Does Control and Transparency Increase the Behaviour Gap?

A behaviour gap can be defined as a divergence between an individual’s actions and what may be considered a rational or optimal path.  In the field of investment, such a discrepancy is often highlighted by detailing the differential between time weighted and money weighted returns; with the latter being impacted by the timing and magnitude of investor cash flows.  Both Morningstar and DALBAR have produced research attempting to calculate the tangible investment cost of our behaviour.

Whilst it is impossible to precisely attribute disappointing investor results to a particular set of behaviours, there is certainly sufficient evidence to suggest that investment outcomes are persistently and materially impacted by our cognitive and emotional biases.  This post will focus specifically on the influence of myopic loss aversion and consider how this phenomenon may be exacerbated by developments in the investment industry.

The existence of myopic loss aversion was first posited by Benartzi and Thaler (1995) in their explanation of the equity risk premium.  The idea combines the concept of prospect theory with the propensity of individuals to make short-term / high frequency observations.  Kahneman and Tversky’s work on prospect theory has been heavily popularised, thus I will not cover this in detail, but rather reiterate the relevant aspect  – that individuals are loss averse (relative to a reference point) and a loss weighs more heavily than an equivalent gain. Thus, our behaviour will tend to direct us away from situations involving losses.

The short-termism of myopic loss aversion is a form of mental accounting wherein gains and losses are appraised over brief time horizons, even if the overarching investment objective is long-term.  The influence of observation frequency was further evidenced in a study by Thaler, Tversky, Kahneman and Schwartz (1997) where, in a hypothetical portfolio management task, participants in the group receiving monthly performance feedback (relative to yearly or five yearly) finished the five year period with the most risk averse portfolio allocations.

The study of myopic loss aversion was furthered by Hardin and Looney (2012), and their review of the relevant literature found three vital variables impacting myopia:

Information Horizons:  The timespan over which prospective returns and risk are presented is an important factor influencing behaviour.  There has been evidence from a number of studies that extending the information horizon leads to a greater appetite for risk taking due to the broader framing.   For example, the potential for recording an absolute loss in an equity fund is greater over a three-month horizon, than a five year horizon (other things being equal), thus our timeframe is central to how we perceive losses.

Evaluation Frequency: How often an investor reviews investment outcomes is also crucial to decision making.  The more readily we monitor performance, the more risk averse we are likely to be.  This is an intuitive concept – higher risk investments are more likely to generate negative returns over short time periods and the more frequently we interact with return information, the greater the opportunity for myopic loss aversion to exert an influence.

Decision Frequency:  The type of investment decisions we make can also be materially impacted by how often we make decisions.  Restricting investment decision making tends to reduce risk aversion, as investors are less likely to encounter, and therefore trade on, short-term losses.

The literature suggests that behaviour consistent with myopic loss aversion is stimulated by focusing on short-term performance information (historically and prospectively), regularly reviewing investment outcomes and making frequent investment decisions.  In isolation, or combination, these factors can promote risk aversion, lead to conservative investment choices and, potentially, substandard long-term returns.  This could be through either cautious initial portfolio allocations or the reduction of risk during periods of short-term stress (or loss).

The impact of myopic loss aversion may also be observable in the preponderance of low tracking error, ‘quasi active’ mutual funds available.  Whilst there are a range of factors that may discourage investors from owning distinctive, high active share funds (despite the evidence supporting such approaches), it is possible that myopic loss aversion is a central driver.   High conviction, differentiated strategies are likely to deliver greater short-term performance variability and periods of relative loss.  Indeed, such approaches are somewhat trapped in a vicious circle where higher levels of relative risk result in meticulous monitoring by investors, potentially promoting behaviour consistent with myopic loss aversion.

The challenge that all investors have to confront is that our vulnerability to myopic loss aversion has increased due to a number of industry developments (particularly technological), which mean that our ability to monitor and control investments has improved markedly.  This visibility and flexibility, coupled with incessant emotional and informational stimulus, makes it increasingly difficult to make, and persist with, prudent long-term investment decisions.

That is not to suggest that increased transparency and control for investors are negative developments – they are an undoubted positive.  It is, however, crucial that as the investment landscape evolves, we are cognisant of the behavioural implications. If not, then any benefits accrued may be offset by the behavioural costs.

Key Reading:

Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. The quarterly journal of Economics110(1), 73-92.

Gneezy, U., & Potters, J. (1997). An experiment on risk taking and evaluation periods. The Quarterly Journal of Economics112(2), 631-645.

Hardin, A. M., & Looney, C. A. (2012). Myopic loss aversion: Demystifying the key factors influencing decision problem framing. Organizational Behavior and Human Decision Processes117(2), 311-331.

Thaler, R. H., Tversky, A., Kahneman, D., & Schwartz, A. (1997). The effect of myopia and loss aversion on risk taking: An experimental test. The Quarterly Journal of Economics112(2), 647-661.