombarded with information flow on a continuous basis, certainly more so than even the most avid amateur investor.

By contrast, managers of passive funds are tasked with tracking the returns of a particular market benchmark. Their performance is evaluated by how closely they track the index rather than on whether they can consistently beat the index by enough to justify their higher fees. This eliminates a significant behavioral roadblock, in that the fear of short-term underperformance and the cacophony of daily market information should have far less impact on the way they manage the portfolio. It is difficult to know for certain, but it seems possible that MLA could be part of the reason that active managers have underperformed their benchmarks historically.

In many ways, the concept of less information being a positive thing feels counterintuitive. It certainly flies in the face of the societal and technological trends we observe around us on a daily basis. Ironically, however, investing may be one area where less really is more.

Notes:

1 “Prospect Theory: An Analysis of Decision under Risk”; Kahneman and Tversky; Econometrica, March 1979
2 “Myopic Loss Aversion and the Equity Premium Puzzle”; Benartzi and Thaler; The Quarterly Journal of Economics, February 1995.
3 “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test”; Thaler, Tversky, Kahneman, Schwartz, The Journal of Quarterly Economics, 1997.
“Causes, Consequences and Cures of Myopic Loss Aversion – An Experimental Investigation”; Fellner and Sutter, The Economic Journal, April 2009.
“Myopic Loss Aversion and Stock Investments: An Empirical Study of Private Investors”; Lee and Veld-Merkoulova; Journal of Banking & Finance; September 2016.
4 “Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders”; Larson, List and Metcalfe; National Bureau of Economic Research, September 2016.
5 “Do financial advisors exhibit myopic loss aversion?”; Eriksen and Kvaloy; Financial Markets and Portfolio Management, June 2010.

By Shelburne, Vermont Financial Advisor Josh Kruk


One Day In July LLC
5247 Shelburne Rd #101
Shelburne, VT 05482
How We Are Different
Low-fee index funds. Transparent & fiduciary financial advisors.
Local Financial Advisor
We are in your community We are local.
Investment Management
We tailor to each client. Index funds at the core.
Our Growth
Founded on a simple idea, growing fast.
Dan's Corner
Meaningful musings from our founder.
Fiduciary
Your best interests are our priority.
Low Fees
Our fees are among the lowest in the nation.
Financial Planner
Financial advisor optimizes your financial picture.
U.S. Treasury Bonds
Use Treasury Bonds to reduce risk.
Book Recommendations
Here are some of our favorites
Who We Serve
We work with clients nationwide from all financial backgrounds.
When Should I Invest?
Life transistions = important financial decisions.
Retirement: 401k and More
Retiring? Plan the future you want.
IRA Rollovers
401k Rollovers. IRA Rollovers
Active vs. Passive Investing
We believe there is a winner in this debate.
The Investment Process
How we work: low-cost index funds, personalized attention.
Simplicity
Simplicity is the ultimate sophistication.
Investing: What to Focus On
Low-fee index funds. fee-only advisor.
Switching Financial Advisors
Can be uncomfortable, but an important step.
Advisor Recruiting
We attract top-tier talent. Not your usual firm.
Basic Investing
Let's start with Investing 101.
Understanding Your Financial Statement
Let's break it down to basics.
Index Funds
Broad market exposure, low expense.
Behavioral Finance
Nudge vs. Sludge.
Advanced Investing
Let's geek out on stats and figures.
How Financial Firms Bill
Fee-based vs. fee-only, and lots more.
Who Supports Indexing?
Bogle, Swensen, Buffett, and others.
Transparency
One click to see our fees.
Mutual Funds vs ETFs
Clarifying the difference.
Does Stock Picking Work?
The resaerch says no.
Countering Arguments Against Index Funds
What happens in a down market?
Annuities
Lots of fees, little clarity.
How Do Mutual Funds Work?
Invest in the basket.
How to Relieve Financial Stress
New client? anxiety is normal.
Financial Terms Glossary
Common investment terms you should know.
Firm Comparison
One Day In July vs the competition.
Retired Investing
Retiring? Let us help.
Young Investors
Plant a seed, watch it grow.
High Net Worth Investors
Preserve and grow your wealth.
Investing an Inheritance
Prioritizing and planning for the future.
Widowed Investors
Managing money after a loss.
Female Investors
Your voice needs to be heard. We are listening.
For the Business Owner
Choosing what's best for your business.
Environmental Investing
Carbon intensity, fossil fuels.

Locations

Vermont

New Hampshire

Maryland

United States

Services

Individuals

401k Plans

Institutions

Environmental

Differentiators

Cash Flows

Low Fees

Fiduciary

Dedicated Advisor

Materials

Advisors: Join Us

Careers

Articles on Investing

About the Secure Act

Quarterly Booklets

Resources

Vermont Investment Management

Vermont Retirement Planning

Vermont Wealth Management

Vermont Financial Advisors

Investment Tools

Shelburne, VT Financial Advisor

Frank Koster | Josh Kruk

5247 Shelburne Rd, Suite #101

Shelburne, VT 05482

(802) 777-9768

Stowe, VT Finanical Advisor

Available for meetings in Stowe.

Steve Schleupner

(301) 514-4499

Burlington, VT Financial Advisor

Hans Smith | Katie Muttitt | Nancy Westbrook

77 College Street #3A

Burlington, VT 05401

(802) 503-8280

Portsmouth, NH Financial Advisor

Paul Barry

4 Market Street, 2nd Floor

Portsmouth, NH 03801

(603) 531-3773

Frederick, MD Financial Advisor

Available for meetings in Frederick.

Steve Schleupner

(301) 514-4499


Disclosures | © One Day In July LLC. All Rights Reserved.