Regular readers of my books and articles are likely well aware that I’m a big fan of the field of behavioral finance. In fact, I try to read everything I can on the subject. The first half of my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” discusses many of the investment errors behavioral economists have found, in addition to explaining how you can avoid them.
While the financial establishment focused on developing “normative” theories describing how investors act as “Econs” (who make rational choices leading to optimal decisions), behavioralists instead focused on “descriptive” theories describing not how investors should act logically, but how they actually do act as human beings (who are subject to all kinds of biases that lead to less-than-optimal choices).
Exploring Biases And Aversions
A new book by Richard Thaler, “Misbehaving,” provides many examples of such behavioral anomalies, the study of which has greatly improved our understanding of how markets work and how decisions are made. Thaler, a professor of behavioral science and economics at the University of Chicago, is considered one of the founding fathers of the behavioral finance field (along with Daniel Kahneman and Amos Tversky).
Among the many phenomena that Thaler discusses are the endowment effect (we value things we own more highly than things we don’t yet own), hindsight bias (after the fact, we think we always knew a given outcome was likely, if not a foregone conclusion), confirmation bias (the tendency to search for, interpret or recall information in a way that confirms our preexisting beliefs or hypotheses) and prospect theory (the hurt from losses is greater than the pleasure derived from equivalent gains).
Hindsight bias can lead to overconfidence, and prospect theory can lead to risk aversion when it comes to gains but risk-taking when it comes to losses. Prospect theory also includes loss aversion—or myopic (short-sighted) loss aversion—and is considered by Thaler to be the single most powerful tool in the behavioral economist’s arsenal. His book discusses several studies demonstrating why he believes this to be the case.
Solving The Mystery Of The ERP
Thaler also details why he believes prospect theory provides an explanation for what’s known as the equity risk premium (ERP) puzzle. The ERP is considered a puzzle by many market observers because the magnitude of the historical equity risk premium has been much greater than could be predicted by normative models.
Rajnish Mehra and Edward Prescott first coined the phrase in their 1985 paper, “The Equity Premium: A Puzzle.” While the authors found an ERP of roughly 6 percent, the largest premium their normative model could predict was just a small fraction of that amount. Prospect theory—specifically, myopic loss aversion—provides an answer.
Thaler and other researchers have found that investors tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This creates a problem for investors who check the value of their portfolios on a frequent basis. Consider the following.
Based on the historical evidence for the S&P 500 Index from 1950 through 2014, investors who check their portfolios on a daily basis can expect to see losses 46 percent of the time and gains 54 percent of the time. However, even though these investors see gains more often than losses, because we tend to feel the pain of a loss with twice the intensity that we feel joy from an equal-sized gain, the more frequently we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will show an average of -38 (or [-46 x 2] + [54 x 1]).
Pain Vs. Joy
Over the period from 1927 through 2014, investors who resisted the urge to check their portfolio daily, and who moved to checking it monthly, experienced losses only 38 percent of the time. That reduced the net pain reading from -38 to -14 (or [-38 x 2] – [62 x 1]).
Over the same period, from 1927 through 2014, losses have occurred on a quarterly basis only 32 percent of the time. Thus, investors who reviewed their portfolio values quarterly (like a lot of 401(k) plan participants who receive quarterly statements) experienced a shift from net pain to a net joy reading of +4 (or [-32 x 2] + [68 x 1]).
Investors whose patience and discipline allowed them to check values only on an annual, calendar-year basis have seen losses just 27 percent of the time. That results in a large improvement in the net reading, from +4 to +19 (or [-27 x 2] + [73 x 1]).
As you would expect, the frequency of losses returned by the S&P 500 Index continues to diminish over time. When using overlapping periods, from 1927 through 2014 the frequency of losses at a five-year time horizon falls to just 14 percent. That results in a pain/joy reading of +58. And at a 10-year time horizon, the frequency of losses falls to just 5 percent. That produces a pain/joy reading of +85, and will surely make for a happy investor.
Thaler describes several experiments which demonstrated that, just as prospect theory predicts, investors who look at their portfolios more regularly take less risk. In other words, myopic loss aversion makes us more conservative in our investments.
So what’s the implication? If you’re a masochist, then check the value of your portfolio as frequently as humanly possible. For the rest of us, the ramifications are striking.
First, the more frequently you check your portfolio the less happy you are likely to be, and less able to enjoy your life. Second, all else equal, the less frequently that you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid pain.
The bottom line is that, if you cannot resist frequently checking your portfolio’s value, you should consider investing more conservatively because you’ll be feeling the pain of losses more frequently. Feel enough pain and even the most well-thought-out of investment plans can end up in the trash heap of emotions as the stomach takes over the decision-making process. And I’ve yet to meet a stomach that makes good decisions.
The Media Doesn’t Help
There’s another important message here. The less you indulge in financial media that shows how the market is doing and the less you pay attention to economic or market forecasts (because they can cause you to imagine pain), the more successful an investor you are likely to be. With the Greek crisis unfolding, this reminder could not come at a more important time.
Thaler’s new book is a well-written and easy read filled with plenty of interesting experiments. Having now spent more than 40 years advising some of the world’s largest companies, as well as pension plans, endowments and individual investors, I’ve learned how important investor behavior is in determining outcomes.
In fact, I’ve found it can be far more important than the investment strategy you employ. Thaler demonstrates that the implications of our behavior on our investment results are profound, as well as entertaining.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.