Bloomsbury blog It's okay to look away

Bloomsbury newsletter, 31 December 2015

The field of behavioural finance sets out to explain how people make (often irrational) decisions about money.

Dr Richard Thaler, of the University of Chicago, is considered one of the founders of the field. In his new book, Misbehaving: The Making of Behavioral Economics, he discusses - in amusing detail - the behavioural biases that seem to affect how we make decisions around money and investing. Those biases include:

• The endowment effect (we value things we own more highly than things we don't yet own)
• Hindsight bias (after the fact, we think we always knew a given outcome was likely, if not a foregone conclusion)
• Confirmation bias (the tendency to search for, interpret or recall information in a way that confirms our pre-existing beliefs or hypotheses)
• Prospect theory (the hurt from losses is greater than the pleasure derived from equivalent gains).

All these biases converge on the thing Thaler describes as the single most powerful tool in the behavioural economist's arsenal - myopic (short sighted) loss aversion.

Our summary of myopic loss aversion is:

• We hate losing money
• We are much more likely to see losses in short time periods
• When we see losses we instinctively believe (1) it was avoidable, (2) the worst is yet to come, or (3) both

All of the above lead us to make poor, emotionally driven decisions about money and investing.

Another summary of the above we can make is that you should not look at your portfolio balance over short time periods. We explain that further below.

One of the biases Thaler discusses, prospect theory, suggests that investors feel the pain of losses about twice as much as they feel the joy of gains. By the way, that is probably perfectly rational. For example, losing your supply of food for the winter can kill you; doubling your supply might just make you more comfortable. Viewing losses as more dangerous than gains is helpful in many areas of life.

Now think about this particular behavioural tool when it comes to investing. In investing, short term losses are inevitable and common.

According to ifa.com, since January 1965 the market (as represented by a US market index) has gone up 51.25% of the days, and down 48.75% of the days. That's nearly a draw.

But it's not a draw emotionally. Remember, a loss is felt twice as much as a gain. If we assign a loss an emotional score of -2 and a gain an emotional score of +1, how would we feel after seeing gains 51.25% of the time and losses 48.75% of the time?

Our emotional score would be:

(51.25 x 1)+(48.75 x -2) = -46.25

Translation: we'd feel lousy.

Checking your portfolio value every day is very likely to make you feel bad because, emotionally, the down days outweigh the up days, even if there are slightly more up days.

However, ifa.com informs us that the more time you are in the market, the more likely you are to see positive results. If you only check your portfolio balance monthly, you have about a 62% chance of seeing a positive return. If you check it quarterly, this increases to a 68% chance, then 78% for annually and 89% for five year cycles. If you have the fortitude to go 15 years before you check your portfolio balance, based on the 50 year time period below you will have never seen a loss.

So, if seeing a loss feels twice as painful as seeing a gain feels good, how often could you check your portfolio and still break even emotionally? The answer is no more than quarterly. You'll need to see gains at least 66% of the time for you to even feel neutral about it.

In his book Thaler describes that investors who look at their portfolios more regularly take less risk, because they can't stand the volatility that they see by checking more often.

In addition, if you don't check your portfolio very often, and are happy to leave that job to your adviser, you should be able to emotionally tolerate a higher percentage of shares in your portfolio. This means an opportunity for higher long term returns. The less frequently you check your portfolio, the happier an investor you are likely to be. Checking too often is essentially tempting yourself to abandon your well-conceived investment plans.

As an adviser, it's one of our jobs to help make you a great investor. That's why it's our job to look at your portfolio for you, to ensure your investments are performing as we expect and that they are likely to achieve your financial objectives. If something needs to change, we'll let you know.