Thinking and Deciding

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Benartzi and Thaler (1995) proposed an explanation of this effect in terms of two
psychological phenomena, loss aversion (Chapter 11) and myopia (Chapter 17 —
myopia means nearsightedness). They called their explanation “myopic loss aversion.”
The value of stocks goes up and down over time, but the value of “safer” investments
such as government bonds changes very little. When the stocks go down,
investors see that as a loss. When they go back up, it is a gain, but (as we saw in
Chapter 11), “losses loom larger than gains.” This loss aversion makes people think
of the the entire sequences of gains and losses as a loss. They segregate the ups and
downs. If they integrated over time, they would see it as a gain.
Two experiments support this explanation (Gneezy and Potters, 1997; Thaler,
Tversky, Kahneman, and Schwartz, 1997). In both experiments subjects made investments
involving potential gains and losses. In one, for example, the stake invested
could be lost entirely, with probability 2/3, or it could return 2.5 times its
value, with probability 1/3. The expected value of this is positive, of course, but
most subjects invested very little in it. When the subjects were required, however,
to decide on a sequence of three investments in advance, they were more likely to
invest. They then realized that the losses were likely to average out, so that an overall
gain was fairly likely. The interesting thing is that both sequences went on for some
time. The subjects were making these decisions repeatedly. When the decisions were
made one at a time, subjects could easily decide to “bind themselves” to invest every
time, knowing that, in the long run, they would come out ahead this way.
We might also think of this in terms of disappointment and regret (Chapter 11).
When investors see their stock go down, they feel these emotions, more strongly
perhaps than the emotions of elation and rejoicing when the stock goes up. The trick
to good investing, then, is buy stock and don’t look. That is, do not look at the stock
market page. Or, if you look, steel yourself to doing nothing. Be warned, though:
This argument is now becoming well known among investors. The better known it
becomes, and the more people who accept it, the less it will work.
Another piece of the puzzle is inflation. Remember I said that the return on bonds
is around 1%. That is a little shocking, when the bonds say things on the front like
4% or 5%. But the bonds that say these things are issued when prices are increasing
at the rate of 3% or 4%, so their real value increases very little. Thus, during a
period of 4% inflation, the “nominal” return on bonds might be 5% and the nominal
return on stocks might be 11%. That ratio of 2.2/1 is nothing like the ratio of 7/1
in the real return (after inflation). If people think about the nominal return instead
of the real return, they might think that the additional safety of bonds is worth it.
Moreover, investors may not think so much about the uncertainty of inflation itself.
A bond that says 5% on its face might yield real returns that vary considerably over
time, depending on the rate of inflation. If investors ignore this, they will think of
the return as completely certain. Changes in the rate of inflation, however, can make
bonds almost as risky as stocks (especially if the value of stocks depends somewhat
on the rate of overall inflation).
Shafir, Diamond, and Tversky (1997) found evidence for both of these effects.
The first effect is the classic “money illusion,” in which people neglect inflation.