Myopia, or nearsightedness, is a common vision condition. Most of us are familiar with the term and know someone who cannot see distant objects clearly without the use of corrective lenses or eye surgery. Few people have heard of financial myopia, yet it is just as prevalent as nearsightedness (if not more). Financial myopia is less nearsightedness and more short sightedness. It’s not that investors lack the ability to view things at a distance, instead they choose to focus on short-term outcomes. We are all free to choose, but this choice can be costly.
Our Desire for Instant Feedback
Our physiological desire for immediate feedback (instant gratification) plays a significant role in our life, and influences financial myopia. The fresh baked chocolate chip cookies, the extra hour of sleep in the morning, the car you can drive away in today with no money down – all things that provide immediate pleasure to our physiological selves while delaying their costs. The incentive is strong and many times we will receive a small dose of dopamine, giving us the pleasurable feeling we desire. While we are unlikely to say “Wow, I just got a hit of dopamine”, we will recognize our mood may improve and/or we will experience temporary pleasure, or else we would not be influenced to engage in the activity. Economists refer to this as having a high discount rate. We overvalue the reward we receive today while undervaluing the price we will pay in the future.
In a similar fashion we are physiologically encouraged to evaluate our financial situations in the short term. The reward is a bit different. Instead of satisfying our sweet tooth, desire for more sleep or the thrill that comes from buying a new car, what investors really want, according to behavioral expert Dr. Daniel Crosby, is “simplicity, safety and surety”. In the case of financial myopia, investors really want surety…they want to know they are doing a good job and will reach their end goals. The illusion of control also influences financial myopia – the illusion that investors can use current news and market outcomes to determine what adjustments they should make to increase the surety of reaching their goals. The problem is many studies show this behavior results in lower returns, therefore less surety.
The financial media adds fuel to the fire. Their constant discussion about the big news story of the day, the sense of urgency they portray, the constant intraday quotations of market indices, and the experts predicting what the market will do in the near future all influence investors to focus on short-term outcomes. The financial media is there to get you to tune in, not to help you reach your goals. Viewer beware. Our physiology and the financial media influence financial myopia, regardless of our stated time horizon.
The Reality of Short-Term Market Focus
Stock market returns are largely random in the short term. Evidence includes the fact that experts cannot consistently predict the market, and fund managers with significant education and experience often cannot outperform an index. Daily market movements are largely influenced by hedge funds, high frequency traders and algorithms – not investors. Does it really make sense for investors seeking surety to be influenced by random outcomes? Consider the following:
1) Over a one-year time horizon the vast majority of your total return comes from random fluctuations in price. However, over a five-year period the majority of your return is driven by the growth in the company’s cash flow (fundamentals).1
If you are actually invested for a company’s future earnings, it may take time for those earnings to be reflected in the stock price.
2) A portfolio with an Expected Return of 15% and Standard Deviation of 10% has a 93% probability of producing positive returns in any one year. Yet that same portfolio has a probability of being positive in a given month of only 67%.2
In other words, a good long-term portfolio can be highly volatile and unattractive in the short term.
3) A good process may produce bad results in the short term. A bad process may produce good results in the short term. It is only over time that a good process will demonstrate good outcomes and vice versa.3
Short-term outcomes are not evidence of whether your investment strategy is good or not.
4) Over the past 20 years, six of the 10 best days for the S&P 500 occurred within two weeks of the 10 worst days.4
Allowing short-term outcomes to influence your investment strategy can be very costly.
Costs of Financial Myopia
Financial myopia entails both psychological and financial costs. The constant evaluation of short-term market performance can cause unnecessary anxiety, distraction from more productive activities and neglecting personal responsibilities. It can cause an investor who has a deliberate, thoughtful investment plan to throw it out because it fails to yield desirable results in the short term (even though it may achieve the goals in the long term).
In addition, financial myopia can cause a significant reduction in future return. Dalbar has found that, because of investor behavior (chasing performance and timing the market), investors significantly underperform their respective benchmarks. For example, over the last 20 years the average stock investor has underperformed the S&P 500 by four percentage points per year. Bond investors fared even worse. They underperformed the Lehman Aggregate Bond Index by five percentage points per year.5
While financial myopia may appease your short-term emotions and desires, it does so at a significant long-term cost.
How to Improve
Volatility is a core characteristic of investment markets. If you don’t like volatility and want to remain invested, you only have one option: Quit looking at it. Daniel Kahneman said it best, “Deliberate avoidance of exposure to short-term outcomes improves the quality of both decisions and outcomes.”6
We want and need instant feedback. Let us not deny our biological desires. But we can change our focus. Rather than focus on short-term returns as the feedback, we should instead focus on creating a customized investment plan and sticking to it, even when the sky is falling (or soaring). Following the crowd is easy. Sticking with a winning strategy even when it is losing is hard. That is your instant feedback. That is what makes you a great investor – you are able to stick with a plan even when the forces of greed and fear are causing everyone else to abandon ship.
References
1. James Montier – The Little Book of Behavioral Investing
2. Nassim Taleb – Fooled by Randomness
3. Michael Mauboussin – The Success Equation
4. JP Morgan – 2015 Guide to Retirement
5. Dalbar – 2014 Quantitative Analysis of Investor Behavior
6. Daniel Kahneman – Thinking Fast and Slow