From 1927 through 2015, there has been a very large difference between the returns to the S&P 500 and the returns to risk-free Treasury bills—about 8.5% on an annual average basis and about 6.7% on an annualized basis. This large spread is frequently referred to as the equity premium puzzle, because unless investors possess implausibly high levels of risk aversion, the equity premium’s historical average is too high to be justified by standard economic models.
Shlomo Benartzi and Richard Thaler, authors of the study “Myopic Loss Aversion and the Equity Premium Puzzle,” which was published in the February 1995 edition of The Quarterly Journal of Economics, proposed that the puzzle’s answer lies in a behavior known as myopic loss aversion (MLA). MLA describes the tendency of investors who are loss-averse (the pleasure felt after observing a gain is inferior to the pain experienced after a loss of an equivalent amount) to evaluate their portfolios too frequently, thus causing them to take a short-term view of investing (losses are experienced more frequently at narrow time scales).
That, in turn, leads to a focus on the short-term volatility of the market. Consequently, they invest too little in risky assets. Using simulations, Benartzi and Thaler demonstrate that when investors only evaluate their portfolios annually, the size of the equity premium is consistent with parameters estimated in prospect theory.
Rebalancing & Evaluation
Boram Lee and Yulia Veld-Merkoulova contribute to our understanding of investor behavior with their study, “Myopic Loss Aversion and Stock Investments: An Empirical Study of Private Investors,” which appeared in the September 2016 issue of the Journal of Banking & Finance. Following the evidence from prior studies, they use portfolio evaluation frequency and rebalancing frequency as proxies for myopia. The authors then investigated the link between MLA and investor behavior.
Their data sample comes from a survey by CentERdata, a specialized online research institute at Tilburg University in the Netherlands. It consisted of more than 2,000 households including members over 16 years of age and is representative of the Dutch population in respect to a number of important demographic characteristics.
The survey data covered the period 1997 through 2010, and averaged eight years of data per investor. To disentangle the effects of evaluation frequency from rebalancing frequency, they adopted a two-by-two design in which each frequency is divided into two levels (low and high). For both evaluation and rebalancing, frequency of more than quarterly is considered high.
Following is a summary of the authors’ findings:
- 44% of investors choose to evaluate their portfolio performance either monthly or more frequently, exposing them to observing portfolio losses on a regular basis, which in turn may be detrimental to their propensity to invest in stocks and to their aggregate wealth.
- 70% of investors rebalance their portfolios less often than annually.
- Investors who trade frequently are also more likely to evaluate their performance more often. The correlation between the evaluation and rebalancing frequency variables is positive and of high statistical significance (significant at the 0.1% level of confidence). However, the two variables are not perfect substitutes for each other, as their correlation is 0.31.
- The correlation between loss aversion and evaluation frequency is just 0.07. The correlation between loss aversion and rebalancing frequency is far greater, at 0.33, but also statistically significant at only the 10% level of confidence.
- The effect of myopia on investors’ decisions dominates that of loss aversion. Regardless of their level of loss aversion, investors who evaluate their portfolios less frequently increase their equity investments over time.
- Investors who evaluate their holdings less frequently increase their holdings over time more than those who check their performance at least monthly. This result is robust to controlling for changes in the value of investments due to stock market fluctuations.
- There was no significant gender effect.
- The self-employed and retired invest in stocks at significantly higher levels than those with regular employment. This is consistent with the concept that self-employed individuals are more risk tolerant and thus invest more in risky assets.
- Total financial assets are not significantly related to the proportion of equity investments. The effect of debt ratio on the proportion of equity investment is, however, positive and significant, possibly reflecting greater risk tolerance among more leveraged households.
- Contrary to their a priori expectations, there was a significant education effect. Investors with college or university degrees tend to invest significantly smaller proportions of their financial portfolios in equities than other investors. These results may indicate that investors’ level of education is distinct from their level of financial literacy.
A Bad Combination
The authors concluded that “it is the combination [emphasis mine] of rebalancing and evaluation frequencies which causes the MLA effect.” They add: “Regardless of loss aversion, infrequent evaluation positively affects investment level changes.”
The bottom line is that, as the authors write, the “combination of high rebalancing frequency with loss aversion has significant negative correlation with individuals’ equity investments. While establishing causality is difficult for the actual investment data, this result is consistent with the main prediction of the MLA theory of Benartzi and Thaler.”
The authors summarize their findings as follows: Investors “who are highly loss averse and frequently evaluate investment performance and rebalance investment portfolios” tend “to have low equity holdings in their financial portfolios, which is likely to lead to utility losses over investors’ lifetimes. However, once individuals establish their portfolio allocations according to their levels of both loss aversion and myopia, myopic loss aversion is no longer associated with further decreases in their levels of equity investment.”
They also write that their results “support the suggestion that long-term investment vehicles (such as defined contribution pension funds) should offer default asset allocations with higher proportions of equities in order to provide potential for more gains from market participation across a broader range of investors.”
Later this week, we’ll provide some additional evidence found in the literature illustrating how the frequency with which an investor checks his or her portfolio can affect MLA. We’ll also discuss the implications of this research for investors, as well as other possible explanations for the equity premium puzzle.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.