How often do you check the performance of your stocks or your portfolio? And, does that affect your returns?
That’s the key question in chapter eight of Michael Mauboussin’s book, “More Than You Know: Finding Financial Wisdom in Unconventional Places.”
And, Mauboussin had another issue on his mind: “One of finance’s big puzzles is why equity returns have been so much higher than fixed-income returns over time, given the respective risk of each asset class.”
He found an answer in a 1995 paper by Shlomo Benartzi and Richard Thaler, who argued it was a phenomenon called “myopic loss aversion.” They based it on two constituent phenomena:
- Loss aversion: As we’ve noted before in this book, this refers to the disproportionate responses to wins and losses. Specifically, we regret losses two and half times more than we celebrate similar sized gains.
- Myopia: A technical term for short-sightedness; in this context, it refers to how often we evaluate our portfolios (or the securities within them). The more frequently we check, the higher the odds we will find a loss and experience loss aversion. On the other hand, the less frequently we check, the greater the likelihood of finding gains.
Mauboussin created this table to show the relationship among the frequency of checking, returns and utility (utility is defined as the probability of a price increase minus the probability of a decline times 2):
He also created this graph to show the relationship between time and the probability of registering a profit:
As the table shows, the probability of a gain or loss in the short term, which is basically less than a year, is about 50-50. After a year, the odds of a positive return begin to move in the investor’s favor. Mauboussin drew this conclusion:
“If Benartzi and Thaler are right, the implication is critical: Long-term investors (individuals who evaluate their portfolios infrequently) are willing to pay more for an identical risky asset than short-term investors (frequent evaluation). Valuation depends on your time horizon.
This may be why many long-term investors say they don’t care about volatility. Immune to short-term squiggles, these investors hold stocks long enough to get an attractive probability of a return and, hence, a positive utility.”
Keep in mind that an evaluation period may differ from an investor’s planning horizon. For example, an investor may plan for retirement in 30 years, but if they check their portfolio annually or quarterly, they are "acting” like a short-term investor. Mauboussin pointed out that while we may use the word “checks,” in reality, the investor is experiencing the utility of the gains and losses.
He went on to argue that portfolio turnover would be a reasonable proxy for an evaluation period when considering most funds. Further, he said, “High turnover would be consistent with seeking gains in a relatively short time, and low turnover suggests a willingness to wait to assess gains and losses.”
While we know frequent turnover may lead to underperformance because of transaction costs, the author pointed out they represent only about a third of total costs for the average mutual fund. He added, “Despite consistent evidence supporting the performance benefits of a buy-and-hold strategy, the average actively managed mutual fund has annual turnover nearly 90 percent. What gives?”
What gives, apparently, are agency costs; in this case, he is referring specifically to the pressure on fund and institutional managers to justify themselves every quarter or every year. For them, not underperforming the market is more important than beating it, so they avoid “controversial” stocks that have great potential if held for a few years. They need stocks that will perform well over the next three months.
To Mauboussin’s argument on agency and other costs, I would have liked to have had his perspective on individual or amateur investors as well. Based on an abundance of reporting and studies, it seems we non-professionals also shoot our own feet with myopic loss aversion.
For example, many of us buy mutual funds with high fees, even front-load and back-load fees. All such fees provide commissions for salespeople and the firms that sell funds. As someone once said, we should be buying yachts for ourselves, not our brokers. It is a manifestation of myopic loss aversion because we buy sales pitches, rather than investing in a bit of knowledge before we go shopping for securities.
There’s also a myopic loss avoidance problem in the way we switch from fund to fund or stock to stock. In hopes of hitching ourselves to the latest growth stock profits, we keep jumping into hot stocks at high prices, rather than exercising patience and discipline.
Conclusion
In chapter eight of "More Than You Know: Finding Financial Wisdom in Unconventional Places," Michael Mauboussin has shown us another pitfall that awaits investors, especially impatient investors: myopic loss aversion.
This refers to our struggle to avoid losses and our tendency to search out quick, short-term wins. And as the author made clear, the more we struggle to get those short-term gains, the more likely we are to underperform. The simple act of checking our gains and losses too frequently will uncover a lot of losses, from which we will try to recover. But if we can take a longer perspective, a year or more, we will see gains where there had been losses and that will allow us to build rather than speculate.
Finally, a warning for mutual fund shoppers: If you’re shopping for mutual funds, be sure to check the turnover rate carefully.
Read more here:
- More Than You Know: What's Behind Investing Hot Streaks?
- More Than You Know: Experts and the Issues They Confront”‹
- More Than You Know: Risk, Uncertainty and Prediction
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