Myopic loss aversion

What Is Myopic Loss Aversion?

Myopic loss aversion is a concept within behavioral finance that describes the tendency for investors to take on less risk when they evaluate their investment performance frequently, leading them to overreact to short-term losses at the expense of potential long-term gains. This phenomenon combines two distinct psychological biases: loss aversion and mental myopia. Loss aversion refers to the human tendency to feel the pain of a loss more intensely than the pleasure of an equivalent gain. Mental myopia, or short-sightedness, describes a focus on immediate outcomes rather than long-term consequences. When these two biases interact, investors may make suboptimal decisions, such as overtrading or choosing overly conservative asset allocation strategies, which can hinder the growth of their portfolios over time.²³,²²,²¹

History and Origin

The concept of myopic loss aversion was formally introduced by professors Shlomo Benartzi and Richard Thaler in their 1995 paper, "Myopic Loss Aversion and the Equity Premium Puzzle."²⁰ Their work sought to explain the long-standing observation, known as the equity premium puzzle, which highlights the historical tendency for stocks to significantly outperform bonds over long periods, despite traditional economic models suggesting a much smaller difference in returns.¹⁹

Benartzi and Thaler hypothesized that investors' aversion to losses, combined with their tendency to evaluate their portfolios frequently, could explain this puzzle. They drew upon prospect theory, developed by Daniel Kahneman and Amos Tversky, which posits that individuals make decisions based on potential gains and losses relative to a reference point, and that losses loom larger than gains.¹⁸ By demonstrating how a moderate degree of loss aversion, coupled with an evaluation period of approximately one year, could account for the observed equity premium, their paper provided a compelling behavioral explanation for a significant market anomaly.¹⁷

Key Takeaways

• Myopic loss aversion combines loss aversion (losses hurt more than equivalent gains feel good) and mental myopia (a focus on short-term outcomes).¹⁶
• Investors exhibiting myopic loss aversion tend to react excessively to frequent, small losses, even if their long-term outlook is positive.¹⁵
• This bias can lead to overly conservative investment choices or frequent trading, potentially reducing overall long-term returns.¹⁴
• It has been used to help explain the long-observed equity premium puzzle.¹³
• Reducing the frequency of portfolio evaluations can help mitigate the effects of myopic loss aversion.¹²

Interpreting Myopic Loss Aversion

Myopic loss aversion is primarily interpreted as a cognitive bias that distorts an investor's perception of risk. Instead of maintaining a consistent investment horizon aligned with their long-term financial goals, individuals affected by myopic loss aversion tend to shorten their effective evaluation periods. This frequent monitoring exposes them to the natural volatility of asset prices, making them more likely to observe short-term negative fluctuations, which are then amplified by their inherent loss aversion.¹¹

Consequently, even a fundamentally sound portfolio might appear to be performing poorly over brief intervals, leading to feelings of anxiety or regret. This skewed perception can prompt investors to withdraw from potentially rewarding but volatile assets like stocks, opting for seemingly safer, but often lower-returning, investments such as bonds or cash. Understanding myopic loss aversion helps financial professionals and individuals recognize that frequent "checking" of a portfolio can be detrimental to sound portfolio management and long-term wealth accumulation.¹⁰

Hypothetical Example

Consider an investor, Sarah, who is saving for retirement, which is 25 years away. She has a diversified portfolio that includes a significant allocation to equities, which historically offer higher long-term returns.⁹

Scenario A: Sarah checks her portfolio daily. On a given day, the market experiences a minor downturn, and her portfolio value drops by 0.5%. Due to myopic loss aversion, the pain of this small, immediate loss feels disproportionately large to Sarah. She sees similar small losses over a few weeks, despite the broader market trend remaining positive over the quarter. Fearing further losses, she decides to sell some of her equity holdings and move the funds into a lower-risk money market account, significantly altering her intended asset allocation.

Scenario B: Sarah checks her portfolio quarterly, consistent with her long-term retirement goal. Over the course of a quarter, while there may have been daily fluctuations, her portfolio experiences an overall gain of 2% due to market recovery and growth. Because she is not constantly exposed to the minor daily dips, the positive quarterly outcome outweighs any fleeting negative sentiments. She maintains her long-term investment strategy, avoiding knee-jerk reactions driven by short-term market noise. This illustrates how less frequent evaluation can mitigate the impact of myopic loss aversion.

Practical Applications

Myopic loss aversion has significant implications across various aspects of investing and financial planning:

• Investment Policy and Design: Financial advisors can design investment communication strategies that encourage clients to focus on long-term returns rather than short-term fluctuations. This might involve reporting portfolio performance less frequently or emphasizing annual or multi-year returns over daily or weekly figures.
• Fund Structuring: Investment products designed with longer lock-up periods or less frequent valuation statements can inherently reduce the opportunity for investors to succumb to myopic loss aversion, promoting a more patient approach.
• Explaining Market Phenomena: Beyond the equity premium puzzle, myopic loss aversion helps explain why many investors shy away from seemingly attractive long-term investment opportunities due to their short-term volatility. It also contributes to understanding behaviors like herd mentality during market downturns, as individuals react collectively to immediate losses.
• Investor Education: Educating investors about cognitive biases, including myopic loss aversion, can empower them to make more rational decisions. Understanding that short-term losses are a natural part of investing can help temper emotional responses.
• Empirical Studies: Research has demonstrated the real-world impact of myopic loss aversion. A field experiment showed that professional traders who received infrequent information about their investment performance invested significantly more in risky assets and earned higher profits than those who received frequent updates.⁸ This suggests that limiting immediate feedback can improve investment outcomes by reducing the influence of this bias.

Limitations and Criticisms

While myopic loss aversion offers a compelling explanation for various investor behaviors, it also faces certain limitations and criticisms:

One primary critique lies in the precise definition and measurement of the "evaluation period." While Benartzi and Thaler suggested an annual evaluation period aligns with observed phenomena, actual investor behavior can vary widely, influenced by access to real-time data and individual psychological traits. It can be challenging to empirically determine an individual's actual internal evaluation frequency.

Furthermore, some argue that myopic loss aversion, while powerful, may not fully account for the entire magnitude of the equity premium puzzle. Other behavioral factors, such as the disposition effect (the tendency to sell winners too early and hold onto losers too long), and traditional economic explanations related to risk-free rate variations, may also contribute to the observed discrepancy between stock and bond returns.⁷,⁶

The theory implicitly assumes that investors are primarily driven by the pain of monetary losses. However, other emotional factors, such as regret, fear of missing out (FOMO), or even the thrill of frequent trading, can also influence investment decisions, potentially interacting with or overriding the effects of myopic loss aversion. Finally, mitigating myopic loss aversion often involves reducing access to frequent performance feedback. While this can be beneficial, it may conflict with an investor's desire for transparency and control over their investments.

Myopic Loss Aversion vs. Loss Aversion

Myopic loss aversion is often confused with, but is a specific manifestation of, the broader concept of loss aversion. Loss aversion is a fundamental cognitive bias where the psychological impact of a loss is roughly twice as powerful as the pleasure derived from an equivalent gain.⁵ It is the inherent human tendency to prefer avoiding losses over acquiring equivalent gains. For example, a person might feel more pain from losing $100 than pleasure from gaining $100.

Myopic loss aversion builds upon this fundamental bias by adding the element of "myopia," or short-sightedness. It describes how loss aversion is amplified when individuals evaluate their investments too frequently, focusing on short-term outcomes rather than long-term objectives. The "myopic" aspect highlights the frequent evaluation period, which exposes investors to more instances of perceived losses, thereby triggering the pain of loss aversion more often. Without the "myopic" component (frequent evaluation), the simple presence of loss aversion would not necessarily lead to the same suboptimal long-term investment behaviors.

FAQs

What causes myopic loss aversion?

Myopic loss aversion arises from the combination of two psychological phenomena: loss aversion (feeling losses more intensely than gains) and mental myopia (focusing on short-term outcomes). When investors frequently check their portfolios, they are more likely to observe small, temporary losses, which triggers their loss aversion and can lead to reactive, rather than strategic, decisions.⁴,³

How does myopic loss aversion affect investment decisions?

It typically leads investors to take on less risk than might be optimal for their long-term goals. Due to the amplified pain of short-term losses, individuals may reduce their exposure to volatile, but potentially high-returning, assets like stocks, opting for safer alternatives. This can result in lower overall returns and may involve higher transaction costs if it leads to frequent buying and selling.²

Can myopic loss aversion be overcome?

While inherent biases are difficult to eliminate entirely, their impact can be mitigated. Strategies include setting a long investment horizon and sticking to it, reviewing portfolio performance less frequently (e.g., quarterly or annually instead of daily), and focusing on overall portfolio returns rather than individual asset fluctuations. Educating oneself about behavioral finance principles can also help in recognizing and managing this bias.¹