Less Pain, More Gain
Summary Pain felt from losses far exceeds joy caused by gains — this psychological asymmetry is called loss aversion. The more often you check your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. If these emotions get the better of you, it can lead you to make investment decisions that you may later regret. This is why investors would do better (and be happier) if they monitored their performance less frequently. If it bleeds, it leads — bad news makes news; good news is no news. That’s the motto of today’s media. It’s no wonder people tend to think the world is always getting worse. But this asymmetry between bad and good is a much broader phenomenon. Our brains are in fact hardwired with a “negativity bias” — that is, we notice, remember, and give more importance to negative things than to positive ones. It’s why one little thing can ruin a good day. Why a reputation that takes decades to build can be destroyed by one mistake. Or why a single cockroach will completely wreck the appeal of a bowl of cherries, while a cherry will do nothing for a bowl of cockroaches. “Loss aversion,” or the tendency to weigh losses more heavily than gains, is another way this negativity bias manifests itself. Consider the following question: You are offered a gamble on the toss of a coin. If it comes up heads, you win $1,500. If it comes up tails, you lose $1,000. Would you accept this gamble? Although this gamble has a positive expected value of $250, you probably dislike it. And you’re not alone — for most people, the fear of losing $1,000 is more intense than the hope of gaining $1,500. In fact, numerous studies have shown that the average person won’t accept this gamble unless the potential gain is about $2,000, twice as much as the loss. This led researchers to famously conclude that “losses are twice as painful as gains are pleasurable.” That asymmetry between losses and gains has important implications for all investors. For instance, the more often you look at your portfolio, the more losses you’ll see, and the more emotional discomfort you’ll feel. The best solution, therefore, is to look at your portfolio as infrequently as possible. A simple example can illustrate this point. Let’s say you had invested $10,000 in the S&P 500 (NYSEARCA: SPY ) in January 1980. By the end of 2014, this would have grown to roughly $481,489 (which includes reinvested dividends) — an attractive return of 11.71% with a reasonable 16.76% volatility per annum. That return/volatility combination translates into a 76% probability of making money in any given year (and a 100% probability in any 10-year period). Sounds pretty good, right? But if you looked at your portfolio on a more frequent basis — say every hour — you’d have observed it making money only 50.65% of the time. In other words, even though you only had a 24% chance of losing money in any given year, the same portfolio when observed on an hourly basis would have disappointed you with losses 49.35% of the time. And since losses hurt twice as much as gains feel good, you’d be incurring a large emotional deficit by examining your performance at such a high frequency. This emotional deficit can actually be approximated mathematically. Simply assign a score of 1 for each positive return observation and a score of -2 for each negative return observation and then add them together to get a “reward-to-pain score.” The higher the score, the better. The table below shows that it’s not until we reach the annual portfolio observation that the reward-to-pain score turns positive. Checking your portfolio more frequently than that would cause you more emotional harm than good — which is why I shake my head when I see investors constantly monitoring their portfolios on their smartphones or tablets. It’s always easy to tell who’s making money and who isn’t (the look on their face says it all). Chances of Positive Returns on an S&P 500 Portfolio (1980 – 2014) Notes: (1) The above calculations assume that stock market returns are normally distributed (an imperfect but workable assumption). (2) Volatility is measured using the standard deviation of annual returns. (3) There are, on average, 252 trading days in a year and 6.5 hours in a regular trading day. (4) Reward/pain score = (1*probability of price increase) + (-2*probability of price decline). Source: A North Investments (“ANI”) Now let’s view this from another angle. The more frequently you look at your portfolio, the more randomness you’re disproportionately likely to get. In other words, you’ll see the short-term volatility of the portfolio, not the returns. This can be illustrated by taking the ratio of volatility to return at different observation frequencies (as shown in the table above). At a yearly observation frequency, the ratio is about 1.4 — or 59% randomness, 41% performance. But if you looked at the very same portfolio on an hourly basis, as many investors have a tendency to do, the composition changes to 98.4% randomness, only 1.6% performance. Yes, that’s right — you get over 60 times more randomness than performance! You’d be drowning in randomness and incurring emotional torture; it’s nearly impossible to make rational investment decisions under such conditions. The obvious moral here is that investors would do better (and be a lot happier) if they monitored their performance less frequently. Because the less often you look at your portfolio, the more likely it is that you’ll see gains. On the other hand, checking your portfolio more frequently increases the likelihood that you’ll see losses and hence suffer emotional distress. Avoiding the latter and focusing on the former prevents you from being fooled by short-term randomness — making it easier to stick to and achieve your long-term financial goals. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.