“Our favorite holding period is forever.”
One of the core beliefs I hold in advising you and my other clients about your financial affairs is that significant decisions should be made in the context of decades not years. There are many reasons for this, but in the end, it’s because long-term decisions made with a short-term perspective usually work out poorly. This is for a couple of reasons – the big one being, I think, because such decisions are often made based on an emotional reaction, and emotion makes a poor counselor – at least in matters financial. This tendency is most apparent when things aren’t going well, which is when fear and despair frequently become the guiding counselors (“Make it stop, make it stop!”), but it can also be true when things are going too well, as they were in the late 90’s (“Everyone else seems to be getting rich, why aren’t I?”)
It’s usually difficult to “talk someone down off the ledge” after the emotions have taken hold (again, usually when things aren’t going well), and I find preventative inoculation to usually be a better strategy. Thus the reason for this document.
As you may know from previous conversations, I’m very interested in behavioral finance, which is the intersection of financial decision making and psychology. There have been many interesting and useful findings in this burgeoning field, but one of the over-arching findings is just how difficult it is for people in general to make rational, unemotional decisions about things related to money. With that in mind, this short article is going to explain, in part, why it’s so important to maintain a long-term perspective and why it can be costly not to.
Let’s start with a hypothetical portfolio that has certain estimated statistical characteristics. This portfolio will be used to create the table that follows based on the same approach used by Professors Shlomo Benartzi and Richard Thaler in their much referenced paper “Myopic Loss Aversion and the Equity Premium Puzzle” published in the Quarterly Journal of Economics.
In short, the following table shows the effects – both psychological and financial – caused by evaluating an investment portfolio over different time frames.
A couple of the items above require further explanation. The first is that, as the frequency of portfolio evaluation increases, the likelihood of seeing a negative return (a loss) also increases; conversely, the longer the time periods between evaluations, the greater is the likelihood of seeing a positive return (a gain). So, for example, if you were evaluating a portfolio such as our hypothetical portfolio every day, statistically speaking, you might expect that on just over half of those days (51.64% of the days) on average, to see a gain, and on 48.36% of the days to see a loss. Contrast this with evaluating such a portfolio every five years, where your statistical likelihood of seeing a gain increases from 51.64% to 96.03%.
Secondly, and of great significance, is the understanding of how people generally perceive losses versus gains. Nobel prize winner Daniel Kahneman and co-researcher Amos Tversky showed in their seminal paper, “Prospect Theory: An Analysis of Decision Under Risk, that people perceive the pain of a financial loss at two-and-a-half times the intensity with which they perceive the pleasure of a similar sized gain. Said another way, to the average person, making $25,000 feels about as good as losing $10,000 feels bad.
The way this is reflected in the Pain Unit and Gain Unit columns in the table above is best shown by an example using the first entry – the Hourly evaluation period row. If a person looks at his portfolio each hour for about seven market days (i.e., 58 hourly evaluations), statistically speaking, he might expect to see the portfolio “up” 29 of those times (50.06% x 58 evaluation periods) and “down” 29 times (49.94% x 58 evaluation periods). If we assign an “psychological gain unit” of 1 to each “up”, and an “psychological pain unit” of 2.5 to each “down” (since a loss is felt, on average, 2.5 times as much as a gain), he’ll have 71 “emotional pain units”, and 29 “emotional gain units” (or a pain/gain ration of 71/29) as shown above. To the average person, looking at his or her portfolio each and every hour, a pain-to-gain ratio of 71-to-29 is not conducive to good financial decision making.
Now, tying these two points together, it’s easy to see why it’s so hard to “stay the course” when evaluating a portfolio too frequently. Since the more frequently you evaluate a portfolio, the more likely you are to see a loss, and since losses “hurt” at 2.5 times comparable gains, looking at a portfolio too frequently is an almost sure-fire way to not be able to “stay the course.” This, of course, is because the overall emotional/psychological experience is likely to be much more negative than positive.
In a very interesting application of their initial data, Thaler and Benartzi then went on to show that the more frequently people evaluated their investment performance, the lower the returns they could expect to achieve, presumably for one of two reasons: either the short-term pain that they would, on average, be more likely to experience would drive them to make short-term, counter-productive investment decisions, or because they would ultimately “have to settle” for a more conservative portfolio – and with it the lower anticipated returns – in order to achieve the same level of emotional comfort as those who evaluated their portfolios less frequently. Thaler and Benartzi termed this the “psychological cost” of frequent evaluation.
Looking at the table from above one more time, the right-most column illustrates the expected “psychological cost” of evaluating our hypothetical portfolio too frequently. Those who evaluate (and react to) portfolio performance with any frequency more often than annually, on average, can essentially expect to earn nothing. Those who evaluated annually, can still expect to give up a sizeable portion (2.11%) of the hypothetical portfolio’s 8.28% return. It’s not until the evaluation horizon expands to at least two-and-a-half years or, preferably, five to ten years, that people can reasonably expect to make evaluations that will help them achieve returns consistent with their chosen portfolio’s actual long-term performance. A short summary of all if this would be to say that “frequent and/or short-term portfolio evaluation is likely to lead to behavior that results in poor long-term results,” with “short-term” being defined as anything less than two-and-a-half to five years.
A concern that frequently comes up when I speak to clients about the appropriate time horizon over which to evaluate investment performance is, “yes, but I’m . . . a) 60 years old b) 70 years old, and/or c) getting ready to retire and don’t have decades.” A couple of thoughts on this: First of all, for a person who is, say, 60 and/or about to retire, it’s quite possible that she will live as many years in retirement as she spent saving for retirement. If this is, in fact, the case, then not only is a decade a reasonable evaluation horizon, but three decades may be an even more reasonable evaluation horizon! Secondly, for a person who has a very short time horizon, say, a 95 year old – where the time horizon might realistically be only five years, then I would suggest that money’s not really the big issue here.
When I was sixteen years old and learning to drive, I very clearly remember trying to focus on the lane line just in front of my car and noticing that I frequently over-steered and, as a result, ended up driving somewhat erratically. I subsequently noticed, though, that when my visual focus was farther down the road – perhaps ten car lengths ahead or farther – that it was much easier to maintain the proper line. Not only was I a better driver for having learned this, I was a more relaxed driver, too. In light of the findings of Benzarti, Thaler, and others, I would suggest that this lesson may have implications for your long-term financial success as well.
So, with that said, this year is off to a rocky start. After 2003, the best overall market year in my ten year career, the early returns this year – combined with the specter of rising interest rates and world-wide security concerns – have clearly left the world financial markets somewhat unsettled. I obviously have no idea of where the markets will be a year from now or three years from now, for that matter, but I do know this: maintaining a long-term, lifetime focus with regard to the financial markets at-large, and more specifically, to your individual portfolio, is most certainly the right and prudent thing to do.
1. For the sake of this illustration, I’ll assume that this hypothetical portfolio has an arithmetic average return of 8.28% and an estimated standard deviation of 9.65%. Standard deviation is an estimated measure of portfolio volatility and risk.
2.Benzarti, Shlomo, and Richard Thaler, “Myopic Loss Aversion and Equity Premium Puzzle”, Quarterly Journal of Economics, Volume 110, Issue 1, Feb 1995, pp 73-92.
3. For those who are statistically inclined and curious about why the likelihood of seeing a negative return increases as the time horizon shrinks, it’s because the average expected return decreases in a manner inversely proportionate to the frequency of evaluation, whereas the standard deviation (the amount of expected fluctuation) decreases more slowly, inversely proportionate to the square root of the frequency. This, in essence, means the returns get closer to zero, but the band of possible outcomes doesn’t shrink as much, making it more likely to cross into negative return territory.
4. Kahneman, Daniel, and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk,” Econometrica, XXXXVII (1979), pp. 263-91