Weekly Recap 6/8/2018 Myopic Loss Aversion

Calibrate Weekly Update

 

 

Weekly Recap

 

S&P 500  +1.53%

10 Yr US Treasury -0.21%

Gold    +0.43%

Volatility  -9.07%

 

 

Myopic Loss Aversion

In behavioral finance Myopic Loss Aversion refers to people’s tendency to forego longer term financial gains because they become overwhelmed by the potential of nearer term losses.  Behavioral biases are what keep me up at night.  Balancing the absolute desire to invest with the optimum opportunity to maximize gains, but still realizing that the money I invest has an owner, and that owner may have behavioral tendencies that run counter to efforts to optimize outcomes.

Long-term projections for returns only materialize if we hold them for the long term.  We intuitively know that we should accept the following wager:  Heads win $2000/Tails lose $1000.  But behavioral finance has tested this very same scenario and found most people reject this wager.  People are twice as sensitive to losses as they are to the prospect of gain.  This particular wager has an expected outcome of $500.  It should be a wager that one should actually pay money to acquire, yet many reject it because they can’t stand the 50% chance of losing $1000. 

The economist Paul Samuelson proposed this same bet to a colleague, Carey Brown, who rejected it, acknowledging his own “loss aversion.”  Brown followed up the proposition by stating that he would, however, accept the opportunity to toss the coin 100 times.  Richard Thaler recounts this story in his book, Misbehaving:  The Making of Behavioral Economics.  Thaler tells how Samuelson set out to prove the illogical nature of rejecting one bet but accepting 100 bets of the same option.  His reason was sound, if it’s good enough to engage in 100 times it is good enough for 1 time.  But where Samuelson focused on the illogical nature of desiring 100 bets of something rejected once, Thaler focused instead on the reason he rejected the one bet.  Thaler determined the rejector of the bet suffered from “myopic loss aversion,” focusing too much on short term results and losing sight of the longer-term picture.  After all, the only way you can take 100 bets is by taking the first.   

Currently we are in the process of investigating additional investment strategies, and as we look at back-tested results we are very encouraged by what we find.  The back-tests of annual returns prove superior to other growth investments such as S&P 500, both on a return and risk metric.   However, as we look over the results on a shorter-term basis, monthly to be precise, there are months in which the returns do not outperform, even months when the returns are negative while the S&P is positive.  We all know intuitively that nothing always outperforms, it is noteworthy only because of the impact on our behavioral tendencies.  Will investors stick with investments where shorter-term results do not match longer-term expectations.  Below is a graph of the returns comparing the investment methodology we are investigating vs SPY (S&P 500 ETF).  Portfolio 1 is our beta version portfolio and 2 is SPY.

The graph displays the ability of Portfolio 1 to outperform in “bad” stock market years such as 2001, 2002, 2008.  It also illustrates the ability to outperform in “good” years as well.  For all intents and purposes, this proposition seems to be a “no-brainer.”  However, what happens if we look more myopically.  What if we had the misfortune of starting in April of 2004?  The column on the left is Portfolio 1 and the column on the right is the S&P 500 ETF. 

Looking back at the annual returns for 2004 we see that both portfolios performed nearly identically over the 12 months, but what would the reaction be if our first “coin flip” was April ’04.  If we gave up on the investment following the poor performance that month, we would’ve missed out on the dramatic outperformance in the years ahead.  Our myopic focus can distort what had proven to be a good wager previously and perhaps lead us to making a poor decision. 

Many of us have invested in 401k(s) and have had the challenge of fund selection for our allocation.  Typically the performances of the funds are listed.  Unfortunately these funds usually list performances beginning with the most recent period, followed by the 3,5, and 10-year performances after.  I say it is unfortunate because it would seem to better serve the needs of the investor if the longer-term returns were listed first, so that we would gain better idea of what we should expect, and what will help us meet our objectives.   

That's it for this week folks.  Thanks for reading.  Thanks also to PortfolioVisualizer.com for the above graphs. 

 

 

Zach and Dave

 

Calibrate Wealth
515-371-5316  

https://www.calibratewm.com/blog-01

 

 

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