(Continued from Discipline: A Necessary Condition for Successful Investing Part 2 of 3)
There’s another way to reduce the risk of investment depression.
Myopic Loss Aversion and the Pain Ratio
Nobel Prize winner in economics Richard Thaler, author of the book Misbehaving, has found that we tend to feel the pain of a loss twice as much as we feel joy from an equal-sized gain. This tendency leads to the behavior known as “myopic loss aversion,” creating a problem for investors who check their portfolio values on a frequent basis. Consider the following: Based on the historical evidence for the S&P 500 Index (1950–2014), investors who check their portfolios on a daily basis can expect to see losses 46 percent of the time and gains 54 percent of the time. However, while they see gains more frequently than losses, because we tend to feel the pain of loss with twice the intensity that we feel joy from an equal-sized gain, the more often we check the value of our portfolio, the more net pain we will feel because our pain/joy meter will be 38 ([46 x 2] + [54 x 1]). Using a longer timeframe and more data, let’s examine how moving from daily checks to less frequent checks affects investors’ pain/joy readings.
Over the period 1927–2014, investors who resisted checking their portfolio daily, and instead moved to a monthly check, experienced losses only 38 percent of the time. That reduced the net pain reading from 38 to 14 ([38 x 2] – [62 x 1]).
Over the same 1927–2014 period, losses occurred only 32 percent of the time on a quarterly basis. Thus, investors who reviewed their values quarterly (like many who participate in 401k plans and receive quarterly statements) experienced a shift from net pain to net joy of +4 ([32 x 2] + [68 x 1]).
Investors whose patience and discipline allowed them to check values only on an annual calendar year basis experienced losses just 27 percent of the time. That results in a big improvement in the net reading from +4 to +19 ([27 x 2] + [73 x 1]).
As you would expect, the frequency of losses has continued to diminish over time. Using overlapping periods, from 1927 through 2014 the frequency of losses at a five-year horizon falls to just 14 percent. That results in a pain/joy reading of +58. At a 10-year horizon the frequency of losses falls to just 5 percent. That creates a pain/joy reading of +85 and will make for a happy (and more disciplined) investor.
If you’re a masochist, the implication for you is that you should check the value of your portfolio as frequently as humanly possible. For the rest of us, the implications are many. First, the more frequently you check your portfolio, the less happy you are likely to be and the less able to enjoy your life. Second, all else being equal, the less frequently you check the value of your portfolio, the more equity risk you should be able to take. Third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid pain.
The bottom line is that if you cannot resist frequently checking your portfolio’s value, you should be more conservative because you will be feeling the pain of losses more frequently. Feel enough pain, and even the most well thought out investment plans can end up in the trash heap of emotions.
There’s another important message here. The less you watch and/or read the financial media and the less you pay attention to economic and market forecasts (since they can cause you to imagine pain), the more successful investor you are likely to be!1
Warren Buffett has accurately stated that, “investing is simple, but not easy.” The simple part is that the winning strategy is to act like the lowly postage stamp, which adheres to its letter until it reaches its destination. Similarly, investors should stick to their asset allocation until they reach their financial goals.
The reason investing is hard is that it can be difficult for many individuals to control their emotions (greed and envy in bull markets and fear and panic in bear markets). In fact, I’ve come to believe that bear markets are the mechanism by which assets are transferred from those with weak stomachs and without an investment plan to those with well thought out plans — meaning they anticipate bear markets — and the discipline to follow to those plans.
A necessary condition for staying disciplined is to have a plan you can adhere to. But that’s not sufficient. The sufficient condition is that you must be sure your plan avoids taking more risk than you have the ability, willingness, and need to take. If you exceed any of those, you just might find your stomach taking over. The bottom line: If you don’t have a plan, develop one. If you do have one, and it’s well thought out, stick to it.
By Larry Swedroe
1 There is no guarantee that the strategies set forth in this presentation will achieve their intended objectives.