Wednesday, October 21, 2009

Myopic loss aversion

In reading Aswath Damodaran’s Strategic Risk Taking: A Framework for Risk Management (Wharton School Publishing, 2007), a very gentle introduction to a tough subject, I lingered over his discussion of how we seem to be hard-wired to pursue irrational risk management strategies.

One important finding from behavioral finance is that loss aversion becomes more pronounced as the frequency of a person’s monitoring increases, a phenomenon known as myopic loss aversion. In one experiment researchers ran nine lotteries. They provided feedback after each round to one group and provided composite feedback only after three rounds to the other group. People in the first group were willing to bet far less than those in the second group.

A 1997 paper co-authored by probably the best-known names in behavioral finance--Richard H. Thaler, Amos Tversky, Daniel Kahneman, and Alan Schwartz—explores this phenomenon in more detail. “The Effect of Myopia and Loss Aversion on Risk Taking: An Experimental Test” (available for download from Thaler’s faculty page) grounds myopic loss aversion in two behavioral principles. First, people are more sensitive to decreases in their wealth—in fact, twice as sensitive—than they are to increases in their wealth. Second, people engage in mental accounting, both cross-sectionally (for instance, “are securities evaluated one at a time or as portfolios”) and intertemporally (how often portfolios are evaluated). The upshot: “An investor who frames decisions narrowly will tend to make short-term choices rather than adopt long-term policies. An investor who frames past outcomes narrowly will evaluate his gains and losses frequently. In general, narrow framing of decisions and narrow framing of outcomes tend to go together, and the combination of both tendencies defines a myopic investor.” (p. 648)

In their experiment the researchers asked 80 undergraduates to imagine that they were the investment manager for a small college’s endowment and that they had to decide how to allocate its investments. They had only a binary choice—Fund A or Fund B. The students were not told about the composition or the risks and returns of the two funds, though in fact Fund A was a bond fund with a mean return per period of 0.25% and a standard deviation of 0.177% and Fund B was a stock fund with a mean return of 1% and a standard deviation of 3.54%. Subjects were randomly assigned to one of four conditions—a so-called monthly condition (actually 6.5 weeks) in which they had to make 200 decisions, a “yearly” condition (comprised of eight periods) in which they made 25 decisions, a “five-yearly” condition where they made five decisions (each of which was binding for 40 periods), and finally an “inflated monthly” condition. In this last condition “the returns were translated upward by 10 percent so that subjects always experienced nominally positive returns from both funds. Subjects in this condition were told that there was a high rate of inflation which was responsible for returns always being positive.” (p. 652) After each decision, the subject saw the results on a bar graph. At the end of the trials, each subject had to make a final allocation that would be binding for 400 periods.

The worst performer by far was the group that had to make the most decisions and that received the most feedback. The “inflated monthly” group had mean final results that did not differ significantly from the “yearly” and “five-yearly” group, indicating that if the risk premium is high enough even myopic investors will be more daring.

Perhaps not surprisingly, Damodaran reports that professional traders have been found to exhibit more myopic loss aversion than inexperienced subjects. As if they didn’t have enough problems already! I know this is a glib retort. Successful professional traders who take frequent small losses and monitor their positions constantly must have trained themselves to defy evolution and adopt rational risk management strategies. Otherwise, they would be middle managers or trading strategy pitchmen. The wannabe trader must learn to be less “human” and recognize that myopic loss aversion is the first, and perhaps last, step into fatal quicksand.

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