Do You Have MLA?

I don’t know about you, but whenever I learn about a new disease or personality disorder, I’m immediately convinced that I have some of the symptoms.  Taking a psychology class in college nearly did me in – during the course, I felt sure that I was paranoid, schizoid, and maybe even a bit crinoid!  I don’t think I’m a hypochondriac, but I might be.  Luckily for me, these fears that I may be abnormal or may be coming down with the latest bug last only for a brief moment.  When the Ebola virus hit our shores, I did check myself for fever and other flu-like symptoms, but all seems well so far…

Then I read about a truly horrifying malady that affects more Americans than any exotic virus ever will – Myopic Loss Aversion (MLA).  Over the last few decades psychologists have been identifying behavioral biases that cause us humans to make irrational choices.  Newer studies have applied some of this work to how we use our brains when we invest.  Despite how rational we may think we are in times of market calm, we generally become less rational in the face of declining stock prices.

The relatively new science of behavioral economics has revealed that the pain people feel from a financial loss (even a paper one in the case of a falling stock price) is about twice as strong as the pleasure felt from a similar financial gain.  In practical terms, this means that many people are willing to give up more potential upside in order to avoid losses.  This preference of avoiding losses versus making gains seems to be hard wired into us.

Our good friends at Fidelity Investments brought our attention to a more damaging strain of loss aversion – MLA.  This form of loss aversion can affect investors who frequently evaluate their portfolio’s performance.  The more one looks at portfolio performance, the more likely one is to see a loss.  Because this causes more anxiety than the gains provide joy, the investor may want to “do something” in response to the loss.  In most cases, this means selling the losing asset class.  We saw this in full bloom during the 2008-2009 period.  We saw a smaller version of this during the week ending October 24th, where $7 billion fled the equity market in response to the recent correction.

In the extreme, MLA can lead a person to have a lower exposure to the equity market than they should, given their age, wealth, etc.  The chart below shows this.

This graphic shows that investors in this study who made decisions on a monthly basis had far less stock exposure than those who gazed at their portfolio statements once a year.  This suggests that some portion of the investing public has a lower allocation to stocks (and hence lower long-term returns) simply because they frequently look at their portfolios!

As shocking as this sounds, we see evidence of this behavior often in real life. Consider October’s stock market correction.  As the market was falling, commentators were struggling to explain the cause of the move. Even Ebola was listed as a possible reason.  How likely was anyone who sold in the heat of the moment as prices were falling able to reinvest their cash on the way up?  More likely is that people who sold are still in cash waiting for the market to go back down.  We know people who did this in 2008 and are still holding cash waiting for the market to go down…

Now imagine the person who was on a month-long cruise without access to their portfolio.  The S&P 500 closed on September 30th at 1,972.29.  Today it closed at 2,018.  The person returning from the cruise would no doubt be pleased for the market’s 2.3% gain for the month and the positive impact for that person’s portfolio.  Who would you rather be – the person who fretted and felt compelled to do something as the market corrected, or the person on the cruise?

If you think you might be prone to contract MLA, don’t see your doctor.  Simply look less frequently at your portfolio.  Your long-term returns may thank you…