Asset AllocationSeptember 22, 2016

How Short-Term Noise Affects Risk Taking

Fewer updates on price movements leads to riskier investments and higher returns, research shows.

Reported by Featured Author

Frequent updates on asset price movements could result in risk aversion—and lower returns, according to the National Bureau of Economic Research.

Investors who keep close track of price information invest in fewer risky assets and miss out on higher potential returns, found Francis Larson, co-founder of behavioral technology firm Normann, along with John List and Robert Metcalfe, researchers at the University of Chicago.

“In their normal course of business, professional traders who receive infrequent price information invest 33% more in risky assets, yielding profits that are 53% higher, compared to traders who receive frequent price information,” they wrote.

The trio studied professional foreign exchange traders between March and April 2016, analyzing over 864,000 price realizations provided through a beta test of a Normann trading program.

The traders, who were unaware of their participation in the experiment, were given a starting cash balance of £1 million ($1.33 million) with the ability to trade a “risky” fund that tracked the relative value of the US dollar.

Half received second-by-second price information while the rest were given updates every four hours.

“While the two groups observed the same price realizations, traders in the ‘frequent’ group saw more negative draws than traders in the infrequent group,” the authors explained.

While it took a few days for traders to learn the expected value of the risky asset, by the end of the experiment the “infrequent” group had invested more in the USD fund, and in turn earned higher returns.

The results backed a prevalent theory among behavioral economists that the “equity premium puzzle”—the high real return of US equities compared to relatively riskless securities—is caused by myopia and loss aversion.

“Since our traders are vital components of the price discovery process,” the authors concluded, “their investment patterns reveal that marginal traders behave in a condition that is consistent with myopic loss aversion.”

Read the full paper, “Can Myopic Loss Aversion Explain the Equity Premium Puzzle?”