Loss aversion is a concept introduced by two behavioural economists, Amos Tversky and Daniel Kahneman, which states that people have a stronger sensitivity to losses than to gains. Researchers have measured this sensitivity and found that we regret loses 2.5 times more than similar sized gains. In other words, the psychological impact (pain) I feel from losing $100 is two and a half times the impact (pleasure) derived from winning $100.
Myopic Loss Aversion, introduced by S. Bernatzi and R. Thaler to explain why equities offer such a higher premium over bonds, expands on loss aversion by discussing how long term decisions are evaluated by their short term results. Under myopic loss aversion, investors are too anxious and evaluate the performance of long term investment decisions by focusing on short term results.
The lessons we should take from myopic loss aversion are as follows:
- By checking the state of my portfolio on a frequent basis, I expose myself more to short term volatility than to long term results. As I increase this frequency, the probability of viewing negative returns increases (see this previous post).
- Given that the pain of a x% loss is 2.5 greater than the joy of the same x% gain, the costs of monitoring my portfolio on a daily basis will probably exceed any positive return I might view.
- The pain experienced by focusing on short term results might push me to change investment strategy. Given that I invest with a long investment horizon in mind (i.e. four decades from now when I retire) I will be basing any changes on (meaningless) volatility.
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