An Intelligent Bet, Not Taken
In the 1960s the Nobel Prize‐winning economist, Paul Samuelson, offered his MIT colleagues a bet. Samuelson would toss a coin and allow each colleague to call heads or tails. If the colleague correctly called the result, Samuelson would pay them $200. If the colleague lost, they would be obliged to pay Samuelson only $100.
Although the odds dramatically favoured each person who had been offered the bet, none took it. One colleague astutely added “I won’t bet because I would feel the $100 loss more than the $200 gain.”
Samuelson correctly concluded that, according to economic theory, which assumes everyone acts with a view to maximizing their wealth, not taking the bet was an irrational act.
Notwithstanding the great economist’s conclusion, most people are inclined to identify with Samuelson’s colleagues who found the prospect of losing $100 on a single toss of a coin daunting. This is because, given a choice between risky outcomes, we are far more affected by fear of a loss than by the hope of a gain. Behavioural psychologists have labelled this mental bias myopic loss aversion. Myopic because we are all hardwired to worry about the immediate (i.e. short term) effect of our actions. And loss aversion because we regret losses, including investment losses, two to two‐and‐a‐half times more than we enjoy gains of a similar size.
Like all animals, humans react instinctively to situations as we do because of the way our brains have evolved. We have millions of years of evolution behind us. During more than 99% of that time, survival depended on short term concerns such as finding enough food to live on, and avoiding predators. Making a wrong move could prove fatal. Hence our instinctual fear of loss.
Consequently, when investing in the stock market, investors, regardless of their planning horizon, fear short term price volatility. This fear often trumps their knowledge that, over the long run, stocks increase in value and outperform other asset classes. Just like Professor Samuelson’s colleagues, even when the odds are clearly in their favour, people will often be incapable of making a rational investment decision.
If, as an investor, you cannot prevent yourself from focusing on the possibility of a short term decline in the market value of your investment portfolio, you will likely follow the conventional wisdom of putting some of your long term capital into bonds rather than stocks. Over time this will cost you money because, over the long run, stocks consistently outperform bonds. However, this strategy is likely to reduce the short term price volatility of your portfolio, which may allow you to sleep better at night. Your decision may be expensive and, in accordance with traditional economic theory, irrational ‐ but it is not unreasonable.
Professional investors have presumably set themselves the goal of maximizing their long term investment returns, and think of themselves as highly rational people. However, they are not immune to myopic loss aversion. Some equity fund managers elect to hold a high cash allocation ‐ a choice which, over the long run, will inevitably prove to be costly.
Perhaps they erroneously think that they can predict short term market movements, and time the market. If so, this raises another irrational mental bias, overconfidence in one’s ability to predict the future. The returns of these managers would, over time, be improved if their cash were to be allocated proportionately across their existing stock holdings or, for that matter, invested in an equity index fund. These professionals will often use expressionssuch as “keeping some powder dry” or “I’d rather be safe than sorry” to justify their cash allocation. Because most people focus far less on their likely long term investment return than on the possibility of a short term loss, these phrases tend to sound prudent rather than irrational. Myopic risk aversion has a grip on us all.
Ultimately, it is impossible to be purely rational when we are programmed not to be. But, to the extent that we understand our mental biases, we will be able, at the margin, to make better decisions. Over time, this will result in significantly higher returns ‐ whether we are investing in stocks or tossing coins.
A version of this edition of The Long View was published in the Globe & Mail on May 30, 2016.