Earlier this week, we examined a pair of studies that sought to explore the relationship between the equity premium puzzle and investor behavior, specifically a behavior known as myopic loss aversion (MLA). MLA describes the tendency of investors who are loss-averse to evaluate their portfolios too frequently, thus causing them to take a short-term view of investing. That, in turn, leads to a focus on the short-term volatility of the market and, as a result, they invest too little in risky assets.
Today we’ll look at some evidence from the academic literature that illustrates how MLA can be impacted by the frequency with which an investor evaluates his or her portfolio, as well as its implication for investors and some other possible explanations for the equity premium puzzle.
Looking Hurts More Than Not Looking
Based on 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% of the time and see gains 54% of the time.
However, while they see gains more frequently than losses, because the average investor tends to feel the pain of a loss with twice the intensity that joy is felt from an equal-sized gain, the more often investors check the value of their portfolios, the more net pain is felt.
The pain/joy meter for an investor who checks his or her portfolio daily will show an average of -38 ([-46 x 2] + [54 x 1]).
Over the period 1927 through 2015, investors who resisted the urge to check their portfolios daily and moved to a monthly check experienced losses only 38% of the time. That reduced the net pain reading from -38 to -14 ([-38 x 2] + [62 x 1]).
Over that same period—1927 through 2015—losses have occurred only 32% of the time on a quarterly basis. Investors who reviewed their portfolio values quarterly (like many who participate in 401(k) plans and receive quarterly statements) experienced a shift from net pain to a net joy reading of +4 ([-32 x 2] + [68 x 1]).
Finally, investors whose patience and discipline allowed them to check their values only on an annual, calendar-year basis experienced losses over that period just 27% of the time. That results in a large improvement in the net reading, from +4 to +19 ([-27 x 2] + [73 x 1]).
As you would expect, the frequency of losses continues to diminish over longer time intervals. The pain/joy reading improves accordingly, and makes for a happy (and more successful) investor.
The implication for you is that, if you are a masochist, you should be checking the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are striking.
First, the more frequently you check your portfolio, the less happy you are likely to be and thus less able to enjoy your life.
Second, all else equal, the less frequently 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 the pain of seeing losses.
If you cannot resist frequently checking your portfolio’s value, consider investing more conservatively, because you will be feeling the pain of losses more often. 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.
There’s another important message here. The less you pay attention to the financial media and economic or market forecasts (since they can cause you to imagine pain), the more successful an investor you are likely to be. With the upcoming U.S. elections, this reminder could not come at a more important time.
Postscript On The Equity Premium Puzzle
Before concluding the answer to the equity premium puzzle is entirely behavioral, let’s review some additional explanations suggested for it. The first is that the risk of owning equities is highly correlated with the risks found in the economic cycle. Thus, in recessions, wage-earning or business-owning investors are exposed to the double whammy of bear markets and either job layoffs or reduced business income (or even bankruptcy).
With the strong body of evidence showing that individual investors are, on average, highly risk averse, it should be no surprise investors have demanded a large equity premium as compensation for accepting the risk of this double whammy, especially since the risks of either unemployment or loss of business income are basically uninsurable. Investors may be forced to sell stocks (because of the loss or diminution of earned income) at the worst possible time.
This high level of risk aversion also helps explain both the existence and the size of the value premium. The risks of value stocks tend to appear during periods of economic distress and tightening credit conditions (when the small business owner is likely to experience difficulty in gaining or maintaining access to capital).
A second explanation for the equity premium having been so robust is that, institutions aside, a very large percentage, if not the vast majority, of equities are owned by high net worth individuals. As net worth increases, the marginal utility of wealth decreases. While more wealth is always better than less, when individuals attain a level at which there is no longer a need to assume risk, only a very large risk premium might induce them to take it.
The 1990s witnessed a “democratization” of the stock market. The percentage of adults holding equities increased from 36% to more than 50%. And the rapid expansion of defined benefit plans, 401(k) plans, IRA and Roth IRA accounts, discount brokerage, electronic trading and even the bull market itself contributed to this trend.
Investors with only a moderate level of wealth have both a higher marginal utility of wealth and the greater need to take risk to achieve their financial goals. They should thus be more willing to accept a lower risk premium. However, it seems highly likely that a high percentage of equity holdings will always be in the hands of the wealthy.
There is a third explanation, and it’s related to the investment life cycle and borrowing constraints. Young investors who would like to invest in equities have very limited ability to do so. First, they are likely to be in the consumption stage, where most of their income is needed to maintain their lifestyle.
Given their long investment horizon and the size of the equity premium, they might want to invest in equities. However, their generally lower levels of income, and the constraints on their ability to borrow to invest in stocks, prevent much equity investment from occurring.
Elderly investors, with their shorter investment horizons, generally have less ability less and willingness to take equity risk. They are also in the withdrawal stage of their investment life cycle. They thus tend to reduce their equity holdings as a percentage of their total assets.
So the risk of holding equities is concentrated in the hands of the middle-aged, saving consumer. This group is likely to be saving for not only retirement, but for college education. This group is furthermore likely to be more risk averse than younger investors. It is also this group that is highly likely to be concerned about minimizing the risks of the aforementioned “double whammy.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.