Expert Analysis and Commentary
Myopic Loss Aversion and the Equity Risk Premium Puzzle
Larry Swedroe Oct 12, 2016
Complementing the theory behind MLA is a number of laboratory experiments that have found evidence consistent with it. The structure of these experiments revolves around varying the frequency of feedback to subjects, and examining if the information provision impacts investment patterns. The underlying hypothesis tests if subjects with infrequent information invest more in a risky asset than subjects who receive feedback more frequently. In general, the literature reports that individuals who received infrequent feedback invested between 30 percent and 80 percent more in the risky asset than individuals who received more frequent information, a pattern consistent with MLA.
Boram Lee and Yulia Veld-Merkoulova contribute to our understanding of investor behavior through their study Myopic Loss Aversion and Stock Investments: An Empirical Study of Private Investors, which appeared in the September 2016 issue of the Journal of Banking & Finance. Following the evidence from prior studies, the authors used portfolio evaluation frequency, in addition to rebalancing frequency, as proxies for myopia. They then investigated the link between MLA and investor behavior.
To summarize their findings: “Those investors, who are highly loss averse and frequently evaluate investment performance and rebalance investment portfolios, tend to have low equity holdings in their financial portfolios, which is likely to lead to utility losses over investors’ lifetimes. However, once individuals establish their portfolio allocations according to their levels of both loss aversion and myopia, myopic loss aversion is no longer associated with further decreases in their levels of equity investment. Our results support the suggestion that long-term investment vehicles (such as defined contribution pension funds) should offer default asset allocations with higher proportions of equities in order to provide potential for more gains from market participation across a broader range of investors.”
Francis Larson, John List and Robert Metcalfe further contribute to the literature on the equity risk premium puzzle with their September 2016 National Bureau of Economic Research paper, Can Myopic Loss Aversion Explain the Equity Premium Puzzle? Evidence from a Natural Field Experiment with Professional Traders.
The authors were presented with an opportunity to depart from the traditional research approach when they partnered with Normann, a technology firm that beta tests trading platforms, to explore features of their new trading program. Within their beta test, they conducted a natural field experiment with professional FX traders around the world, who would be unaware that they were part of a scientific experiment when they made their investment choices.
Within this natural setting, the authors followed the spirit of previous literature by randomizing information feedback to determine whether MLA is evident in trader behavior. One set was randomized into a frequent information group (second-by-second price information) and an infrequent information group (price information every four hours). The authors’ findings were consistent with the hypothesis that professional traders exhibit MLA, and that this behavior leads to significantly lower profits. Specifically, Larson, List and Metcalfe found that traders receiving infrequent price information invested 33 percent more of their portfolio in risky assets, yielding profits 53 percent higher compared to traders receiving frequent price information. And their findings were statistically significant at the conventional 5 percent level.
This finding creates a significant puzzle in that “traders in the field constantly seek more frequent return information, yet more might actually mean less in terms of profits. Furthermore, even amongst those with many years of trading experience, the MLA effect is alive and well.” The authors concluded: “As a whole, our empirical insights provide evidence that MLA is a viable explanation for at least part of the equity premium puzzle observed in the literature.”
Second, all else equal, the less frequently you check the value of your portfolio, the more equity risk you should be able to take.
And third, the more frequently you check your portfolio, the more tempted you will be to abandon your investment plan in order to avoid the pain of seeing losses.
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