Myopic Loss Aversion

This rather obscure term is meant to describe the psychological result of too carefully following your investments. The investor’s goal should be to buy low and sell high. Myopic loss aversion causes us to do the opposite.

While close attention to your investments might seem like a good idea, for many investors it can generate negative side effects. If your goal is successful long term investment, constant checking your results by way of an irrationally volatile stock market can cause the inexperienced investor to sell at the wrong time, or to buy the current media frenzy.

Shlomo Benartzi wrote in a Wall Street Journal article on November 2 2015;

“if you monitor the S&P 500 index at different intervals. If you check every single day, there’s a roughly 47% chance that the market will have gone down, based on its past movements. But what happens if you check once a month? The numbers will start to look a little better, as the market will only have gone down 41% of the time. Years are better still, as the S&P generates a positive return seven years out of every 10. And if you check once a decade, then you’re only going to get bad news about 15% of the time.” --- There’s solid evidence that experiencing short-term losses — noticing that your portfolio is losing money — leads to poor choices.

Professors Richard Thaler, Amos Tversky, and Daniel Kahneman where pioneers in the study Behavioral Economics a discipline based on the study of the impact of emotion on investment decisions. They found in a 1997 study that, subjects were far more likely to invest in the safer option when feedback was given more frequently. Unfortunately, the safer investment also generated lower returns over the long haul, decreasing your portfolio’s ability to deal with inflation, and increasing the chance that the retiree will outlive his money.

“Providing such investors with frequent feedback about their outcomes is likely to encourage their worst tendencies. …More is not always better. The subjects with the most data did the worst in terms of money earned.”

Kahneman in his 2010 book “Thinking Fast and Slow” touches on the emotional nature of the investor’s choices when buying or selling stocks. Fast thinking is the emotional party of the brain, and it is the part that is most often used (and least qualified) to make buy and sell decisions.

Investors tendency to use the emotional part of the brain when it comes to buy and sell decisions is greatly compounded by our hyperactive financial media’s tendency to focus on short term developments such as quarterly earnings, and ignore the critical long term trends like a company’s success in building its competitive advantage.

The tendency of investors to rely on their emotion to make investment decisions is fed by a fundamental error in “Modern Portfolio Theory”. This is the discipline taught by most business schools and institutionalized by the CFA Institute, a global organization that seeks to train and measure the performance of investment professionals. Modern Portfolio theory compounds the damage from loss aversion by measuring risk with in terms of volatility.

Warren Buffett on the other hand defines risk as “the permanent loss of capital” and says that “Volatility is your friend”, in other words the volatility provided by todays hyperactive stock market does not translate into risk unless you sell when you should be buying. The stock market fluctuates from minute to minute or day to day, sometimes for good reasons, but often for no reason at all.

In order to make volatility your friend you must avoid Myopic Loss Aversion, so turn off CNBC, and the emotional part of your brain, lose stock market app on your cell phone, and check your investments less often. Whenever you feel compelled to buy or sell an investment based current market behavior, seek professional help.

Zircon - This is a contributing Drupal Theme
Design by