In the book Thinking, Fast and Slow author Daniel Kahneman famously describes how people are generally loss averse when it comes to money decisions:
“Losses loom larger than gains. The ‘loss aversion ratio’ has been measured in several experiments and is usually in the range of 1.5 to 2.5: 1.”
In other words, people are 1.5 to 2.5 times more fearful of a loss than reflecting the emotion of greed for a gain.
Loss aversion can have a profound effect on how you view your portfolio, especially when it comes to stocks. Most investors claim to be unnerved by uncertainty, but really we all hate to lose money. It’s one of the reasons that crash predictions and negative thinking always seems to sound more intelligent, make more sense or have more authority.
You may have seen similar data in the past, but I think these rolling historical performance numbers put things into the correct long-term perspective for investors:
*The S&P 500 index is a measure of performance of the broad domestic economy through 500 stocks from major industries. Past performance is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
You can see that daily returns in the market are more or less a 50-50 proposition. Since loss aversion essentially means “losses make us feel worse than gains make us feel better” by a factor of 1.5 to 2.5, this means that if you check the value of your stock portfolio on a daily basis, you are likely disappointed every single day.
Every good feeling you get from gains seems to get completely wiped out by the terrible feelings from the down days. However if you lengthen your time horizon, the effects of loss aversion slowly start to fade.
In the book More than You Know, Michael Mauboussin discusses the phenomenon of loss aversion with respect to investment decisions and time horizons. He describes investment decisions andloss aversion this way:
“We regret losses two to two and a half times more than similar-sized gains. History certainly has demonstrated the longer the holding period in a financial market the higher the probability of a positive return.”
He also concludes that the more frequently we evaluate our portfolios, the more likely we are to see losses and hence suffer from loss aversion. Inversely, the less frequently investors evaluate their portfolio the more likely they are to see gains. This is what Richard Thaler has termed “myopic loss aversion.” It’s a combination of loss aversion with our tendency to look at the outcomes of events far too frequently.
So what is an investor to do? Well, either:
Follow along so closely that you become immune to the daily gyrations or
Stop looking at your portfolio’s market value so much (quarterly probably works for most people).
Kahneman describes in his research that professional risk takers in the financial markets are more tolerant of losses than non-professionals because they become accustomed to the daily fluctuations. Yet even the pros can have a difficult time focusing on the correct time horizon with an increased focus on quarterly and annual results against benchmarks and peers in the industry. It takes time and experience in the markets to build up your tolerance for the correct time horizon.
With the ease of access to real-time information, it’s harder than ever to not look these days.
The analogy I like to share with new investors is something I call the “towel over the treadmill screen” strategy. If you’ve ever been to the gym in January you will noticed the New Year’s resolution runners who haven’t worked out in a while. Usually they are on the treadmill with a towel draped across the screen so they can’t see the time or distance.
Like the watched kettle that never boils, watching the time tick away on the treadmill can feel like an eternity. Obviously, it’s completely psychological, but the trick seems to work for those that stick with it. Eventually they get used to it and remove the towels.
I’m not suggesting you neglect your investments by any means. You still need to occasionally track performance, make sure the asset allocation is in line with your risk tolerance, periodically rebalance, and continue to make contributions on a regular basis.
The “less is more” philosophy seems to work in almost all areas of the portfolio management process. Checking the value of your account is no different in this respect.
If you would like to have a conversation about the topic of loss aversion, feel free to contact us.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including potential loss of principal.
https://prosperion.us/wp-content/uploads/2014/12/towel_over_the_treadmill_approach.png426758Steve Boorenhttps://prosperion.us/wp-content/uploads/2017/02/whitelogosized.pngSteve Booren2014-12-02 17:32:122017-05-22 15:07:37The "Towel Over the Treadmill" Approach
After almost 45 years as a financial advisor, one realizes that there’s truth behind the phrase, “Reality is made up of circles, but we see straight lines.” Market cycles, crises, and investor behavior are all echoes of things we’ve seen in the past and will likely experience again in the future. No doubt the COVID-19 crisis impacts us all, and while it may feel like something completely new, it really isn’t.