avoiding contagion and myopic loss aversion
Updated: Jan 8, 2021
The danger of Coronavirus contagion is very serious, but there is a different kind of highly contagious pathogen that can be very damaging to your long-term financial health. From the very beginning Phronimos has implemented strict protocols for handling this type of contagion and they became absolutely essential during the month of March.
The contagion we speak of is the emotional variety, namely Fear.
In his 1987 annual letter Warren Buffet wrote, ‘an investor will succeed by coupling good business judgement with an ability to insulate his thoughts and behavior from the super- contagious emotions that swirl about the marketplace’.
It is no coincidence that ‘going viral’ is the term for the contagious spread of opinions, ideas, views and emotions in this hyper-networked world of Twitter, Facebook, WhatsApp, Instagram, Tik-Tok, blogs, podcasts, memes and so forth. The power of ideas has long been understood for their virus-like ability to replicate, and mutate. Just ask the Romans: one minute Christians are lion snacks in a macabre form of public entertainment, the next minute your 340-year old empire has become the vehicle for transmitting Christian ideas to the rest of the known world.
The kind of moves we saw in stock markets in March can only be produced by a massive viral load of highly contagious Fear. Which is why it is more important than ever, amidst the maddening digital crowd, to practice good emotional and intellectual hygiene and even to a certain degree, ‘investor social distancing’. This involves, at a minimum, washing your hands of CNBC and Bloomberg, shunning virus-transmitting digital devices, avoiding the crowded squares of sell side research, and self-isolating with an annual report.
It may even involve NOT checking your portfolio.
Yes, you read that correctly. When the screen is alive with lots red flashing tickers and headlines - red for danger, run! - it may be better simply NOT to look. We aren’t trying to bury our heads in the sand or avoid accountability (our results will be reported to our investors no matter what) we are trying to avoid what the psychologists call myopic loss aversion.
Decades ago researchers demonstrated that we suffer the pain of a loss at roughly twice the rate at which we enjoy the equivalent sized gain; that is we are ‘loss averse”. Even in a situation where over a large number of outcomes there is an expected gain (heads you win $200, tails you lose $100 repeated 100 times), observing each outcome can be emotionally challenging. Our attempts to avoid pain in the short term can override our gains in the long term, hence the term “myopic” (short- sighted).
In a paper published in 1993 Shiomo Benartzi and Richard Thaler wrote: The longer the investor intends to hold the asset, the more attractive the risky asset will appear, as long as the investment is not evaluated frequently.
Repeatedly subjecting yourself to the emotional stress of losing or having lost money by frequently checking performance when the market is down is a sure fire way to prompt poor decision making to cauterize the psychic wound. The research on myopic loss aversion shows that as long as you are sticking to a sound long term strategy, the less often you check, the better the outcome.
As portfolio tracking apps and investment sites promote themselves on the basis of the ease and efficiency of being able to monitor your portfolio, perhaps they should come with a health warning:
"CAUTION: FREQUENT MONITORING OF YOUR PORTFOLIO MAY BE HAZARDOUS TO YOUR FINANCIAL HEALTH!"
While our role doesn't allow us to avoid looking at the portfolio from time to time, our most important job in times like these is to be prepared for market turbulence so that we are not rattled by temporary losses and are able to take advantage of the declines to progressively deploy capital into new investments or our existing portfolio at lower prices.
We recognize that in a market like this our purchases may decline further, but only by accepting that reality can we hope to achieve the superior returns offered by a moderately diversified portfolio of equities in the long-run.