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April Newsletter:  Myopic Loss Aversion, Take the Test Thumbnail

April Newsletter: Myopic Loss Aversion, Take the Test

Markets have rallied in the last week and continue to do so.   Will it hold?  We are not convinced of that and would not be surprised to revisit the lows of late March.  If that occurs, we will take a deep breath knowing that our client’s portfolios are built with quality defensive holdings and we will wait for the bottoming process to begin.  We believe that this contraction is temporary and there will inevitably be an end to it.   

That doesn’t alleviate the fact that losses, even if they are not realized (ie assets are not sold), are painful to watch.   There have been many studies to show that the pain of loss exceeds the pleasure of gain by at least double.  An example is based on a classic experiment based on the flip of a coin.   If the coin comes up tails, the person loses $100 and if it came up heads, they win $100 or $200, etc.  On average, people only proceed with the bet if the gain is at least twice the loss.  

However, when it comes the investment world, there is more to it than that.  People can also be extremely sensitive to short term losses.  We talk to clients who are building successfully with long term goals that are very stressed by sudden contractions.  Dr Richard Thaler (University of Chicago) and Shlomo Benartzi (University of California) named this phenomenon myopic loss aversion.  Could you suffer from this? 

Here’s a short assessment Dr Benartzi developed to determine whether you're more likely to buy high and sell low during a market panic.

1. In normal times, how often do you evaluate the performance of your investments?

A. Daily or weekly

B. Monthly or quarterly

C. Annually

D. Every few years

E. Never

The more often you check your performance, the more likely you suffer from myopic loss aversion. That's because you feel the pain of the losses more frequently and potentially overreact by panic selling. The problem is not necessarily the losses, but how often we mentally account for them.

2. I often set a goal but later choose to pursue a different one. Is this:

A. Very much like me

B. Mostly like me

C. Somewhat like me

D. Not much like me

E. Not like me at all

This question was borrowed from the "grit" assessment developed by Prof. Angela Duckworth and colleagues. She and others have shown that grit—the willingness to persevere for a long-term goal, especially when it's difficult—can help predict a variety of outcomes, from academic success to creditworthiness.

If you often give up on your longer-term goals, you're probably at higher risk of selling low during a market decline. The pain of the short-term loss is going to make you give up on your long-term investment strategy.

In contrast, those who tend to stick with their goals are probably more likely to shrug off the market losses. This is akin to gritty long-distance runners ignoring the aches of their muscles so they can finish the race. It's a useful mind-set. For most of us, investing isn't a sprint—it's a marathon.

3. Do you use any apps to regularly check on the performance of your investments?

A. Yes

B. No

Although smartphones can make investing more convenient, that convenience becomes problematic during periods of high volatility. That's because people tend to be more impulsive and emotional on mobile devices.   

 

What can you do if you are hypersensitive to short-term losses?

The most obvious thing is to stop looking at the market/your portfolio.  Day to day changes are not going to affect your long-term goals.  Zoom out and look at time frames that are more meaningful to your goals.  

Change your perspective.  Frame the market decline as an opportunity rather than a negative.   Remember Warren Buffet:  Be fearful when others are greedy and be greedy when others are fearful.   How can you benefit from the decline?  Maybe we adjust your portfolio or deploy some cash.  

We continue to be here for you.  We have time to talk about anything that is on your mind.  We are available by phone or zoom – whatever your preference.  

Take care of yourselves as you and your relationships are what matter.  The financial markets will recover with time.  Some things are more valuable than money.