Myopic Loss Aversion
Myopic loss aversion. With market volatility up and investors rotating out of tech stocks into cyclicals spurred by rising bond yields I thought it would be a good idea to write about a topic that you may know from experience but perhaps not precisely, which is myopic loss aversion. I am not an expert on this topic. Indeed, there are a lot of research papers on myopic loss aversion by economic professors and I am not one. But to put it simply, myopic loss aversion is the tendency of investors who are loss-averse to evaluate their portfolios too frequently resulting in a short-term view of investing. I will go over an example of myopic loss aversion below. Furthermore, myopic loss aversion has a real affect on investor returns over longer periods of time. Are you guilty of this? I certainly look at my portfolio daily, but I am a financial blogger and need ideas to write about. However, I do not have a short-term view of investing since I am a dividend growth investor. By definition this requires you to have a long-term view of investing.
Loss Aversion is Real
What is loss aversion? Loss aversion is not the same as risk aversion. The graph below explains loss aversion well. The loss side of the curve is sloped more steeply than the gain side of the curve. Investors who are loss averse value gains less than losses of the same magnitude. An investor who is not loss averse, but values gains, and losses equally would exhibit behavior explained by a straight line where the slopes are the same for gain and loss side of the curve. Loss aversion is real not only in the stock market but also the real estate market. An example of myopic loss aversion is that many homeowners will avoid selling their house for a loss and take many months to lower the price hoping for a rebound in the real estate market.
Myopic Loss Aversion and Returns
Another way to put this is that myopic loss aversion is when investors are focused on the short-term reacting more strongly to negative losses than positive gains of equal magnitude and assessing their portfolios too often. This has real consequences as it causes investors who display myopic loss aversion to avoid riskier assets, e.g., equities, that have better returns over longer periods of time. In the U.S., equities have an annualized real return of about 7% over longer periods of time versus 1% on risk-free U.S. Treasury bills. In a second example, investors who exhibit myopic loss aversions will refer the U.S Treasury bills over equities despite the higher returns of the latter.
So, if you exhibit myopic loss aversion you are probably avoiding equities or weighing it very little in your overall portfolio. This is despite the fact that real returns on equities are much higher than real returns on U.S. Treasury bills or bonds for that matter over longer time periods. The risk of losing your principal in the short-term maybe even on paper and not a realized loss is too high if you display myopic loss aversion. I think those that lost money during the dot-com crash or sub-prime mortgage crisis may display this behavior. Certainly, some who experienced the Great Depression display this behavior. A friend of my parents would only invest in bonds and they needed to be fairly high investment grade. The fear of losing principal was too great to invest in stocks.
Myopic Loss Aversion and Today’s Market
Now let’s get back to my opening paragraph where I was talking about today’s market. The go-go tech stocks of today are volatile. For instance, Tesla (TSLA) has a beta of over 2.0 so it is twice as volatile as the broader market. I attribute this at least in part to myopic loss aversion. The fear of losses causes traders to sell and exit to cash.
But what about dividend growth investors? Well, the interesting part is that academic research shows that investors who display myopic loss aversion are willing to accept more risk if they evaluate their portfolios less often or if the payoffs (returns) are increased enough to eliminate losses. In my mind, this sounds a lot like a buy and hold dividend growth investor who checks his or her portfolio maybe quarterly or annually. From the perspective of eliminating losses, that is not possible in the stock market since your principal is at risk. But over longer periods of time the advantage of dividend growth investing is that it can generate a passive income stream and decent total returns as you build to your first $100,000, which is the hardest, and beyond. If you need some examples of investors who do not exhibit myopic loss aversion, I just published my fourth Millionaire Interview about Gen X Investor.
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Chart or Table of the Week
One thing about this year’s market is what worked in 2020 may not be working in 2021. One stock I want to highlight is Costco Wholesale (COST), the warehouse retailer, that seemingly everyone loves. The stock did well in 2020 on the strength of its business model, expanding delivery, and a special dividend. But Costco is in correction territory in 2021 at over -15% and the P/E has come back down to nearly 31X. This is high but Costco was trading well above that at the end of 2020.
The company has raised the dividend for 16 consecutive year making it a Dividend Contender. The payout ratio is only 28%, which is excellent. This is a stock that is rarely trading cheaply. It did reasonably well during the sub-prime mortgage crisis and obviously during the COVID-19 pandemic. The screenshot below is from Stock Rover* and shows the dividend growth and special dividend.
Dividend Increases and Reinstatements
Horace Mann Educators (HMN) increased the dividend 3.3% to $0.31 from $0.30 per share quarterly. This is the 11st yearly increase in a row. Horace Mann is a Dividend Contender.
Dividend Cuts and Suspensions List
I updated my dividend cuts and suspensions list last week. The number of companies on the list has risen to 518. We are well over 10% of companies that pay dividends having cut or suspended them since the start of the COVID-19 pandemic.
The following companies were added to the list this past month (February 2020): JD Bancshares (JDVB), Pzena Investment Management (PZN), DHT Holdings (DHT), Healthpeak Properties (PEAK), Corby Spirit and Wine (CBYDF), Antero Midstream (AM), and Danone S.A. ADR (DANOY).
Dow Jones Industrial Averages (DJIA): 31,496 (+1.82%)
NASDAQ: 12,920 (-2.06%)
S&P 500: 3,841 (+0.81%)
The S&P 500 is trading at a price-to-earnings ratio of 38.1X and the Schiller P/E Ratio is at about 34.8X. These two metrics up slightly in the past week. Note that the long-term means of these two ratios are 15.9X and 16.8X, respectively.
I continue to believe that the market is overvalued at this point. I personally view anything over 30X as overvalued based on historical data. Note that we are near 40X and valuation levels near the top of the dot-com era. However, the market is faced two tough weeks due to rising interest rates.
S&P 500 PE Ratio
Shiller PE Ratio
Stock Market Volatility – CBOE VIX
The CBOE VIX measuring volatility fell more than three full percentage points this past week to 24.66. The long-term average is approximately 19 to 20.
Fear & Greed Index
I also track the Fear & Greed Index. The index is now in Neutral at a value of 51. This is up about 3 points this past week.
There are seven indicators in the index. They are Put and Call Options, Junk Bond Demand, Market Momentum, Market Volatility, Stock Price Strength, Stock Price Breadth, and Safe Haven Demand.
Junk Bond Demand is indicating Extreme Greed. Investors are accepting 2.07% yield over investment grade corporate bonds. The spread is down further from recent levels indicating that investors are taking on more risk.
Stock Price Strength is signaling Greed. The number of stocks hitting 52-week highs compared to those hitting 52-week lows is at the upper end of its range.
Market Volatility is set at Neutral. The CBOE VIX reading of 24.66 is a neutral reading.
Stock Price Breadth is indicating Neutral as advancing volume is 5.13% more than declining volume on the NYSE. This is middle of its range over the past two years and the indicator is rising.
Market Momentum is indicating Neutral. The S&P 500 is 6.09% over its 125-day average. This is above the average over the past 2-years.
Safe Haven Demand is in Fear. Stocks have outperformed bonds by 2.39% over the past 20 trading days. This is near the weakest performance over the past 2-years.
Put and Call Options are signaling Extreme Fear. In the last five trading days, put option volume has lagged call option volume by 51.87%. This is amongst the highest level of put buying in the past two years.
The seasonally adjusted final IHS Markit US Services PMI Business Activity Index registered 59.8 in February, up from 58.3 in January. The February PMI showed the fastest expansion of business activity since July 2014. The upturn in output was supported by an increase in new orders – which grew at their steepest pace since 2018. There was only a small rise in employment. Businesses also increased their selling prices at the second fastest rate in 11 years, contributing factors include elevated supply-chain prices and PPE expenses. Business confidence did moderate with concerns over the ongoing adverse effects of the pandemic.
The Energy Information Administration reported that U.S. crude inventories were up by 21.6 million barrels for the week ended February 26th. Refineries operated at 56.0% of their operable capacity. Inventories are about 3% above the five-year average for this time of year. Total commercial petroleum inventories decreased by 2.8 million barrels. Total products supplied was down 4.2% from the same period last year, averaging 19.6 million barrels a day. Over the past four weeks, motor gasoline product supplied was down 11.8%, distillate fuel product supplied was up 5.8%, and jet fuel product supplied was down 24.2% as compared to the same four-week period last year.
The Labor Department reported an additional 379,000 jobs were added in February as the unemployment rate dipped slightly to 6.2% from 6.3%. The February figure was better than the 166,000 jobs that were added in January and the loss of 306,000 in December. Employment in leisure and hospitality increased by 355,000. Employment declined in state and local government education, construction, and mining. The number of unemployed remained at 10.0 million, the long-term unemployed stayed at 4.1 million, and the labor force participation rate remained at 61.4 %. The long-term unemployed currently account for 41.5% of the total unemployed.
Thanks for reading Myopic Loss Aversion – Dividend Power Week in Review!
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Prakash Kolli is the founder of the Dividend Power site. He is a self-taught investor, analyst, and writer on dividend growth stocks and financial independence. His writings can be found on Seeking Alpha, InvestorPlace, Business Insider, Nasdaq, TalkMarkets, ValueWalk, The Money Show, Forbes, Yahoo Finance, and leading financial sites. In addition, he is part of the Portfolio Insight and Sure Dividend teams. He was recently in the top 1.0% and 100 (73 out of over 13,450) financial bloggers, as tracked by TipRanks (an independent analyst tracking site) for his articles on Seeking Alpha.