Last updated on: September 8, 2015.

Definition

Combination of loss aversion and frequent evaluations of risky returns:

  • pleasure felt after observing a gain is inferior to the pain experienced after a loss of an equivalent amount
  • losses are experienced more frequently at narrow time scales

More frequent evaluations lead to increased risk aversion. Definition source: my wife‘s behavioral finance course.

Effect

For investing use cases, the more frequently the client/manager is checking the net positions, the more pain she is experiencing, and the higher the aversion to risk goes, leading to underweighting investments with high long-term returns but high daily/weekly volatility.

For instance, this may one explanation of why employees have historically foregone substantial financial gains by investing their retirement funds in safe bonds rather than in equities, even though the long-term return of equities is often many times higher. (Benartzi, S., & Thaler, R. H. 1995)1

Great and vivid example

In Fooled by Randomness2, Nassim Taleb gives the following great example of the emotional effect when an investor is checking his net gains/losses over narrow timeframes versus long-term timeframes.

In this example, a retired dentist invest in a portfolio generating a great return with moderate volatility.

“A 15% return with a 10% volatility (or uncertainty) per annum translates into a 93% probability of success in any given year. But seen at a narrow time scale, this translates into a mere 50.02% probability of success over any given second[…]. Over the very narrow time increment, the observation will reveal close to nothing. Yet the dentist’s heart will not tell him that. Being emotional, he feels a pang with every loss, as it shows in red on his screen. He feels some pleasure when the performance is positive, but not in equivalent amount as the pain experienced when the performance is negative. […]

A minute-by-minute examination of his performance means that each day (assuming eight hours per day) he will have 241 pleasurable minutes against 239 unpleasurable ones. These amount to 60,688 and 60,271, respectively, per year. Now realize that if the unpleasurable minute is worse in reverse pleasure than the pleasurable minute is in pleasure terms, then the dentist incurs a large deficit when examining his performance at a high frequency.

Consider the situation where the dentist examines his portfolio only upon receiving the monthly account from the brokerage house. As 67% of his months will be positive, he incurs only four pangs of pain per annum and eight uplifting experiences. This is the same dentist following the same strategy. Now consider the dentist looking at his performance only every year. Over the next 20 years that he is expected to live, he will experience 19 pleasant surprises for every unpleasant one!”— Fooled by randomness

Related external links

Some relevant case studies:

  1. Benartzi, S., & Thaler, R. H. (1995). Myopic Loss Aversion and the Equity Premium Puzzle. The Quarterly Journal of Economics, 110(1), 73–92. doi:10.2307/2118511 (link)
  2. Fooled by Randomness, Nassim Taleb, 2001, Amazon link
2015-06-16T06:06:22+00:00

About the Author:

Julien Le Nestour
Applied behavioral scientist & international consultant — I am using the results and latest advances from the behavioral sciences—specifically behavioral economics—to help companies solve strategic issues. I am working with both start-ups and Fortune 500 groups, and across industries, though I have specific domain knowledge in banking, asset management, B2B and consumer IT, SAAS and e-commerce industries.