Myopic loss aversion and portfolio returns - look away now

When it comes to exploring the ways in which human emotions cause investing mistakes, a simple illustration can be a big help. With that in mind, here’s a question…

Let’s say you and I play a game based on the flip of a fair coin. If you call it correctly, you win £110. But if you lose, you pay me £100. Does that sound like an appealing proposition?

Research suggests that you’ll probably tell me where to go. In fact, when presented with this gamble most people demand a much, much higher potential payback. Tests have shown that the average player offered this type of challenge demands a win of around £200 to accept it (and often a lot more).

The reason for that comes down to human emotion. Typically, we feel the pain of a loss much more than the satisfaction of a win. So what’s needed is a gain-to-loss ratio of something like 2-to-1 for the average punter to feel comfortable with this game. In behavioural science this is the essence of something called loss aversion.

The pain of losing

On its own, loss aversion has been blamed for one of the reasons why investors sell winning positions too readily and hold losing positions too long. Put simply, crystallising a loss, and accepting failure, seems to be much harder than taking profits on a winner - even though it can damage returns.

But there’s more. Loss aversion can also trigger other decisions that don’t work well in investing. For a start, it can cause investors to sell positions at the wrong time, particularly when faced with uncertainty. It may lead us to become too risk-averse and forget that, as an asset class, stocks do endure short term volatility but still tend to outperform other assets over the long term.

This problem is made worse when you combine loss aversion with another well known emotional tendency of constantly watching portfolio performance. When that happens you get something called myopic loss aversion.

To start untangling what all this means - and why it’s important to be conscious of loss aversion - it’s worth taking a flick through the research...

A whistle-stop tour of loss aversion

Our introductory coin flip test has its roots in work dating back to the 1960s by Paul Samuelson. But loss aversion was really first demonstrated in the mid-1980s by two titans of behavioural psychology, Amos Tversky and Daniel Kahneman. Their work concluded that in many areas of life, humans are programmed to be risk-averse.

Fast forward 10 years and loss aversion was picked up by another couple of academics, Shlomo Benartzi and Richard Thaler. They were trying to solve something else that had been troubling stock market watchers - the equity premium puzzle.

This puzzle was basically a question of why stocks had outperformed bonds by a wide margin over the previous century. In particular, there was a mystery about why, since 1926, the annual real returns from stocks had been 7%, but from treasury bills it was less than 1%. It begged the question as to why anyone would invest in T-bills. Benartzi and Thaler laid the blame squarely at the door of investor behaviour. They wrote:

“How can investors be extremely unwilling to accept variations in returns, as the equity premium implies, and yet be willing to delay consumption to earn a measly 1 percent per year? ...Our solution to the puzzle is to combine a high sensitivity to losses with a prudent tendency to frequently monitor one’s wealth.”

Their tests - and others that followed - showed that investors react badly to the variations in returns from stocks. That was despite the long term outperformance of stocks. The more frequently investors focused on these short term variations, the more they recoiled (and resorted to the safety of T-bills).

What all this showed is that constantly checking portfolio performance prods at the human tendency to be risk-averse. It shakes our resolve to stay invested for the long-term. Kahneman later wrote that providing investors with frequent feedback about their outcomes is likely to encourage their worst tendencies. In tests, those with the most data did the worst in terms of money earned, he said, since they were the ones that invested the least in stocks (and thus earned the least).

What are the lessons?

In short, evidence suggests that risk-averse humans find it hard to stomach short-term variations in stock returns. That’s despite the fact that shares generally outperform most other assets over the long term. Combine that with the fact that we like to keep a close eye on portfolio performance and you get the damaging effects of myopic loss aversion. Quite simply, it may just pay to look away.

It’s interesting to be covering the issue of loss aversion at a time when there is genuine uncertainty about how the EU referendum may impact on stock prices. To an extent, unlike the dotcom crash or financial crisis, there’s a sense now that investors are knowingly heading into a period of uncertainty. For some that poses a simple question of whether to get out or ride it out - and much will depend on individual future time horizons.

In many respects this dilemma was tackled in a classic quote by Warren Buffett - a man not easily shaken by price swings and keen to take advantage when the market goes his way:

“If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”

We’ve tackled loss aversion in previous articles that you can find here, and you can find our gradually growing library of behavioural finance articles here.