- Losses loom heavier than gains
- Looking at day-to-day fluctuations of market prices and your portfolio is not beneficial
- Share prices tend to follow long term trend of earnings growth; having a long term investment horizon helps you capture that
If you were offered a gamble where you had a 50% chance to lose $100 and 50% to win $200, would you accept it? Chances are that you would reject it. This gamble is now known as the famous Samuelson’s gamble, where Paul Samuelson offered the above gamble to a colleague. His colleague declined to play it once, however, he commented that he would play the gamble if it would be repeated a hundred times.
This resulted in a paradox as it contradicted classical economics models. To explain the issue and address the inconsistency, Daniel Kahneman and Amos Tversky (1992) founded prospect theory which will be explained below.
The Theory
Chart 1: Value Function for Prospect Theory
In prospect theory, losses have a heavier impact than on gains, which is represented by the kink at the origin and steeper slope in the negative region (bottom left quadrant) in the graph above (Tversky and Kahneman, 1992). This is also known as loss aversion – people are more sensitive towards losses than gains. In 1995, Benartzi and Thaler came up with myopic loss aversion (MLA) to explain the equity premium puzzle, where the S&P 500 earned over 6 percent annually more than Treasury bills from the studied period of 1889 to 1978.
MLA combines two factors – loss aversion and mental accounting. The former is explained above, while mental accounting deals with aggregation – whether securities are evaluated individually or as a portfolio, and how often they are evaluated. They defined a myopic investor as one who frames decisions and outcomes narrowly, i.e., making short-term choices rather than adopting long-term policies, and evaluating his gains and losses frequently.
To prove the hypothesis of MLA, Gneezy and Potters (1997), and Thaler, Tversky, Kahneman and Schwartz (1997) ran experiments of their own. The experiments featured at least two groups of participants – a high treatment group and a low treatment group. The high treatment group will look at their gambles/investments individually and more frequently while the low treatment group evaluate their gambles/investments in groups. We will explore the experiment done by Gneezy and Potters below.
The Experiment
Participants were given two dollars and faced a gamble where they have two-thirds chance to lose $x and one-third chance to win $2.5x, where x is the amount that the participants bet. Each participant would participate in 9 rounds. However, the high treatment group would bet and receive their results each round whereas the low treatment group would bet and receive their results every three rounds.
In the experiment, participants who had been framed into looking at gambles individually invested less and earned less than those in the other group. In both experiments, the low treatment group gambled/invested more initially and earned more. In the other experiment, the high treatment group did not even realise that they were myopic, whereas the other groups learned and invested more on the riskier option over the course of the experiment.
The Myopic Investor
The implications of the experiments are obvious. The participants in the high treatment group were the myopic investors – blindsided by temporary losses, they were unable to look at the longer horizon and unable to figure out the better choice. Similarly in the stock market, equities are inherently more volatile, it would be more beneficial both financially and psychologically to look at them with a longer time horizon. Let us illustrate the point using Citigroup Inc. and the S&P 500 index as examples.
Chart 2: Frequency of Negative Returns
Chart 3: Proportion of Negative Returns
Suppose that you bought into Citigroup Inc. and S&P 500 Index after the aftermath of the Great Financial Crisis at the start of 2010. If you were to examine your portfolio weekly, the frequency of negative returns stands at 214 and 181, or 48% and 41% for Citigroup Inc. and the S&P 500 index respectively. When we take it up a notch by revising them monthly, you would only see negative returns for 39 and 34 months out of 102 months, approximately 38% and 33% of the time. These numbers would certainly decrease more as you aggregate them even further.
However, if you were to look at your returns daily for the past five years, you would have seen negative returns for 617 and 580 days for Citigroup Inc. and the S&P 500 index respectively, or about 50% of the time. During this period, you could have been more affected psychologically by red days, which may lead to early divestment. This would have led to you missing out on 32.4% and 66% cumulative nominal returns in Citigroup Inc. and the S&P 500 index respectively.
This is consistent with our beliefs – share prices tend to follow the trend of earnings growth in the long run. In the short run, prices will fluctuate due to investors’ sentiment and irrationality (Chart 4). As how Benjamin Graham summarised it succinctly –‘in the short run, the market is a voting machine but in the long run, it is a weighing machine. In one of our previous articles, we have stated that staying invested is your best bet. Checking your portfolio regularly and exiting early due to the pain of loss could result in missing the best days of the market.
Chart 4: Share Price vs Earnings
The Bigger Picture
For new investors, frame investing as a long-term activity where you check your portfolio quarterly or semi-annually instead of daily or weekly, and investing with a time horizon of at least three years. Doing so would help you avoid unnecessary pain or making rash decisions. Additionally, instead of evaluating your stocks individually, look at them as an overall portfolio and diversify your portfolio such that you would be more protected in times of unfavourable and volatile conditions.
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