When the short-term nature of markets collides with the long-term goals of investors, the market wins the attention war and investors lose…when they act on it.
Excessive action (trading) leads to worse returns, says the research. And selling to avoid losses, when your portfolio is a sea of red, is often a result of myopic loss aversion.
That’s a fancy way of saying that investors who check their portfolios often are more likely to see losses, and mistakenly act on it. In addition, they allow their aversion to losses to affect their portfolio allocation. They shift their portfolio to a larger holding of bonds and cash when it should be in stocks and they earn less money over time.
Bill Miller explained it further in his 1995 commentary:
Professor Richard Thaler, now at the University of Chicago, has studied what the academics call the equity premium puzzle: A dollar invested in stocks has returned, after inflation, about 7% per year on average for more than 68 years, while a dollar invested in bonds has returned less than 1%. The puzzle is why do any long-term investors own bonds? Not only do they own bonds, investors typically have a greater percentage of their assets in bonds than in stocks.
The answer, according to Thaler, is myopic loss aversion. People are risk-averse. Psychological testing has established that for most of us, the pain of losing an amount of money is greater than the pleasure of winning that same amount of money. Being risk-averse, we are more likely to act to avoid the pain of loss the more aware we are of potential losses. The more short-term-oriented one is (the more “myopic”), the greater one’s willingness to react to the risk of loss. Because stocks go up and down more than bonds, they confront one with more frequent, and greater, potential losses. The shorter one’s time horizon, or the more often you look at your portfolio, the more you will see losses, the more psychological discomfort you will feel, and the riskier you will perceive stocks. The more risk-averse you are, the more you will orient your investments to bonds, or cash.
Since one’s perception of the risk of stocks is a function of how often you look at your portfolio, the more aware you are of what’s going on, the more likely you are to do the wrong thing. “Where ignorance is bliss, ’tis folly to be wise” said the bard, who understood myopic loss aversion centuries before the professors got hold of it.
Markets shift from long periods of calm to chaos and back. We had calm for most of the year. This week chaos hit — a rise in recession fears, a deflating AI bubble, and a Yen carry trade that blew up the Nikkei and reverberated in global markets (some people borrowed a lot of money in Japan at low interest rates, invested it in stocks, and were forced to sell to unwind the trade when Japan raised rates).
The reality for investors is that the market will always give you something to worry about. So it will always give you a reason to sell. Market history is filled with these chaotic moments that push the limits of investors’ behavior and emotions. But market history also teaches that its long-run compounded return of around 10% is earned in these moments.
Richard Thaler’s research backs this up. The downside to paying attention to daily market news is that you get sucked in. Doom-scrolling social media doesn’t help. Neither does logging into your brokerage account multiple times per day to “check” your portfolio.
Thaler’s research suggests that more information is not always better for investors. It combines two behavioral concepts: loss aversion and myopia. Loss aversion suggests that we regret losses twice as much as gains. Myopia says that we’re more likely to see losses and suffer from loss aversion when we check our portfolios more often (checking less often means we’re more likely to see gains).
The simple explanation is that more information is not the same as complete information. We know the “worry.” It’s a reason to sell. We see red in our portfolio. Losses hurt. So we sell.
What now? When do we get back in?
What we don’t know is what happens next. Selling may rid us of the pain felt from losses but compounds the mistake because we miss the market’s eventual recovery.
Having more information shrinks our attention spans, shortens our time horizons, and leads us to overreact to market losses. Simply put, we see our portfolios not through a long-term lens but with a time horizon of one year or less. We lose sight of the bigger picture.
Stocks are long-term assets. Viewed through the lens of days, weeks, or even months, anything can happen with stocks. Experiencing a loss or gain is practically a coin flip. However, the odds of earning a positive return from stocks increase with time.
The solution is to:
- Tune out the noise. There’s a benefit in not knowing everything that’s going on in the market.
- Check our portfolios less often. It’s still there. I promise.
- Remind ourselves why we own stocks whenever the market gets chaotic — to participate in the massive long-term upside of growing businesses. Selling interrupts that process.
Inaction is a key principle to investing success. Doing less pays in the long run.
Source:
Value Trust Market Commentary 1995
Related Reading:
Don’t Overemphasize Volatility
Wise Words on Handling Market Gyrations