Review & Outlook

Our take on the investing, financial, & economic themes of the day

Avoiding “Myopic Loss Aversion”

As I write, the Dow  is down more than 200 points, and the S&P 500 is also down more than 1%. News of Argentina’s possible default on its debt along with a slew of disappointing corporate earnings reports seem to have contributed to the sharp pullback today.

Could this be the start of the long-awaited correction, or it is just a dip that will lead investors waiting on the sidelines to jump back in, causing the market to rebound tomorrow? It’s hard to say. We’ve had a bunch of strong economic data recently along with a surprisingly good earnings season so far. These conditions make the case for a continued rally, but of course the state of the economy and the performance of the market are not inextricably linked. Investor sentiment often becomes unhinged from the fundamental economic data, pushing the market up or down in unpredictable ways over a shorter-term period.

So what should investors do now? The main thing is not to overreact. Some recent research from Fidelity highlighted a common investor bias called “myopic risk aversion,” which causes investors to overreact to losses.

A perfectly rational investor would have a reaction to a 1% rise that is roughly as strong as his reaction to a fall of 1% in his portfolio. However, a lot of research on behavioral investing indicates that our reaction to the 1% loss is considerably stronger. Often it leads people to overreact. One way to avoid falling prey to this common bias is to ignore the daily market swings. Investors who only check in on their portfolio every once in a while are far less likely to overreact.
fidelity 2

 

Myopia literally means nearsightedness. The more we watch the swings in the market, the more we are prone to be blinded by emotion. We fail to see the big picture. As the graph demonstrates, investors who check their portfolios regularly are likely to have a much more conservative portfolio. This seems to be the result of an overreaction to small losses that leads frequent market watchers to have an inappropriately conservative asset allocation.

Of course, few investors will actually check their portfolio only once a year as the graph above seems to advise, and checking it more often is okay. But if you do so, keep in my the loss aversion bias, and try not to let the emotional response to loss override the more rational plan that was previously set in place.