In this series of articles I explore behavioral influences on investors’ decision-making and the effects these have on investment success.
The purpose of these articles is to shine a light on common behavioral biases in order to help investors avoid costly mistakes. In this article I focus on the most common, and the most costly, of all the biases that cause perfectly rational people to make irrational investment decisions: Myopic Loss Aversion.
Most investors – amateurs and professionals alike – repeatedly fall into behavior traps that cause them to make decision errors. This happens regardless of intelligence or skill level. The literature on Behavioral Finance documents this tendency and describes it as irrational behavior. It’s not the loss aversion that’s irrational. It’s the myopic part.
We all have a natural and healthy aversion to losing money. It’s what helps us avoid falling for financial scams (Think Bernie Madoff, penny stock touts, Nigerian Princes, etc). It also keeps us from over-spending, and helps us to save for a rainy day. But Myopic loss aversion is different. It happens when we temporarily lose sight of the bigger picture, and focus too much on what lies immediately in front of us. For investors, this usually means panic selling during sharp market declines.
My own encounter with myopic loss aversion happened on March 9, 2009. I was having lunch with my brother-in-law Bob in Hilton Head, South Carolina. We were on vacation, relaxing and playing golf in the warm sun while our friends and family back in Chicago were digging out from the last snowstorm of a fading winter.
While we were waiting for our food to arrive I looked up at the big screen TV that was suspended from the ceiling in the bar area across the room from our booth. It was tuned to CNBC, and I could see the pictures but we were too far away to hear what the talking heads were saying.
There was a graph of the falling stock market with the words “Stocks continue to plunge” in big red letters, crawling across the bottom of the screen. The graph showed how much the stock market had fallen since the housing bubble burst in 2007. It showed a succession of cascading stock prices that looked more like Niagara Falls than the New York Stock Exchange. I remember feeling a slight twinge in the pit of my stomach.
As I looked at the silent images that flashed across the screen I remember saying to Bob, “This is bad… this is really bad.” I began to imagine scenes of widespread panic, like those old newsreels from the Great Depression of the 1930s. I imagined crowds of people lined up in front of the bank, desperately trying to get their money out before everything collapsed. I saw bread lines and soup kitchens. And I saw myself, living in a van, down by the river. That’s when I began to panic.
Without thinking, I called my stockbroker back in Chicago. “Sell everything. Sell it at the market. I don’t care what the price is, just get me out!”
Rich, my long-time business partner and close friend, couldn’t believe what he was hearing. “Erik, are you sure you want to do this?”
Yes, I said. I was convinced that things were going to get much worse before it was over, and I wasn’t about to sit there and watch my entire life savings go down the drain.
Rich pleaded with me to reconsider. “Erik – take a breath. You sound a little upset right now.” He could tell that I was in panic mode. Somehow he was able to convince me to sell just half of my holdings, and then wait and see if the market would stabilize. He had talked me down from the ledge.
When I ended the call I felt sick. I knew I had panicked. I knew I had acted irrationally. But I couldn’t help myself. I’m only human, after all, and humans panic sometimes. But I’m also an experienced, professional investor. I should have known better. How could I have allowed myself to make such an obviously irrational decision?
The answer is that I failed to follow my own plan, which includes specific instructions about how to handle extreme market events like this. I was on vacation, and I had made a decision to completely get away from work and “leave my worries behind,” which included my laptop, emails, to-do list, and my written investment plan. Without it, I fell into the trap of allowing my emotions to drive my decision that day. By focusing only on the sharpness of the market’s decline on that particular day, my loss aversion was myopic – it prevented me from seeing the bigger picture.
By the time I got back to Chicago, I had calmed down and realized that the world was not coming to an end, the stock market was not going to fall all the way to zero, and I had made a poor decision while under the influence of myopic loss aversion. What I learned from the events of that day was that I can never make an important buy or sell decision based solely on how I feel at the time. Had I taken the time to consult the part of my plan that spells out how to deal with big market declines, I would have been more rational, and it’s very unlikely that I would have made that panic sale.
When I take on a new client, one of the first things we do is write out an investment plan that covers behavior traps like myopic loss aversion. If I had brought my written plan with me that day, I would have been in a better position to put the dramatic market action into its proper perspective and avoid falling into this behavior trap.
What behaviorists have to say about myopic loss aversion
Behaviorists have noted a tendency for investors to check the performance of their portfolios too frequently. If an investor checks his holdings on a daily basis, he will experience many days of losses. Conversely, the longer the time frame between checks, the less likely it is that the portfolio will experience losses. Given that investors feel the pain of losses far greater than they feel the pleasure of gains, they are likely to not only experience disappointment if they check their portfolios with great frequency, but they are more likely to panic and sell as the pain of losses becomes intolerable.
How can myopic loss aversion impact investment results? Investors that check on the values of their portfolio with great frequency are more likely to be subject to this particular bias. And with the advent of the Internet age, most investors now have the capability to check on their portfolio’s valuation in real time, with great ease – subjecting themselves to the pain of losses with great frequency. This pain, caused by myopic loss aversion, can easily cause them to stray from a well-thought-out investment plan. This is especially true in bear markets when the frequency and intensity of the pain are high. Thus investors become susceptible to buying high and selling low.