Myopic loss aversion and remembering one’s strategic asset allocation

Analysis - 7/26/2017

There is a direct link between the frequency of checking one’s portfolio and risk-taking. By drawing up a strategic asset allocation and keeping it in mind, investors can better accept the turbulence encountered by individual assets.

The use of smartphones alters our perception of financial risks!

This is the conclusion of a study by two UCLA researchers, Uri Gneezy and Jan Potters. The digital world is changing the pace at which investors check the value of their portfolio. Whereas they used to do so once a month or even once a quarter, now the exercise has become far more frequent. This increases the probability of noting that their portfolio has run into turbulence. And such market dips, which in the vast majority of cases are temporary, tend to make investors forget the strategic allocation they devised with a view to dividing up their assets optimally. This is called ”myopic loss aversion”. It results from the lag between an investor’s time horizon and how often he checks up on his portfolio. Generally speaking, the longer the interval the more the investor will be tempted to overreact to short-term losses. Gneezy and Potters demonstrated a direct cause-and-effect link between the frequency of monitoring a portfolio’s return and the acceptance of risk. The more an investor checks how his investments are performing, the more sensitive he is to losses. He then tends to reduce his portfolio’s average risk level.

A study by researchers at the University of Jerusalem pointed up another consequence of myopic loss aversion: checking up on investments frequently reduces one’s sense of well-being. Thus an investor can be tempted not only to take less risk but also to move in practically the opposite direction from a financial standpoint. Namely, he is liable to overweight assets that are illiquid, are assigned a value infrequently (or not assigned any value at all) and are therefore much easier to handle emotionally. Such assets include rental real estate, which investors rarely diversify by region or segment (e.g. residential vs. retail or office space) and are often not easy to sell when necessary.

The two consequences of myopic loss aversion that we have just described result in highly respectable choices. But while these choices are “optimal” for the investor from an emotional point of view, they rarely make sound financial sense. In other words, having a long investment horizon should make it possible to obtain better returns than those which are actually pocketed in the end. This is particularly true in the present context of historically low interest rates in most developed countries.

How can one fight off fear and not yield to the stress that comes from being bombarded with information?

A solution to this problem is to review one’s strategic asset allocation regularly. This is the allocation designed to maximise long-term performance (over more than 10 years) by diversifying assets efficiently— the only proven way to preserve wealth.

An investor’s strategic asset allocation is a roadmap that he can consult in order to keep his bearings and not fall into the trap of focusing on any one component of his portfolio that is behaving disappointingly near term.

To each investor his own allocation, since it will depend on his performance objective, risk appetite (the level  of loss that he can tolerate in a given time horizon) and cash needs if any (for example, to finance a project).

The aim is to build a sturdy foundation with interlocking assets that have different risk/return ratios, different degrees of liquidity, different sensitivity to economic factors and thus, in all probability, different degrees of correlation to each other. This last notion is important as some assets move in sync and therefore do not provide diversification. Such assets are said to be correlated. Others behave in totally separate ways and so are referred to as uncorrelated.

A strategic allocation that is well diversified across liquid and less liquid assets, with little overall correlation, protects an investment portfolio from the unexpected and sometimes significant movements of a single component.

 

Here are a few examples to illustrate these notions

Real Estate and Bonds:

The chief asset is unquestionably real estate. Our earlier reference to its being illiquid was not meant to rule it out. But one would be wise to spread the risks inherent in individual properties. Investment funds can do this by providing access to underlying assets which would be hard to acquire by oneself and to a large number of them (also difficult to acquire by oneself). Some funds moreover offer the dual benefit of exposure to the real estate market via shares that are immediately negotiable.

Rendement réel sur l’obligataire (%) durant des périodes extrêmes, 1900-2016

Historically returns on property investments have ranged between those delivered by bonds and equities respectively. What is special about real estate is its loose correlation to fixed income. This stems from the natural protection it affords against inflation, since rents in many countries are indexed to the cost of living.

Bonds, in contrast, deliver their highest returns in periods of low inflation or even deflation. Their biggest strengths are that they are liquid and historically feature little correlation to equities and real estate.

Equities and Private Equity:

Despite stockmarkets’ dramatic recovery since the turmoil of 2000-2008, their average performance over the past 16 years has been mediocre and this is unusual from a historical perspective. It is interesting to compare this low overall return with the one observed in the previous 20 years, from 1980 to  1999. To some extent, the fabulous gains delivered by equities in that period explain why they did less well in subsequent years.

Even so, equities and private equity are the combined asset class which best reflects the economic performance of companies and which is best equipped to generate absolute returns. This is illustrated by a longer look back:

Rendement réel sur l’obligataire (%) durant des périodes extrêmes, 1900-2016

 

Although the correlation between private equity and listed equities is uneven over time, these assets are clearly helped and hurt by the same economic situations.

In the long run, however, private equity carries an illiquidity premium compared with listed equities. This alone justifies including it in a strategic allocation but is not its only benefit. It provides access to market segments that simply cannot be had via publicly traded shares.

 This brief introduction to strategic asset allocation is not meant to cover all the asset classes. Our aim is to remind readers of some of the broad guidelines that can be easily forgotten when emotions come into play:

  • Diversify, diversify, diversify! Each asset class has a role in a portfolio.
  • Keep the bigger picture and the long term in mind.Follow the roadmap that your strategic allocation represents, instead of dwelling on that “sore spot” when you check up on your investments. Often as not there will be one! It is vital not to be taken aback by the behaviour of a single asset. What is also really important is to know the historical risk/ return profile of each asset (risk being its volatility, maximum drawdown or degree of illiquidity).

Muriel Tailhades
Chief Investment Officer
Edmond de Rothschild (France)

 

 


This analysis is an extract from the first House View published by Edmond de Rothschild. 

This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes. 

Access the other analyses presented in this publication: 

 


*Source: Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists, Princeton University Press and subsequent research

  1. Shlomo Benartzi PD professor, UCLA Andersen School of Management. “The neglected variable affecting portfolio choices”
  2. Gneesy and Potters. “An experiment on risk taking and evaluation periods.” The Quarterly Journal of Economics (1997)
  3. Galai and Sade, Jerusalem school of business. “The Ostrich Effect and the relationship between the liquidity and the yields of financial assets”
  4. Elroy Dimson, Paul Marsh and Mike Staunton, “Triumph of the Optimists”, Princeton University Press and subsequent research

 

 


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