What is myopic loss aversion?
For the answer, it helps to break this concept down into its two component parts: investor myopia and loss aversion. Let us begin with the concept of loss aversion. Loss aversion is the tendency for people to feel losses more acutely than gains. That is, a $100 loss will have a greater—often significantly greater — psychological or emotional impact than a $100 gain. People measure gains and losses from a subjective reference point. For an investor, that reference point could be her initial investment amount, the highest balance her portfolio reached, or her portfolio balance at the end of a calendar period, such as the prior quarter or year-end. People prone to loss aversion will often make suboptimal decisions to avoid or minimize investment losses. Research psychologists Amos Tversky and Daniel Kahneman first introduced the concept of loss aversion. Their ground-breaking research led to the birth of Behavioral Economics. Behavioral Economics posits that people are prone to suboptimal decision making due to a host of cognitive, emotional, and sociocultural factors. Behavioral finance is a subfield of behavioral economics.
Stock market screen showing a loss
An example of loss aversion is illustrated by the disposition effect. Research finds that investors exhibiting the disposition effect are prone to hold individual stocks that have declined in value and sell stocks that have increased in value. For such investors, their subjective reference point from which they measure gains and losses for an individual stock is typically the purchase price at which they bought the stock. Research finds that stocks that have increased in value are more likely in the future to outperform stocks that have declined in value. However, loss averse investors are more likely to sell their stock that has appreciated in value and are reluctant to sell their losers to avoid the pain associated with turning a paper loss into an actual loss. In large part, the disposition effect can be explained by loss aversion.
For investors, myopia refers to a short-sightedness that is a form of narrow framing. Narrow framing occurs when investors focus on the performance of specific or narrow components of their investment portfolio rather than their aggregate portfolio performance. Narrow framing is also evidenced when investors focus on a narrow time span when judging their investments—this is myopia. Investors exhibiting myopia are prone to be hyper-focused on short term results, frequently checking the status of their investment accounts. Today, technology allows us to access our investment account balance and performance in seconds, which often serves to intensify investor myopia. Frequent or hyper-frequent analysis of our personal investments often leads to undue stress and suboptimal decision making, often in a reactive way. This is especially true for investors who exhibit both myopia and loss aversion—myopic loss aversion.
Myopic loss aversion often leads to suboptimal decision making by investors. Investors exhibiting myopic loss aversion are prone to sell equity funds and individual stocks during a period when the stock market is declining. These investors are also less likely to invest in equities after a prolonged market downturn.
What does myopic loss aversion look like? As an example, meet Seth, a hypothetical investor. Over several years, Seth has contributed a total of $400,000 to his IRA, and by the end of 2024, Seth’s IRA account had grown to $950,000. Seth is age 55 and plans to begin withdrawing from his IRA in 15 years, when he retires at age 70. After Seth’s IRA balance reached its $950,000 high water mark at year-end, it declined in value and at the end of the first quarter, Seth’s IRA account balance was $875,000. Although Seth considers his IRA a long-term investment account, since the first quarter decline, Seth has become decidedly myopic in his focus. His subjective reference point for his IRA is the year-end balance of $950,000 rather than his aggregate investment amount of $400,000 and it is from that reference point that Seth measures gains and losses. Seth continually tracks his IRA account balance, often multiple times a day on his mobile phone. Investment losses are especially painful for Seth and upon initially viewing his first quarter statement, Seth lamented to a friend, “I’ve lost $75,000.” Given the stock market’s volatility this year, Seth’s frequent viewing of his IRA account has him often see his account balance decline and so he frequently feels the acute pain of losses. Seth is considering transferring the equity portion of his IRA into the bond and money market investment fund options. Further, he thinks that an all-bond investment allocation may be best for him for his long-term investment approach.
As an investor, how do you spot if you are prone to myopic loss aversion and how can you mitigate its effects and avoid suboptimal investment behavior? Here are a few strategies:
First, self-awareness is key in improving any unwanted and unhealthy behavior. Do you find yourself viewing your investment accounts frequently, perhaps weekly or even daily? Do you experience an elevated level of disappointment or stress when you see that your investment account has declined in value? If you answered yes to both questions, you may be experiencing myopic loss aversion.
Reminding yourself of the objectives of various investment accounts may help you reframe your vision and change your behavior. For investments that have long term objectives, there is no need or usefulness to continually view your account balance and performance. As noted above, such a narrow focus is likely to be counterproductive.
Similarly, having a long-term strategy and staying disciplined to that strategy regardless of short-term market volatility and account fluctuations can help you keep a wide or broad frame rather than a narrow frame.
WestHill’s investment portfolio review process has us meet with clients regularly rather than frequently. Further, our portfolio reviews emphasize long-term performance over short-term results. We also discuss investment performance in the context of our clients’ long-term financial plan and objectives. Also, by employing semi-annual portfolio rebalancing, we can help our clients stay true to their investment strategy. This focus and discipline helps keep our clients focused on the long term and helps alleviate the tendency to narrowly focus on short term performance.
History shows us that the equities have provided a long-term annual return that is far superior to that of fixed investments, such as bonds. For example, over the past 50-year period ending on December 31st, 2024, U.S. equities as measured by the S & P 500 have averaged approximately 11% per year vs. 4.79% for U.S. Treasury Bonds. This long-term investment dominance of approximately 6% per year for equities over fixed investments is known as the equity premium. Nobel Prize-winning economists Richard Thaler and Shlomo Benartzi find in their research that the behavioral finance concept of myopic loss aversion is the key driver in explaining the reason for the equity premium.
Summary
Myopic loss aversion is a behavioral finance concept whereby investors exhibit both myopic investment behavior and loss aversion. Specifically, an investor’s frequent scrutiny of their investments coupled with the acute psychological or emotional pain they feel when experiencing investment losses makes them especially prone to making poor investment decisions. This experience often manifests itself in selling equity investments during down market periods and underweighting or avoiding equity investments in the future. Technology can exacerbate myopic loss aversion. There are a number of strategies investors can employ to view investment performance through a broader frame and to make disciplined investment decisions with one’s long-term objectives in mind.