Myopic loss aversion helps explain the equity premium puzzle

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larryswedroe
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Myopic loss aversion helps explain the equity premium puzzle

Post by larryswedroe » Mon Aug 29, 2016 7:52 am

http://www.etf.com/sections/index-inves ... s-aversion

Findings are consistent with others showing that the more frequently check their portfolios, the worse the results. As Buffett has said, we make more money when snoring than active

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Larry

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flashboy
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by flashboy » Mon Aug 29, 2016 8:45 am

Larry, do you (and do researchers) expect the equity premium to persist? If it decreases over time because of greater financial literacy (indexing is definitely becoming mainstream, as are robo-advisers), and if inflation and real interest rates remain low, couldn't the resulting massively lowered expectations for equity returns spell disaster for investing as a whole in the decades to come?

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arcticpineapplecorp.
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by arcticpineapplecorp. » Mon Aug 29, 2016 8:47 am

Good article Larry. Thanks. So the recommendation for investors is only check your portfolio once a year (or less) to improve your portfolio's performance.

I had a question about the following in the article:
The self-employed and retired invest in stocks at significantly higher levels than those with regular employment. This is consistent with the concept that self-employed individuals are more risk tolerant and thus invest more in risky assets."
I understand this of self-employed individuals but I hardly see retirees as more risk tolerant unless what is meant is the following:

1. retirees have been through so many bear markets they can stomach losses better than the inexperienced (as in the seniors buying stocks in 1974-1975 when others were calling it "the death of equities").

2. Does the paragraph just mean that retirees have greater number of DOLLARS in stock, not necessarily a higher PERCENTAGE of their portfolio in stocks?

If that's the case, then sure. A millionaire retiree with a 30/70 portfolio is going to have more MONEY invested in stocks than new graduate with the median salary who invests his/her portfolio 80/20 (or 90/10).

Thanks.
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Tigermoose
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by Tigermoose » Mon Aug 29, 2016 9:15 am

flashboy wrote:Larry, do you (and do researchers) expect the equity premium to persist? If it decreases over time because of greater financial literacy (indexing is definitely becoming mainstream, as are robo-advisers), and if inflation and real interest rates remain low, couldn't the resulting massively lowered expectations for equity returns spell disaster for investing as a whole in the decades to come?
Great question and one I've been pondering lately myself. In the 1920s, everyone knew that stocks would just go up forever. With indexing and "greater financial literacy", we all just know that it is best to ride out the crashes and rebalance along the way. Will greater financial literacy results in a lowered equity premium and a reduction in the severity of stock market crashes?
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afan
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by afan » Mon Aug 29, 2016 9:54 am

Interesting, but I am worried about the implication of what investors are doing when they "check" their portfolios frequently. I don't know in what these people were investing, but someone who holds stocks or ETFs rather than open end funds has a regular stream of dividends coming in and would need to invest them in something. This might lead to logging in monthly to check the cash balance and make purchases. This would not reflect a desire to monitor the value of the account on a constant basis as much as the fact that one cannot login, determine the amount of cash available and buy a stock or ETF without checking what is in the account.

Thus, one might see regular activity but it might not be reasonable to attribute it to any particular pattern of loss aversion.
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goingup
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by goingup » Mon Aug 29, 2016 10:12 am

afan wrote:I don't know in what these people were investing, but someone who holds stocks or ETFs rather than open end funds has a regular stream of dividends coming in and would need to invest them in something. This might lead to logging in monthly to check the cash balance and make purchases.
Anyone who holds stocks, ETFs or mutual funds will have dividends. I advocate auto-reinvestment of dividends to minimize dithering and decision making (and perhaps loss averting behavior). I agree with you, though, people do log in to check out their distributions. Perhaps any type of constant portfolio monitoring may lead to sub optimal investor behavior, according to this article.

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njboater74
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by njboater74 » Mon Aug 29, 2016 10:14 am

Excellent article, as always, Larry.
Contrary to their a priori expectations, there was a significant education effect. Investors with college or university degrees tend to invest significantly smaller proportions of their financial portfolios in equities than other investors. These results may indicate that investors’ level of education is distinct from their level of financial literacy.
What do you think is the significance of this? It almost seems to imply that a to hold a certain amount of your financial portfolio in fixed income is 'financially illiterate'. It doesn't go on to say that higher educated invest less in equities than they should, just that they invest less. Does the study also evaluate whether lower educated invest too much in equities?
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Johnnie
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by Johnnie » Mon Aug 29, 2016 10:21 am

flashboy wrote:Larry, do you (and do researchers) expect the equity premium to persist? If it decreases over time because of greater financial literacy (indexing is definitely becoming mainstream, as are robo-advisers), and if inflation and real interest rates remain low, couldn't the resulting massively lowered expectations for equity returns spell disaster for investing as a whole in the decades to come?
I'm wondering if in the shorter term (the next five years) the trend does just the opposite and makes the premium rise as the masses come crowding into indexes. For example, it was recently pointed out that there's not enough publicly traded "small cap value" stocks to meet the demand in this kind of environment.

~~~~~~~~
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larryswedroe
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by larryswedroe » Mon Aug 29, 2016 10:46 am

First, given that there is risk in stocks, and significant risk, yes the premium should persist, and a bear market would make it larger (would be good for the younger investors).

Second, other studies have found that the more people check their portfolios the worse they tend to do with the reason being checking might lead to action when inaction is likely better.

Third, it obviously depends on the individual and their level of MLA. Some can check with no impact, others only makes things worse.

Fourth, the education thing was bit strange to me, as the higher level of education should lead to lower correlation of labor capital with markets. On other hand, and thus more equity risk taking ability. On other hand, they likely have lower need to take risk. And reverse likely true for lower levels of education (more need to take equity risks). So hard to know.

Fifth, I do believe that more finanical literacy does lead to more patient capital, and less panicked selling. We see that with clients, and have almost never seen panicked selling. In 2008 for example I only know of one of our clients that did that.

Larry

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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by pkcrafter » Mon Aug 29, 2016 1:14 pm

Thanks, Larry, good article.

And here's what's going to happen--

Most retail investors are short on knowledge--and more importantly--short on understanding and the ability to use the knowledge, and they not only have myopic loss aversion, they also have myopic attraction to recent returns. These traits are built in and not easy to change.

The delight (strongly attracted to recent returns) has resulted in a huge inflow to Vanguard's index funds, particularly large growth. This also happened in the tech bubble, and you know how that ended.

Returns of the S&P500 over years 2012-2014.
15.82, 32.18, 13.51

Low return in 2015, but rebound this year. The jumpers are still pretty much in, but are watching carefully and will leave rapidly when a downturn appears. Part of that is due to these investors not really believing in index investing in the first place. Don't worry about investors getting smart enough to stop this behavior.

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by livesoft » Mon Aug 29, 2016 2:40 pm

I don't get the description of the research.

If an investor evaluates frequently AND rebalances frequently, does that not mean that investor is buying more equities when equities have losses in order to maintain (i.e. rebalance back to) their asset allocation? It would also mean that the investor is selling equities when they go to maintain their asset allocation. Is either one of those a bad thing to do?

If I understood the report on the research it is simply that folks who have a lower equity allocation tend to evaluate frequently and rebalance frequently.

And folks who have a higher equity allocation probably don't worry about things too much. But which came first, the higher equity allocation or the lack of worry?
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AtlasShrugged?
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by AtlasShrugged? » Tue Aug 30, 2016 6:10 am

Mr. Swedroe...One question. In the conclusion section of your article, you mention the combination effect as being deadly.

Q: What did the authors define as 'frequent rebalancing'?
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carolinaman
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by carolinaman » Tue Aug 30, 2016 7:04 am

I do check my investment performance monthly, but I have a low cost passive portfolio, and am inclined to stay the course in down markets. Things were different when I was an active investor. Then I was inclined to sell when the market went down substantially. Is my thinking consistent with the study results?

larryswedroe
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by larryswedroe » Tue Aug 30, 2016 2:45 pm

jce
From my blog post
For both evaluation and rebalancing, frequency of more than quarterly is considered high.
Best wishes
Larry

tanstaafl
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by tanstaafl » Wed Aug 31, 2016 8:42 am

Thanks for posting, Larry. Thats a clear writeup of a very nice recent paper.
larryswedroe wrote: Second, other studies have found that the more people check their portfolios the worse they tend to do with the reason being checking might lead to action when inaction is likely better.
Larry and others, you might find the study in this link interesting (the paper was published in the Economic Journal in 2009, but its gated so the link is to a working version of the paper):

http://citeseerx.ist.psu.edu/viewdoc/do ... 1&type=pdf

The researchers use a controlled laboratory experiment to study underlying causes of myopic loss aversion. In a controlled setting with random assignment, they can identify causal relationships better than with field data. The have subjects play a simple investment game that is repeated over several rounds. The game is simpler than stocks versus bonds, as they choose how much of an endowment to put into a risky investment and how much to keep as guaranteed earnings. Two things seem to matter: the length of investment horizon (making a choice that will carry for several periods versus making a new choice every period) and the frequency of feedback (whether subjects see the results of every period, or see aggregate results over several periods). All of this fits well with the MLA story. The really interesting part is that when given the choice between long/short horizon and frequent or infrequent feedback, subjects strongly prefer the short term horizon and frequent feedback, even when they know this tends to lead to lower earnings. I agree with you that financial literacy can help, but this study shows that improvement may be very slow, as we are hesitant to "give up control" even if we know it will be better for us.

Again, great article and thanks for posting.

larryswedroe
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Re: Myopic loss aversion helps explain the equity premium puzzle

Post by larryswedroe » Wed Aug 31, 2016 4:23 pm

tanstaffl
Thanks for sharing. And I agree with the conclusions based on my 20 years of working with investors. Advisors in effect are managing people at least as much as they are managing assets,
Larry

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