Don't Look Now

Wednesday, February 15, 2017

By: Christopher P. Cline

There’s so much going on these days.  The stock market is rising, bond prices are dropping (sort of), emerging markets are all over the place.  Portfolio-watching is becoming as big a spectator sport as football.  Maybe bigger, given football’s recent television ratings.

But watching your portfolio can be bad for your financial health.  As Professor Richard Thaler points out in his book, Misbehaving, the more often people look at their investments, the less likely they are to take on risk because the more they look, the more short-term losses they’ll see.  Thaler identifies such behavior as “myopic loss aversion.” 

He cites a study that showed that, when a government agency changed the way retirement funds reported their returns, the opposite was also true.  The agency required the funds to show investors their returns over a full year as a default (the previous default reporting was to show returns over one month).  After the agency made this change, which gave investors a longer-term view, the investors shifted more of their assets into stocks, traded less often, and were less prone to shifting money into funds with high recent returns. 

These observations are consistent with a broader investment theme: people are prone to making serious investment mistakes.  For the past three decades, investment theory has been based on two principles:  People make rational decisions, and they are unbiased in their predictions about the future.  Modern portfolio theory is built on these assumptions.  However, psychologists have for years questioned their validity.

More recently, some economists have agreed with psychologists that (to no one’s surprise) investors can be irrational. The field of behavioral finance, once thought to be a marginal area of study, now has its own Nobel laureates. It studies the ways emotions and biases affect financial decisions. 

Behavioral finance manifests itself in several different ways.  First, investors are overconfident.  This appears, for instance, in the "better-than-average" effect (under which most people think they are better than average in any range of activities, which of course is mathematically impossible).  It also appears in the illusion of knowledge.  Everyone knows that when a six-sided dice is thrown, the odds of any one number coming up on that roll are one in six. However, numerous studies show that if people are told that the number four has come up on the previous three rolls, many will assume that the odds are either higher or lower for the number 4 to come up again. This despite the fact that the odds for any one roll are always one in six. 

Second, pride and regret are significant factors in decision making.  People obviously seek to minimize or ignore the regrets from their bad past decisions and follow the pride they feel in making good ones. However, this combination can lead to bad future decisions.  The fear of regret and pursuing of pride can result in the “disposition effect,” which in the investment world means selling winning investments too early and holding losing investments too long.

Third, people perceive risk differently, depending on past outcomes.  People are much more likely to accept a bet if they’ve previously won money (in which case their bet is made using “house money” in their minds) than if they have previously lost (in which case either risk aversion or “trying to break even” kicks in). In other words, prior winners are often more willing to accept risk on a current investment, whereas the results vary for those who’ve just experienced investment losses.

These are just three examples of the ways in which we can make irrational decisions about our investments.  And looking at our portfolios too often can make the impact of these decisions worse, because seeing that information can increase the overconfidence, pride, regret or other emotions that we feel about our portfolios.

We can take a few steps to counteract this emotional noise:

• First, know that it’s there. If you’re reacting emotionally to the economy, the markets or politics, it’s probably not a good time to make investment decisions.
• Second, follow the evidence. Markets are volatile in the short-term but fairly predictable over the long term (20 years or more). The evidence shows that market timing, stock picking and active management don’t work in the long run. But too much portfolio viewing might lead you to believe that they do, if you see short-term gains from those strategies.
• Third, know your goals. If you only need a 5% return, make sure that your asset allocation is geared toward that, rather than taking on too much risk because you see other investments doing better than 5% in the short run (remember the Tech Bubble?).
• Fourth, if you use an investment advisor, make sure he or she follows these rules as well.

So if you need a spectator sport, choose something less stressful (like football, soccer or X Games).  Better yet, turn off all your devices and go for a nice outdoor excursion.  Your body, mind and portfolio will thank you for it.