Chas Craig, BridgeTower Media Newswires
The first three paragraphs below summarize the section on prospect theory found in chapter 7 of “Investment, A History” by Norton Reamer and Jesse Downing.
In 1979, Daniel Kahneman and Amos Tversky wrote a seminal paper in the field of behavioral finance describing what they call prospect theory, which shows how individuals are not the super-rational economic actors contemplated in classical financial models like the efficient market theory. Two central conclusions of their paper are that individuals exhibit loss aversion (experience greater pain from losses than pleasure from equal gains) and are more concerned with changes in wealth than the absolute level of total wealth. Subsequent research has drawn from the tenets of prospect theory to explain market anomalies. One such anomaly is the equity premium puzzle, which was first put forth in a 1985 paper by Rajnish Mehra and Edward Prescot.
The puzzle is that the excess compensation historically earned by investors to own riskier equities as opposed to risk-free T-bills seems excessive. One explanation of this phenomenon that builds upon prospect theory is myopic loss aversion, which was presented by Shlomo Benartzi and Richard Thaler in 1995. Benartzi and Thaler posited that investors who frequently (daily or weekly) check the value of their holdings will have diminished mental welfare compared to those that have longer evaluation periods (quarterly or annually). Reason being, individuals experience greater pain from losses than pleasure from gains, and over shorter periods the stock market exhibits randomness, gyrating up and down. However, over longer periods, a diversified portfolio of common stocks tends to increase in value.
The upshot of myopic loss aversion is that our psychological wiring makes it more likely that short-interval portfolio observers will make panicked sales than their more stoic, longer-interval observer peers whose feeling of loss aversion is diminished by the fact that equities tend to increase over longer time frames. This diminished loss aversion for the longer-interval observers makes it more palatable to hold equities. Therefore, if all investors examined their portfolios less frequently, they would demand a lower premium and the puzzle would be resolved.
It is important to note that the expected equity risk premium has declined meaningfully in recent years as equity valuations have steadily risen (higher than normal valuations are typically followed by lower than normal stock market returns) while T-bill yields have also increased. There are several reasons why the equity risk premium should rationally be lower than the long-term historical average, such as lower macroeconomic volatility and declining costs to own stocks.
Additionally, the widespread adoption of index investing in recent years, which we argued in our most recent column likely has both cyclical and secular dynamics, has probably also played a role in suppressing equity risk premiums owing to a diminished feeling of loss aversion among market participants. Since the basic premise of index investing is to take what the market gives you, ostensibly, people adhering to this approach take a long-term view of their investments, an admirable and usually profitable trait.
However, taking the long view is easy when the stock market moves mostly upwards, which has been the post-Financial Crisis experience. As Mike Tyson once elegantly put it, “everyone has a plan until they get punched in the mouth.”
It might be that the next time stocks go down meaningfully and stay down for a while individuals who adopted index investing in recent years will start logging into their brokerage accounts more frequently. If so, a higher degree of loss aversion is likely to creep back into the equity risk premium.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
