Are you a bit shortsighted? Well, I was.
I can see clearly now
Do you suffer from Myopic Loss Aversion—when it comes to money?
Myopic-what-aversion?
Myopic Loss Aversion is the tendency to focus on avoiding short-term losses—even—at the expense of long-term gains.
As a consequence in the investment field—and we should all be active in this field—the attractiveness of the riskier asset depends on the time horizon of the investor.
An investor who is prepared to wait a long time before evaluating the outcome of the investment—as a gain or a loss—will find the risky asset more attractive than another, who expects to evaluate the outcome soon.
Why?
Two reasons:
1) Loss aversion: We regret losses at least two times more than similar gains.
Since the stock price is generally the frame of reference, the probability of loss or gain is important. Naturally, the longer the holding period in a financial market is, the higher the probability of a positive return.
Source: Motley Fool USA
Are you aware that financial markets must have a positive expected return to lure capital, since investors must forgo current consumption? Without that positive expected return, the money would go somewhere else, but it doesn’t. Thus, financial markets are excellent arenas to grow your money—above and beyond the inflation rates—so make sure that you are in that arena and don’t just watch the action from the stands.
2) Myopia: The more frequently we evaluate our portfolios, the more likely we would see losses and hence suffer from loss aversion.
Do stay calm and don’t do that. Because, inversely, the less frequently that investors evaluate their portfolios, the more likely they would see gains. Therefore, do that to feel better with your investments.
You may tell yourself that you are saving for your retirement X-years down the road, but if you evaluate your portfolio (or more accurately, experience the utility of the gains and losses) monthly or daily, you are behaving as if you have a short-term planning horizon.
Side-note: If all investors were as long-term oriented as you are, the market would suffer a diversity breakdown and will be even less efficient than today’s market.
Still, no worries as we do have the financial institutions with their quarterly time horizons, resulting in many portfolio managers not buying a controversial stock that they think will be attractive over a three-year horizon, because they have no idea whether (or not) the stock will perform well over a three-month horizon.
And this may explain some of the overreactions we see in markets and shows why Myopic Loss Aversion is actually an important source of inefficiency. But, luckily, you are not one of those inefficient investors, right?
So how does one overcome Myopic Loss Aversion?
Eyes off your portfolio statement. Checking the statement once every quarter is a good start, although once a year would be even better. And then, hands off.
Checking that statement does not mean you have to act; to buy or sell something and doing nothing is often the best long-term choice (of course, only after you have already built up your portfolio, if not, do something and build it further, by buying more of the good stuff).
And let this story from Fidelity Investments teach us a valuable lesson:
“Fidelity had studied which customer investing accounts performed the best: They were the ones held by people who had forgotten they even had Fidelity accounts, and so did no buying or selling from them. Something similar happened with families fighting over inherited assets. Because of extended court battles, in some cases the accounts couldn’t be touched for 10 or 20 years. No buying new investments or selling old ones. Those families subsequently found that the period of inactivity was the time when their investments performed best.”
Remember: There is nothing more important in investing than the amount of time you can invest for. It’s also one of the most discounted and ignored traits. Start early and stick with it, regardless of what the media tries to convince you of. Stay away from panic selling during sharp market declines, and relax as you have a diversified portfolio and a long-term focus.
Myopic Loss Aversion also explains why people tend to buy insurance policies with low deductibles and low limits, despite it being the opposite to what is clearly in their long-term best interests. Inversely, most people would be best served with high deductibles and high coverage limits in insurance policies.
But this does not apply to you, right?