Saturday, June 22, 2013

Loss Aversion Keeps You From Higher Stock Returns

Now that we are familiar with the concept of loss aversion we can explore how it may help explain a range of behavioral paradoxes. Specifically, today’s post focuses on loss aversion and the Equity Premium Puzzle; the paradox in which equity (stocks) receives a higher premium than risk-free government bonds, although they have comparable risks[1].

I hope to underscore a vital point about behavior science with this topic; having a key grasp on behavioral concepts like loss aversion are not just intellectual curiosities. In light of the recent market crash of 2009, the loss felt by others illustrates that a lesson from loss aversion can protect you from making grave errors in judgment with stakes as high as your life savings on the line.  

Equity Premium Puzzle

The Equity Premium Puzzle investigates the phenomenon of investors investing in bonds as opposed to equities. More plainly put, why does a market for government bonds exist at all when an investor can get consistently higher returns through stocks with the same exposure of risk?[2] Since stocks far out-perform bonds, a rational actor seeking to maximize his expected utility should always choose stocks over bonds. Therefore, the equity premium puzzle at its core queries why actual observed stock returns far exceed the average investor’s expected utility as evidenced by their investment behavior. 

Myopic Loss Aversion: Explaining the Puzzle

Loss Aversion Defined

Loss Aversion stands for the idea that losses loom larger than gains.[3] “Empirical estimates find that losses are weighted about twice as strongly as gains… The disutility of losing $100 is roughly twice the utility of gaining $100.[4]” 

Myopia Defined

Myopia in this context is similar to mental accounting, the practice of individuals constantly monitoring and evaluating the success or failure of their financial investments.[5]

Combined: Myopic Loss Aversion Explains The Equity Premium Puzzle

Combined these two concepts asserts that individuals are prone to frequently evaluate their stock purchases. In contrast to bonds, since stocks prices fall almost as often as they rise on a daily basis, and since their losses are psychologically doubled[6], the average investor is unduly aggravated when engaging in mental accounting, and as a result will irrationally undervalue the stock’s expected utility.[7] The irrational myopic risk aversion towards stocks thereby act to induce a demand for bonds as an alternative investment.

Myopic Loss Aversion & The Recent Recession

In the recent market crash of 2009, many people lost half their investments in the stock market almost overnight. This sparked a debate amongst investors everywhere; should they pull out now to stop the bleeding, or stick it through in hopes of a recovery. Those prone to myopic loss aversion abandoned their investments in equities, being overly sensitive to the pains of their losses.[8] However, since 2009 markets have rebounded - client account balances at Fidelity investments have since increased 75%, while those who abandoned equities all together in light of the market crash only saw their accounts increase 26%.[9] Those who were alert to watch out for their tendency for myopic loss aversion could adjust their behavior to hold on to their investments rather than trust their instincts which are overly sensitive to the pains of loss.

Like this post? For more on loss aversion, see [TAG] Loss Aversion Keeps You From Higher Stock Returns.                       
[1] Jeremy J. Siegel and Richard Thaler, Anomalies: The Equity Premium Puzzle, Journal of Economic Perspectives, 192.
[2] Id.; Also See Rajnish Mehra and Edward C. Prescott, The Equity Premium: A Puzzle, Journal of Monetary Economics. 143. (In pertinent part: “ Historically the average return on equity has far exceeded the average return on short-term virtually default-free debt. Over the ninety-year period...the average real annual yield of the Standard and Poors 500 Index was 7%, while the average yield on short-term debt was less than 1%.)
[3] Daniel Kahneman, Thinking Fast and Slow, 415.
[4] Richard H. Thaler, Amos Tversky, Daniel Kahneman, Alan Schwart, The Effect of Myopia And Loss Aversion on Risk Taking, The Quarterly Journal of Economics (1997). 648.
[5] Line Isager-Nielsen, Myopic Loss Aversion and the Equity Premium Puzzle, Copenhagen Business School, 21.
[6] See Thaler, supra note 4, at 650. (In pertinent part: "The probability of observing a loss is higher when the frequency of evaluation is high. If losses cause more mental anguish than equivalent gains cause pleasure the experienced utility associated with owning stocks is lower for the more myopic investor."
[6] See Siegel, supra note 1, at 197.
[9] Id.
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