Do You Suffer From Myopic Loss Aversion?

The field of Behavioral Finance has helped us gain valuable knowledge into how human behavior can influence investment returns. Myopic loss aversion is one of the most important concepts to understand in order to keep you on a path to investing successfully. Until you understand it, you could end up making poor investment decisions that lead to poor returns. What is Myopic Loss Aversion? The concept of myopic loss aversion was first introduced by Daniel Kahneman and Amos Tversky in 1979. Myopia refers to a narrowing of a view – focusing on the most recent short-term results, even if the investment time horizon is 20-30 years.

Humans have a natural aversion to losing money, property or anything else they find value in. This helps us avoid scams, keeps us from over-spending and helps us save for a rainy day. Myopic loss aversion is different. It happens when we temporarily lose sight of the bigger picture and focus on what is immediately in front of us. For investors, this usually leads to panic selling during steep market declines such as normal, healthy corrections.

To that end, I have stated I would not be surprised to see a pullback in the market at some point this year. Don’t let this scare you into selling stocks and abandoning a long-term investment strategy. Don’t become myopic and focus too much on what the market does on a daily, weekly or monthly basis. It’s impossible to time corrections and it’s a fool’s errand to try. I do not believe any market weakness we experience in the short-term is a harbinger of anything much worse, like a sustained bear market. This should be looked at as a buying opportunity if nothing else. The U.S. economy is stronger than media reports so keep your eye on the horizon and not the waves crashing on the beach.

How Often Should You Check Your Portfolio Value? Studies  have shown that investors dislike losses 2-and-a-half more times than  they like gains.  Because of this, investors will base their decisions  on perceived gains rather than perceived losses. If a person were given  two equal choices, one expressed in in terms of possible gains and the  other in possible losses, people would choose the former. This leads  investors to not only experience disappointment if they check their  portfolios with great frequency, but they are more likely to panic and  sell as the pain of losses becomes intolerable.

Behaviorists have  noted a tendency for investors to check the performance of their  portfolios too frequently. The result is the shorter the time horizon,  the more likely it will be that the investor will experience a loss of  value in their portfolio. If an investor checks their holdings on a daily  basis the odds of experiencing a loss is about 50/50. Those who check  the value every month don’t improve their odds much more from 50/50.  Even those who check the value of their portfolio once a year still have  a 30% chance of experiencing a drop in the value of their portfolio.  But if you extend that out to 10 years, there have only been two 10-year  periods since 1926 with declines in value (1928-1938 and 1930-1939).

Investment Gains Occur During a Small Number of Trading Days If  you were to look at the historical record of investment returns you’d  find the majority of long-term returns come from a relatively small  number of trading days. The returns for the majority of the remaining  time, on average, are virtually zero.  What this means is, in order to  achieve equity-like returns you must stay in the market and deny the  impulse to sell stocks when things may seem bad. When you become myopic  and can no longer see the forest from the trees, you are putting  yourself in danger of missing out on long-term returns by jumping in and  out of the market.

Myopic loss aversion can have a severe  negative impact on returns. Now, in a world where we are connected to  the internet at pretty much all times, it has become even easier to  check portfolio values in real time and feel the day-to-day pain of  losses.  This pain caused by myopic loss aversion can make an investor  stray from a well-thought-out investment plan.

Putting it All Together The  conclusion one can draw is that the less frequently individuals observe  the performance of their portfolios, the more disciplined, and more  successful they are likely to be. If you’re experiencing stress  related to your portfolio, you may want to think about making a conscious decision to only look at the value during pre-determined  intervals of time; the longer the interval the more likely you’ll be to see appreciation in the value. The best defense against this  psychological phenomenon is too always look at the big picture and focus  on the long-term. If you have a well-diversified portfolio, don’t look  at the value too often and don’t worry if there are several positions  that are down from the price at which you bought them. Don’t become  myopic and cheat yourself out of potential gains.

 

by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.

Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.

 

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