Myopic loss aversion
Myopic loss aversion (MLA) is a behavioral bias that combines loss aversion, mental accounting, and time horizon-based framing. The theory was proposed by Benartzi and Thaler in 1995 in a paper titled “Myopic loss aversion and the Equity Premium Puzzle”, which was published in the Quarterly Journal of Economics.
On this page, we discuss MLA and how it can be used to explain the equity premium puzzle.
Myopic loss aversion definition
Benartzi and Thaler use Myopic Loss Aversion (MLA) to explain the equity risk premium (ERP) puzzle. The equity risk premium puzzle is the empirical observations that, adjusted for risk, equities earn higher returns than other types of investments. Particularly in the United States over the past 100 years, equities have outperformed bonds by a very large margin. This difference cannot be explained by traditional finance (that is, plausible levels of risk aversion don’t yield that high a risk premium).
MLA argues that investors are loss averse and evaluate their portfolios too frequently. In the short term, losses are experienced more frequently than when examining performance over a longer time horizon. This short-term focus results in overreaction to short-term losses. The strong focus on short-term losses in turn means that investors require high return potential on equities to justify investing in equity. This explains why the equity premium is so high.
Overcoming myopic loss aversion
Is it possible to overcome this kind of loss aversion? Yes, it can be overcome by maintaining a disciplined well thought out process based on the future prospects of an investment, not perceived gain or loss.
We discussed the main idea behind MLA and how it may explain the equity risk premium (ERP) puzzle. Because investors focus on the short-term and experience big interim losses, they require high premiums to hold stocks.