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Those who constantly control their investments focus far too much on losses

09/13/2018

Another side of loss aversion

Humans tend to care more about losses than about profits. One consequence of this distortion is the phenomenon of the "Equity Premium Puzzle": Rajnish Mehra and Edward C. Prescott discovered this paradox in 1985, realizing that the returns on equities in the past century were 6 percentage points higher than those on risk-free government bonds. The risk premium included in the stock yield ("equity premium"), which one receives as a premium for a riskier investment, is thus higher than it should actually be - according to the empirically determined degree of risk aversion of the investors.

Picture of an unsolved puzzle
The "Equity Premium Puzzle" is one consequence of caring more about losses than profits. Photo © CC0 Licence

One explanation for this is short-sighted (myopic) loss aversion: the so-called "myopia" occurs when a long-term investor evaluates his portfolio too intensely or too often. The frequent evaluation of the portfolio often leads investors to perceive gains and losses in their equity portfolio too strongly. Due to the loss aversion, they are more disrupted by the losses than they enjoy the profits.

As a result, they tend to invest too little in company shares. The lack of demand lowers the price of the shares and thus increases the risk premium to be expected ex ante when buying shares. Myopic loss aversion means that very high risk premiums have to be paid on the market for equity investments so that investors buy shares at all. This increases the returns.

 

The presentation of results influences risk appetite

The following related phenomenon also results from the loss aversion: The way in which an investor is presented with the performance of his/her portfolio has a great influence on the willingness to take risks. Investors invest at higher risk when the results are aggregated over time or across securities. You only see the result of the entire portfolio instead of that of the individual securities. This reduces the number of perceived losses.

Graph showing different developments for shares & bonds

On the other hand, the shorter the intervals in which investors evaluate their portfolios are or the more they break down their portfolios into individual components for performance analysis, the less risk they take, because they then also perceive losses all the more frequently. As a result, such investors forgo lucrative risk premiums that they could earn in the long term with a riskier strategy.

 

Tips

With a long-term investment horizon, you can benefit from the equity premium puzzle by investing an appropriately high proportion of your portfolio in equities (e.g. a fund that replicates a broad equity index) and thus collect the excessively high risk premium. When determining the proportion of shares in your overall portfolio, take your risk aversion into account, i.e. your possible fear of price fluctuations in both directions. However, you should neglect your possible loss aversion - i.e. the fear of a negative price development.

 

Take an aggregated view of your portfolio instead of a single security level and do not analyze its performance too often! Accept losses on one security if you have made a profit with another security. Accept losses in one quarter if you have made high profits in another quarter. The only thing that counts is the return of the entire portfolio over the entire investment horizon. With these tips you can even benefit from the loss aversion of the others.

 

This article was published in the Austrian business magazine GEWINN. Read the original article here (in German).

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