Allan Williams: The madness of myopia

The human brain helps us make decisions under conditions of uncertainty, but nothing could have prepared us for the complexity of the sharemarket.
We are ill-equipped and exposed to emotions with the potential to destroy wealth faster than the meanest bear market.
One insight that can make a big difference to long-term financial planning is that, on average, shares have outperformed cash and fixed-interest investment by around 5-7 per cent annually.
The return, above the cash rate, from shares is called the equity risk premium, but we'll call it The Prize.
Say you invest $100,000 today and received a 4 per cent return for 30 years, compounded monthly. Ignoring inflation and taxes and assuming you re-invest all income, after 30 years you have $331,350.
What if you could turn that $331,350 into more than a million dollars?
If you invest the same amount of money for the same period, with an average return 5 per cent higher, at the end of the 30 years you come away with $1,473,057. Suddenly your retirement is much brighter.
By investing in a quality, diversified portfolio of shares, having a long-term outlook and avoiding knee-jerk reactions to short-term volatility, it's actually quite easy to capture The Prize. Yet it eludes so many.
Why is The Prize so generous? In their 1995 paper, Myopic loss aversion and the equity premium puzzle, Shlomo Benartzi and Richard Thaler put forward a convincing explanation called "myopic loss-aversion".
Presume you have the choice of investing in either of the following assets:
A risky asset expected to return an average 7 per cent annually, but subject to all the ups and downs of the market.
An asset that pays a guaranteed 1 per cent annually.
Which would you pick? For a single-year investment, an allocation to the risky asset would be considered a gamble. Across five or more years, however, the risky asset would start to look attractive. The length of time involved would generally allow for markets to recover from a fall.
Time is an important factor in investment decisions. Suppose, even if you have invested for 30 years, you receive a report every six months from the manager of the risky asset showing you its price. Would these performance updates affect your decisions?
Research says it would. If you don't like what you see, you'll sell the risky asset, despite its long-term prospects.
This "myopic loss aversion" means investors treat the long term as a series of short terms.
The more frequently investors evaluate their returns, the more likely they are to make inappropriate short-term decisions.
That explains one of the reasons why The Prize from sensible, long-term sharemarket investment is as high as it is - a fact that astute, emotionally strong investors can benefit from.
- Allan Williams is an adviser with Spicers Portfolio Management