Sunday, January 11, 2015

Myopic risk aversion, keeping investing clients happy

Studies have shown that over a 70-year period, stocks yield average returns that exceed government bond returns by 6-7%. Stock real returns are 10%, whereas bond real returns are 3%. However, academics believe that an equity premium of 6% is extremely large and would imply that stocks are considerably risky to hold over bonds. Conventional economic models have determined that this premium should be much lower. This lack of convergence between theoretical models and empirical results represents a stumbling block for academics to explain why the equity premium is so large. 

Behavioral finance's answer to the equity premium puzzle revolves around the tendency for people to have "myopic loss aversion", a situation in which investors - overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains - take a very short-term view on an investment. What happens is that investors are paying too much attention to the short-term volatility of their stock portfolios. While it is not uncommon for an average stock to fluctuate a few percentage points in a very short period of time, a myopic (i.e., shortsighted) investor may not react too favorably to the downside changes. Therefore, it is believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss. 

Seth Klarman in the most expensive investment book ever written "Margin of Safety" explained the difference between long term and short term thinking as follows: "" Loss avoidance must be the cornerstone of your investment philosophy. The avoidance of loss is the surest way to ensure a profitable outcome. This does not mean that investors should never incur the risk of any loss at all. Rather ‘Don’t lose money’ means that over several years an investment portfolio should not be exposed to appreciable loss of principal.

The goal is not to maximize returns in the short or medium term. “Outperformance” in one or more years may be irrelevant. That is because it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. In other words an investor is more likely to do well by achieving consistently good returns with limited downside risk than by achieving volatile and sometimes even spectacular gains but with considerable risk of principal.

An investor who earns 16 percent annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20 percent a year for nine years and then loses 15 percent the tenth year.

There is an understandable, albeit uneconomic, appeal to the latter pattern of returns, however. The second investor will outperform the former nine years out of ten, gaining considerable psychic income from this apparently superior performance. If both investors are money market professionals, the latter may also have a happier clientele (90 percent of the time, they will be doing better) and thus a more successful company. This may help explain why risk avoidance is not the primary focus of most institutional investors."
Comments, questions or E-mails welcome:

No comments: