Frequent Monitoring of Your Portfolio Can Be Injurious to Your Financial Health

By Larry Swedroe, Contributing Writer

Behavioral finance has provided us with many valuable insights into how human behavior can impact investment results. For example, we have learned that individuals are highly risk averse - on average odds of 2:1 or greater are required to entice them to accept an even money (50:50) bet. Another related example is that investors feel the pain of losses much more than they enjoy the good feelings generated by equivalent profits. By studying human behavior patterns we can learn how to avoid mistakes that we seem almost programmed or hard-wired to make.

When we look at the historical record of investment returns, we find that the vast majority of long-term returns are derived from just seven percent of all trading months. The returns of the remaining ninety-three percent of the months on average is virtually zero(1). The result is that the shorter the investment horizon, the more likely it is that an investor will experience a loss in the value his or her portfolio. At a horizon of one day, the odds of experiencing a loss are about 50:50. The odds don't improve much if we extend the horizon to a month. Even stretched out to one year, the odds of seeing the value of an equity portfolio shrink are about thirty percent. However, if we extend the horizon to a decade, there have been only two 10-year periods since 1926 with nominal declines in value (1929-1938 and 1930-1939).

Let us examine how the length of the investment horizon can impact investment results. Behavioralists have noted a tendency for investors to experience what is called myopic loss aversion. The concept of loss aversion, first introduced by Daniel Kahneman and Amos Tversky in 1979, refers to the aforementioned tendency of investors to weigh losses more heavily than gains(2). Myopia refers to a narrowing of the view - focusing on the most recent, short-term results, even when the investment horizon is long(3). Given the random nature of short-term investment results, investors that check the performance of their portfolios on a daily basis will experience many days of losses. Conversely, the longer the time frame between evaluations, the less likely it is that the portfolio will experience losses. Given that investors feel the pain of losses far greater than they feel the joy of gains, they are likely to not only experience disappointment if they check their portfolios with great frequency, but they are more likely to panic and sell as the pain of losses becomes intolerable.

Behavioralists have used myopic loss aversion as one possible explanation for the answer to what is known in academic circles as the "equity risk premium puzzle." The puzzle is why the equity risk premium has been so large when there have been very few long periods of poor equity performance. The behavioral solution to the puzzle is that the pain of short-term losses is so great that investors demand a large risk premium in order to compensate for the pain they endure in the short term(4). Of course, another solution is a risk-related one: equities are very risky and the large risk premium reflects that risk. The large return to investors simply reflects what has been called "the triumph of the optimists" - the risk of equities simply has not shown up in the U.S. over the long term. There is of course no guarantee that it will not show up in the future.

How can myopic loss aversion impact investment results? Investors that check on the values of their portfolio with great frequency are more likely to be subject to this "disease." And with the advent of the Internet age, most investors now have the capability to check on their portfolio's valuation on a daily basis with great ease - unfortunately subjecting themselves to the pain of losses with great frequency. This pain, caused by myopic loss aversion, can easily cause them to stray from a well-thought-out investment plan (asset allocation). This is especially true in bear markets when the frequency and intensity of the pain are high. Thus investors become susceptible to that dreaded condition known as convex investing - buying high and selling low.

The obvious conclusion that one can draw is that the less frequently individuals observe the performance of their portfolios, the more disciplined, and more successful, they are likely to be as investors. Unfortunately, the Internet age tempts investors with tools that make checking valuations far too easy a task. Investors are best served by going on a "portfolio valuation diet" - long periods of fasting, and the longer the better, with a very occasional stop at the dessert tray. The longer the fast, the more likely it is that the dessert will be sweet.

(1) Sanford Bernstein.
(2) Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision Under Risk," Econometrica, 47, 263-291.
(3) Uri Gneezy, Arie Kapteyn, and Jan Potters, "Evaluation Periods and Asset Prices in a Market Experiment." Rand, Labor and Population Program, Working Paper Series: 02-02.
(4) Ibid.

10/15/2002

Larry Swedroe is the Director of Research and a Principal for both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.

For those interested in learning more about how human behavior leads to investment mistakes, the first section of Swedroe's third book, Rational Investing in Irrational Times, covers thirteen behavioral mistakes investors make. The book provides both the diagnosis and the prescription for the cure. The book also covers another forty-nine investment mistakes even smart people make.