Myopic Loss Aversion, Portfolio Monitoring,
and the Equity Risk Premium
Dave:Because of how badly I was doing in the market, I even consid-
ered giving up on stocks and sticking with bonds, although I know that
in the long run that is a very bad idea. How often do you suggest that I
monitor my stock portfolio?
IC:Important question. If you buy stocks, it is very likely that the value
will drop below the price you paid, if but for a short time soon after your
purchase. We have already spoken about how loss aversion makes this
decline very disturbing. However, since the long-term trend in stocks is
upward, if you wait some period of time before checking your portfolio,
the probability that you will see a loss decreases.
Two economists tested whether the “monitoring interval” affected
the choice between stocks and bonds.^26 They conducted a “learning ex-
periment” in which they allowed individuals to see the returns on two
unidentified asset classes. One group was shown the yearly returns on
stocks and bonds, and other groups were shown the same returns, but
instead of annually, the returns were aggregated over periods of 5, 10,
and 20 years. The groups were then asked to pick an allocation between
stocks and bonds.
The group that saw yearly returns invested a much smaller fraction
in stocks than the groups that saw returns aggregated into longer inter-
vals. This was because the short-term volatility of stocks dissuaded peo-
ple from choosing that asset class, even though over longer periods it
was clearly a better choice.
This tendency to base decisions on the short-term fluctuations in
the market has been referred to as myopic loss aversion. Since over longer
periods, the probability of stocks showing a loss is much smaller, in-
vestors influenced by loss aversion would be more likely to hold stocks
if they monitored their performance less frequently.
Dave:That’s so true. When I look at stocks in the very short run, they
seem so risky that I wonder why anyone holds them. But over the long
run, the superior performance of equities is so overwhelming, I wonder
why anyone doesn’t hold stocks!
IC:Exactly. Shlomo Bernartzi and Richard Thaler claim that myopic loss
aversion is the key to solving the equity premium puzzle.^27 For years, econ-
332 PART 4 Stock Fluctuations in the Short Run
(^26) Shlomo Bernartzi and Richard Thaler, “Myopic Loss Aversion and the Equity Premium Puzzle,”
Quarterly Journal of Economics, 1995, pp. 73–91.
(^27) See Chapter 8 for a further description of the equity premium puzzle.