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Myopic Loss Aversion

Myopic Loss Aversion

February 24, 2022
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“Power does not corrupt. Fear corrupts... perhaps the fear of a loss of power.” – John Steinbeck

                As we start a new year, it’s a good idea to take stock of your current state of mind. With market volatility increasing in the fourth quarter of 2021, it seems relevant to discuss loss and how it can impact us emotionally and mentally. As I see it, losing money in the investment world falls into two categories: unrealized and realized. Unrealized losses occur when your position is at a loss, but you still hold it. A realized loss, on the other hand, is when you sell your position and actualize the loss of the investment. As we explore loss in the context of risk, gain, objectives, and time, it will be important to reference these two basic definitions.

                Everyone begins investing with the intention of making money and consequently risk is often overlooked. If you were asked, how do you define risk? you might come up with an answer, but understanding risk in investing is tough because it’s constantly changing. There are many types, including inflation, volatility/standard deviation, liquidity, and credit, to name just a few. The risks that you consider can influence the implications of loss. For example, if your bond investments have low credit quality, you could risk default which would be a catastrophic outcome. In this scenario, however, if you had the time and financial wherewithal to weather the storm, the default risk might have eventually evaporated entirely.

                The ability to gain wealth in the stock or bond markets is easily achieved although the magnitude of each type of gain is different. It’s possible that the ease in which money can be made in the market causes some people to abandon all hope at only the slightest amount of unrealized loss. On average, most retail investors focus more on their losses than on their gains. When this myopic (short-sighted) relationship occurs, the investor is influenced by emotion instead of by logic and reason. Looking at 2020, we rolled over an annualized return from 2019 in the S&P 500 of more than 30%, yet with COVID-19 and lockdowns, we experienced a -19.6% loss within the first quarter, surely a show of extreme volatility. For most this tested the bounds of reality and led to large sell-offs throughout the last part of the first quarter. However, if you stayed invested through the entire year, you would have gained 18.4%. At times investors believe that they’ve lost power over their investment outcome. Just waiting for time to pass can sometimes be the best cure for myopic thinking.

                Time (not timing) is also an important factor. There are instances when timing can pay off, but if you know how much time you have to invest, you can typically weather short-term volatility. When assessing your performance, you should also consider time and frequency. It is normal for people to get tunnel vision and pull out during poor performance periods without considering the wider view. For example, if your trees lose their leaves in the fall, do you cut them down because they look ugly? Clearly not because you know that this is a normal occurrence with trees. The frequency with which you review your investments should be consistent and disciplined; you should consider both short and long-term views at least every month or every quarter. Clipping a long-term winner and turning an unrealized long-term gain into a realized gain because of short-term unrealized losses is foolish.    

                With any investment a healthy sense of fear and greed is good; however, it is crucial to stay focused on your goals and objectives. Considering the impact of risk, gain, and time can improve your investing outcomes. It can also lead to more consistency and potential for less loss. As we move into 2022, I hope you will consider the elements discussed so you experience better outcomes and less stress.

 

PLEASE CONTACT PETER WALDRON TO SCHEDULE A COMPLIMENTARY REVIEW OF YOUR FINANCIAL SITUATION: 925-786-7686 or peter.waldron@lfg.com

Peter T. Waldron, California Insurance License #0E47827, is a registered representative of Lincoln Financial Advisors, a broker/dealer, member SIPC, and offers investment advisory services through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, Waldron Partners, 3201 Danville Blvd., Suite 190 PO Box 528, Alamo, CA 94507. Waldron Partners is not an affiliate of Lincoln Financial Advisors. Insurance is offered through Lincoln Marketing and Insurance Agency, LLC and Lincoln Associates Insurance Agency, Inc. and other fine companies. This material is for use with the general public and is designed for informational or educational purposes only. It is not intended as legal, tax, or direct investment advice. Lincoln Financial Advisors does not offer legal or tax advice. CRN-4027875-122321