By Shelburne Fiduciary Partners | September 24, 2019
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.
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.
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.
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
There are a number of significant implications to the concept of MLA which could have a material outcome on wealth accumulation over time.
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.
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.
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.
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