Myopic Loss Aversion And Portfolio Returns - Look Away Now

20th Jun '16 by Ben Hobson

8 comments 12325 reads

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…

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RedRon

20th Jun '16

I agree with the conclusions reached but, when you have an investment plan which incorporates stop losses or intersecting MA's then I find it necessary to be aware of what the market and particular shares are doing on a daily basis. Also, if the plan includes 'buy' signals then you do not want to be late in recognising their existence. The problem is separating your emotional reaction from your plan rules and this, I agree, can be a danger in constantly monitoring the market. It all comes down to personal discipline,

ChesterChow

21st Jun '16

In 2008 I panicked and sold a large portion of my portfolios, at a loss, only to see the Market rise soon afterwards. I now spend more time on deciding what stock to buy, and holding for the long term, even though I do monitor my portfolios daily.

Dearg Doom

Hi Ben,

Thank you for your interesting article above. I wonder have you by accident given the result of the Brexit vote to us.

"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."

People who intend to vote to leave would like to receive twice the likely benefits versus the downsize risks. Do ordinary people feel that they would enjoy better wages, better job security, lower interest rates, higher property prices, greater influence on home affairs that matters to them personally etc.

For each voter it is their own Brexit benefits they are voting on. Unless the benefits are tangible and the downside risks underplayed, than in their minds than a vote to remain is most likely.

The case for Brexit can't be made with the certainty of future outcome required. People would have to have seen another country leave the EU and see how they got on 10 years from the time of leaving.

I suspect this brief analysis indicates a bigger margin of victory for the Remain support than actual bookmakers, political pundits and polls are showing.

We will see,

FREng

22nd Jun '16

You write: "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. "

The FT last Saturday reported research that showed that the best cash deposit accounts outperform equities over most time periods.

Edward Croft

FREng... that's a laugh ! I googled for the article - https://next.ft.com/content/75ad9d30-345c-11e6-bda...

The comparison was versus the FTSE 100 ... I don't think too many here use a FTSE 100 tracker as their primary investment vehicle. The FTSE 100 is a very poorly composed index and has been highly overweight mega cap mining stocks etc.

If they'd done the comparison against the FTSE 250 or FTSE All Share there would have been a very different outcome. If they'd done it against a Quality Income index, or sensible small cap fund managers or the equity value premium it would have had a different winner.

Anyway - who'd really want to own fiat currencies as an investment strategy? ...Surely it's a fast road to the poor house.

Rusty2

The All share has not done much better over the last 10-16 years and no doubt the dividends will be lower.

Ed,

I agree that the article in no way undermines the Stockopedia / StockRank approaches to stock selection - but it does seem to provide evidence that it's not enough just to put your money in FTSE 100 trackers or collective funds that are covert trackers (which is where most pension money perhaps is invested, and where many financial advisors might suggest as a low-risk strategy). "In the long term, shares are best" is perhaps over simplistic advice.

Personally, I find I have too much cash in my ISAs and SIPPs (because the market feels overvalued in the UK and USA) and I haven't found a low-risk way to get a positive return on spare cash, that can be held in the ISA/SIPP and give easy access for investment opportunities as they arise.

Are you able to suggest anything? Where do you, yourself, put cash inside these tax-free wrappers?

I think you can switch money now between cash and share ISA's but its a good point, as I sold about 1/3 of my ISA shares that money is not earning anything. I thought maybe preference shares which pay about 6.5% a good investment but not sure how safe they actually are.

Myopic loss aversion and portfolio returns - look away now

The pain of losing

A whistle-stop tour of loss aversion

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Ben Hobson

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