Why it’s OK to look away
04 Feb 2016
If you follow investment markets or have your own investment portfolio you’ll have realised that volatile times such as these can make for nervous investors.
Dr Richard Thaler, of the University of Chicago, is considered one of the founders of the field of behavioural finance which sets out to explain how people make decisions about money. In his new book he discusses the behavioural biases that affect decisions around money and investing. Those include:
- The endowment effect (we value things we own more highly than things we don't yet own)
- Hindsight bias (we think we knew a given outcome was likely, if not a foregone conclusion, after the fact)
- Confirmation bias (the tendency to search for, interpret or recall information in a way that confirms our pre-existing beliefs)
- Prospect theory (the hurt from losses is greater than the pleasure derived from equivalent gains).
All these biases converge on the thing Thaler describes as the single most powerful tool in the behavioural economist's arsenal – myopic (short sighted) loss aversion.
Our summary of myopic loss aversion is:
- We hate losing money
- We are much more likely to see losses in short time periods
- When we see losses we instinctively believe (1) it was avoidable, (2) the worst is yet to come, or (3) both
These reactions can lead us to make poor, emotionally driven decisions about money and investing. Another conclusion we can make from the above is that it might be best not to look at your portfolio balance over short time periods.
One of the biases Thaler discusses, prospect theory, suggests that investors feel the pain of losses about twice as much as they feel joy from an equivalent gain.
In investing, short term losses are inevitable and common. According to ifa.com, since January 1965 the market (as represented by a US share market index) has gone up 51% of the days, and down 49% of the days. That's nearly a draw.
But it's not a draw emotionally. If we assign a loss an emotional score of -2 and a gain an emotional score of +1, how would we feel after seeing gains 51% of the time and losses 49% of the time?
Our emotional score would be: (51 x 1)+(49 x -2) = -47
Translation: we'd feel lousy.
Checking your portfolio value every day is very likely to make you feel bad because, emotionally, the down days outweigh the up days, even if there are slightly more up days.
However, ifa.com informs us that the more time you are in the market, the more likely you are to see positive results. If you only check your portfolio balance monthly, you have about a 62% chance of seeing a positive return. If you check it quarterly, this increases to a 68% chance, then 78% for annually and 89% for five year cycles. If you have the fortitude to go 15 years before you check your portfolio balance, based on a 50 year time period you will have never seen a loss.
So, if seeing a loss feels twice as painful as seeing a gain feels good, how often could you check your portfolio and still break even emotionally? The answer is no more than quarterly. You'll need to see gains at least 66% of the time for you to even feel neutral about it.
In his book Thaler says that investors who look at their portfolios more regularly take less risk, because they can't stand the volatility that they see by checking more often. If you don't check your portfolio very often, and are happy to leave that job to your adviser, you should be able to emotionally tolerate a higher percentage of shares in your portfolio. This gives an opportunity for higher long term returns.