Back in July, we published a Bright Paper: Loss Aversion and Client Portfolios: Strategies for addressing a powerful bias. The paper has generated much interest – and a lot of comments. That’s not surprising, perhaps given the volatility of equity markets over the past two years. Many advisors have found the behavioural perspective a useful one, for the simple reason that the better we understand behavioural tendencies, the better we understand our clients and how to serve them.

As we approach the fourth quarter of 2016, with annual portfolio performance discussions on the horizon, the topic of loss aversion is worth keeping top of mind. One aspect of the bias – “myopic loss aversion” – is a specific form of loss aversion, where the greater sensitivity to losses than gains is compounded by a client’s frequent review of their portfolio performance.

LOSS AVERSION REFRESHER

Before we look at myopic loss aversion – and why the frequent checking of investments and portfolio balances can be problematic – here’s a quick recap of the loss aversion principle.

Our recent Bright Paper discusses the Nobel Prize-winning research of psychologists Daniel Kahneman and Amos Tversky, who discovered that the pain people feel from a loss is about twice as strong as the pleasure felt from an equivalent experience of gain.1

Putting this in a portfolio context, the strong desire to avoid loss could have two negative impacts for clients:

  1. Cause them to miss out on portfolio growth opportunities (by investing too conservatively)
  2. Take emotional actions after a loss – such as exiting the market entirely – that are contrary to their long-term investment goals.

In short, our tendency is to avoid situations that could lead to a loss, even if the situation could potentially mean even greater rewards. For long-term investors faced with short-term market volatility, this defines the essence of successful investing: ignore our natural bias to avoid short-term (and often temporary) paper losses and focus on the much greater potential for long-term gains instead.

The Myopic Loss Aversion Challenge

The problem today is that it’s harder than ever to focus on this long-term potential, because the ability to view, analyze and react to short-term market impacts is greater than ever.

Technology is the great enabler. According to research by technology service agency Catalyst2, 68% of Canadians in 2015 owned a smartphone, compared with 55% just a year earlier, a year-over-year increase of 24%. The Catalyst research revealed that for those who use their smartphones as their primary device (which Yahoo research3 suggests is two-thirds of smartphone users), more than 50% used it at home to check bank accounts and stock quotes.

Clearly, there’s a lot of “financial checking” going on, and that means the short-term impact of markets’ movements is more front-and-centre than ever before. While I believe this engagement with our finances has many positives – greater awareness, fewer surprises, and the opportunity to take action – the negatives of frequent checking can be significant.

MYOPIC LOSS AVERSION – A CLOSER LOOK

The key negative to frequent checking is a creation of the desire to move to short-term “safe havens” that can hamper long-term growth.

Research4 has shown that those who check performance frequently stand a greater risk of reducing their equity exposure over time, due to the unsettling nature of the performance fluctuations they observe.

The graph below shows results from a study where investors under simulated conditions made portfolio decisions. One group received portfolio feedback on a monthly basis; the other, on a yearly basis. It’s obvious the myopic loss aversion bias had a significant impact when portfolio performance was monitored monthly, as exposure to growth assets is much lower when the portfolio was checked more frequently.

Monthly: Bonds 59% ; Stocks 41% | Yearly: Bonds 30% ; Stocks 70% | Note: In the study, subjects were assigned simulated conditions that were similar to making portfolio decisions on a monthly or yearly basis. Source: Thaler, Tversky, Kahnerman, Schwartz, 1997.

STRATEGIES TO COUNTER MYOPIC LOSS AVERSION BIAS

While the myopic loss aversion bias is a real one, it’s by no means insurmountable. There are a number of strategies you can use to counter the impact of technology and how frequently your clients check portfolio balances and performance. Here are three to consider:

  1. Communicate – especially during the bad times. By proactively communicating with clients during the bad times of volatility – when they’re apt to take actions that are contrary to their long-term interests – you can reassure them they’re on the right track during these inevitable short-term market declines.
  2. Educate on the need for growth. Don’t underestimate the need to show clients why exposure to equities is critical to achieving long-term portfolio goals. This includes after the initial education you provide at the time you establish the portfolio. You can discourage overly frequent reviews of portfolio performance by clients and provide context to current market performance. This will help them avoid issues of myopic loss aversion that can trigger a desire to exit important market investments.
  3. If needed, reassess risk tolerance. Risk tolerance questionnaires aren’t flawless. Clients may think they can weather portfolio declines on day one, but the first real test can show a far greater level of discomfort than they realized. And client situations can also change, creating more discomfort with short-term volatility. If you find clients frequently questioning portfolio declines and clearly uncomfortable with what’s happening in the markets, it’s likely time to perform another risk assessment. Rebalance their portfolio as needed based on the results, including wealth products that offer some insurance guarantees.

By acknowledging and addressing the myopic loss aversion bias that continues to grow as technology creates even easier online access, you can help ensure clients stay invested and achieve their long-term financial goals.

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1 Kahneman, Tversky (1979, 1992).

2Catalyst, “With growth comes change: the evolving mobile landscape in 2015” http://catalyst.ca/2015-canadian-smartphone-market/

3 Yahoo Flurry Insights, http://mobilesyrup.com/2015/11/11/canadians-spend-7-million-hours-using-apps-per-month-says-report/

4 Kahneman, Tversky (1979, 1992).

Rocco Taglioni, Senior Vice-President, Head of Distribution, Individual Insurance and Wealth, is responsible for the overall leadership of Sun Life Financial’s distribution organizations across its Retail business in Canada. His role encompasses the leadership of the distribution company, as President Sun Life Financial Distributors Inc., as well as the Insurance and Wealth wholesaling sales organizations. Through the various leadership teams he oversees the development, direction, and execution of the Distribution strategies centered on wealth management, protection, retirement, and estate and financial planning.

Since joining Sun Life in 2004, Rocco has held various executive leadership roles, including Vice-President Business Development, Group Benefits; Head of Individual Wealth Management; Senior-Vice-President, Client Solutions; and most recently Senior Vice-President, Distribution and Marketing, Individual Insurance and Wealth. Throughout his tenure at Sun Life, Rocco has led various business strategies centered on building, transforming, and evolving organizations and teams to drive higher levels of performance and success.

Rocco has 36 years of experience in strategic leadership in the insurance and investment industries. He has served on and is a member of a number of boards. Rocco is currently President and Chair, Sun Life Financial Distributors (Canada) Inc. and is a member of the Sun Life Financial Investment Services (Canada) Inc. board. He is a member of various industry associations, including Advocis, GAMA Canada, the Canadian Pension and Benefits Institute, and the Association of Canadian Pension Management.

Rocco holds a Bachelor of Arts in Economics from York University.