As you probably know we are big fans of Behavioural Finance. It’s a field that is designed to explain how people actually make (mainly irrational) decisions with money. It was in pursuit of understanding this topic in greater depth that we read a new book by Dr Richard Thaler of the University of Chicago. He is considered one of the founders in the field and, as it turns out, a witty and amusing author as well.
Thaler discusses in amusing detail how they discovered and proved the behavioural biases that seem to particularly affect how we make decisions around money and investing. Those biases include:
• The endowment effect (we value things we own more highly than things we don’t yet own).
• Hindsight bias (after the fact, we think we always knew a given outcome was likely, if not a foregone conclusion)
• Confirmation bias (the tendency to search for, interpret or recall information in a way that confirms our pre-existing beliefs or hypotheses) and
• Prospect theory (the hurt from losses is greater than the pleasure derived from equivalent gains).
Here’s my summary of myopic loss aversion:
• We hate losing money
• We are much more likely to see losses in short time periods
• When we see losses we’ll instinctually believe (1) it was avoidable or (2) the worst is yet to come or (3) both
All the above leads us to make poor emotionally driven decisions.
Therefore… don’t look at your account balance over short time periods.
Prospect Theory suggests that investors feel the pain of losses about twice as much as they feel the joy of gains. By the way, that is probably perfectly rational. For example, losing your supply of food for the winter can kill you. Doubling your supply might just make you more comfortable. In other words, losses are more dangerous than gains are helpful in many areas of life and emotionally we process it that way.
But now think about this set of behavioural tools when it comes to investing. In investing short term losses are inevitable and common.
According to ifa.com, since January 1965 the market (as represented by a US market index) has gone up 51.25% of the days and goes down 48.75% of the days. That’s nearly a draw.
But it’s not a draw emotionally. Remember, a loss feels twice as good as a gain. If we assign a loss an emotional score of negative 2 and a gain an emotional score of a positive one, how would we feel after seeing gains 51.25% of the time and losses 48.75% of the time.
Our emotional score would be 51.25 times 1 + 48.75 times -2 = -46.25.
Translation; we’d feel lousy. Checking your account value every day is very likely to make your feel bad because the down days just outweigh the up days even if there are slightly more up days.
Hope is not lost. Again IFA.com informs us that the more time you are in the market the more likely you are to see positive results. If I only check my account monthly I have about a 62% chance of seeing a positive return. If I check my account balance quarterly this increases to 68% chance, 78% for annually, and 89% for 5-year cycles. If I have the fortitude to go 15 years I will have never seen a loss in the whole 50 year time period.
So if seeing a loss is twice as painful as seeing a gain feels good, how often can I check my account just to break even emotionally. The answer… 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 describes that investors who look at their portfolios more regularly take less risk. Why? Because they have to. They can’t stand the volatility. It just hurts too much.
Why does this matter? Well if you otherwise enjoy pain, check the value of your portfolio as frequently as humanly possible. For everyone else, the fact is, the less frequently you check your portfolio the happier you are likely to be. Checking too often is akin to tempting yourself to abandon your well-conceived plan simply on the basis that it momentarily doesn’t feel good.
Second, and perhaps just as interesting, if you are not likely to check on your account very often, and are happy to leave that job to your adviser, the higher percentage of shares you should be able to emotionally tolerate in your portfolio. This means an opportunity for higher long-term returns.
What’s the bottom-line? For all their PhD’s and reams of academic studies, behavioural economists have crystallised their message for you and your portfolio… don’t look at it. If you don’t you are likely, they say, to be happier and to be a better investor as the direct result.
It’s one of our jobs to help make you a great investor. That’s why it’s our job to look at your portfolios for you, to ensure the investments are performing as we expect and to ensure they are likely to achieve your financial objectives. If something needs to change we’ll let you know. In fact, it’s probably one of the greatest joys of our work, to take the pain and worry out of the investing process for our clients and give them peace of mind so they can enjoy the life they’ve earned.
Success as an investor starts with the key questions of why, what, where, when and how.
Recently, one of America’s largest life insurers (New York Life) did a survey of over 2,000 people to find out what they considered to be their largest financial mistakes, and how long it took to recover from them.
Rob and Mary