Article "Pitfalls Of The Irrational Mind" appeared in The Edge Malaysia dated February 2 ~ February 8, 2015.
An article that can ponder us to think how we make investment decisions, and also advising clients to. I have attended a seminar on Behavioural Finance but has forgotten about it. Time to refresh how it affects clients' emotion and their investment decision making.
Like said in the article, we should focus on long-term perspective because over the long-term period, fundamentals will prevail.
Market are supposed to behave in a rational manner. However, during times of
boom and bust, all economic theories are out the window. Investors
abandon sanity for either irrational exuberance or unmitigated panic.
Economic theories fail to adequately predict human behaviour, an
important but often overlooked factor that affects investing decisions
and consequently, how markets behave.
Behavioural finance is a relatively new area on the interaction
between psychology and finance [that considers] the psychological
factors in decision~making
It is about applying psychology theory to how people make financial
and economic decisions, which don't fit in with conventional economic
theory. Human being, are rational when we can process information. But
we also allow emotions to take over when we can't, causing us to make
irrational decisions.
Those who push for behavioural finance believe that people evaluate losses and gains by using mental shortcuts
to provide quick solutions. This, however, inevitable leads to errors
and psychological biases.
'I saw how irrational people got. When the market panics, it becomes a self~fulfilling prophecy,'
'In the beginning, there was a good reason to panic. If a company's
prospects alter because of the changes in the economy and you think it
will run into difficulties, [you sell and the] share prices go down. But
there are also people who just panic and sell because they think it
will go down. And because they sell, it does go down.'
The sensible move would have been for investors to hold on to
what they had or take advantage of the low prices to invest further.
'That's the correct thing to do for an economically rationally person.
If you hold plantation stocks during a crisis, nothing is going to
happen. The palm trees will still be there and people will still consume
oil,'
'So, how do you have this crazy crisis where prices become so
irrational? A lot of people get fearful and no longer evaluate the
situation in a rational manner. And once you aren't rational, you make a
lot of bad decisions. We saw the same thing happen during the dotcom
bust and 2008 global financial crisis.'
THE HERD IS NEARLY ALWAYS WRONG
Mob mentality results in something known as representative bias, a kind
of psychological trap. 'When there is an upward move in a bubble and
you see your friends making quick money, you might think you can go in
without studying the market's fundamentals. You are exhibiting short
term-ism, and making what is known as representative bias.
'You listen to rumours and your friends, who tell you it's a good
investment. You think the whole world is thinking like that. But your
friends don't represent the entire population; they are just reinforcing
each other. That's why it is important for the investor to think for
himself and stand out from the crowd,'
Another example of representative bias is in oil prices. A rational
economist should see that the supply factor of oil is changing as the
shale gas revolution in the US is not new.
Anyone who cares to look will realise that the US is going to be a big
producer of gas. Shale technology is changing oil economics. You know
that US$100 to US$150 [a barrel] is not going to be sustainable. But
everybody in Malaysia jumped into the oil and gas bandwagon without
looking at the big picture,'
'The early movers would have done well because they went in when prices
were low. But the late movers went in when the prices were already high
and could not go any higher. That's where the bias is. It's when you
are not looking at the big picture, that shale technology is here to
stay.'
Another common psychological trap that hinders rational decision~making
is the emotional investment in sunk costs, as people are often attached
to what they pay for. This applies to both individual investors and
companies.
'When you make decision on an investment, whether as an investor buying
shares or a company investing in a new project, you don't look at what
you have spent on it. You look at what you have and how much you will
gain if you sell it,'
However,
what is taught in theory isn't always easily translated into practice.
An investor holding a RM2 share will adamantly hold on to it if he
bought it at RM5, even if the company's future does not look good.
'Most people will not sell in this situation, even though they feel the
share price will not go up. They hope it will go back to RM5 before
they sell, which is an incorrect decision,'
In economic and finance theory, sunk costs are irrelevant. But for
human beings, these costs are totally relevant,
'Sunk costs are responsible for one of the strongest
behavioural biases I see,'
'Investors also make the mistake of being overconfident, a trait similar to attribution bias. In this
case, investors tend to praise themselves for a good investment
decision, but blame everyone else when things go wrong.
'Let's say you buy a house. When the market turns out well, you
attribute the right decision to your intelligence even though most of us
are not smart,' he explains. 'But if things go wrong, say property
prices drop, you attribute it to bad luck or blame other factors instead
of admitting it was your mistakes.'
Attribution bias can be risky, as it leads investors to keep making the
same wrong decisions. This happens especially when the investor has a
series of successes that are not due to his own intellect or knowledge,
but luck.
'In this case, you would continue making decisions that turn out to be
wrong in the end. You are overconfident and all of us are like that to
some extent,'
Other common psychological traps that investors often fall prey to
include anchoring and confirmation bias, which share similar traits.
Anchoring is a cognitive error where less weight is placed on new
information that contradicts a currently held view, while confirmation
bias is more behavioural in nature.
[Confirmation bias is when] we tend to search for and give more weight
to information and opinions that agree with our pre~existing opinion.
Contradictory information is deemed less reliable and often ignored,'
When previous outcomes are similar, people get
anchored to them and expect similar outcomes in the future.
This also happens with daily habits, like reading the newspaper. When you don't have time to read the entire
paper, you only read news that reinforces your existing beliefs.
'When you have a preconceived views, you immediately absorbs it [the
news item]. But if the news is negative or against your belief, you will
say it is wrong,'
What
investors should do to get over their biases is to always test them.
One way to do so is to spend more time investigating the validity of
opinions that opposes their biases instead of confirming them.
'Don't spend more time on research that confirms your biases. Look at
people who challenge you. Don't discount those ideas or trends;
investigate their validity. If you can read up, take this into account
when making a decision. Knowledge of all this helps, although it is not
easy,'
TAKE A LONG~TERM VIEW
Besides making the effort to confront opinions that are in conflict
with your own, perhaps the most valuable thing for investors are their
own mistakes.
'You have to develop the capacity to learn from mistakes: why you made
the bad decision, what went wrong and what biases you were operating
under, and how you can avoid making the same mistake in future,'
'You will get better if you keep doing that. There is no perfect
investors. Even the best ones make wrong decisions. Warren Buffett
admitted he made a mistake by investing in Tesco ~ and you cannot be a
better investor than him!'
Investors also need to overcome the desire for instant gratification
and adopt a long~term outlook. Instant gratification is the impulse
created by media and advertising, prompting investors take a short~term
view
Long~term investors should not panic when things go wrong or get too
thrilled when things go well. 'Take a long~term focus. Choose a
diversified portfolio without being too influenced by noise. Don't sell
just because stock prices are going down. Long~term investors will not
let their short~term emotions get in the way,'
the dumbbell strategy. This means putting most of your money
in very safe, albeit dull, investments and a small amount in extremely
risky investments to handle 'black swan' incidents. black swan
theory describes rare, unexpected events that occur without warning and
leave a major impact.
So most of your investments are safe, and if [the risky investments]
turns out positively, you make a big returns. But if not, you'll lose
just that. This sounds interesting to me because it satisfies two human
emotional needs - security, but also some fun,' who
stresses the importance of portfolio diversification.
'Many Malaysian invest in only one class of assets - property. They
don't diversify. That's because, again, of the confirmation and
anchoring bias,'
The new wave of Malaysian investors today is from Generation Y, which grew up without ever seeing property prices decline.
'If you were an adult in the 1980s, you would have seen them decline.
Property prices peaked before going down in 1981, hitting rock bottom in
1988. Since then, we haven't really had a property decline,'
That's almost three decades ago. So they will all tell you that you
cannot make a mistake from buying property. I find that younger people
are taking huge leverage on property and their cash flows are very
tight. I think this is a very big risk because if prices stop rising and
there is a glut, rents will go down. And if they are cash tight to
begin with, they will be in trouble.'
Not everyone believes in the concept of behavioural finance.
Behavioural economists attribute financial market imperfections to
psychological traps and biases.
Its critics, however, are advocates of the efficient market hypothesis,
or those who believe wholly in market efficiencies.
Then there is the perpetual debate: Does the market control our psychology, or does our psychology control the market?
market fundamentals and behavioural finance can
co-exist. 'I believe behavioural biases play a big role in the market,
but I also believe in fundamental analysis. It's not a contradiction. In
the long run, market fundamentals work. But in the short term, it's
behavioural finance biases that to dominate.
'But let me end with a small caution. As economist John Maynard Keynes
pointed out about market behavioural in the short term: 'The market can
stay irrational longer than you can stay solvent'.'
OTHER EXAMPLES OF BEHAVIOURAL BIASES
HERDING: This is when a group of investors who hold individual
objectives start making the same decisions as each other. This happens
especially in times of uncertainty. In other words, this means investors
care more about investments that the market would value instead of
their own.
LOSS AVERSION: The loss aversion theory states that a loss will always
appear bigger than a gain of an equivalent size to people. Estimates
find that losses are felt between 2 and 2 1/2 times as strongly as
gains. Hence, this favours the status quo, or inaction over action.
FAMILIARITY BIAS: This occurs when investors have a preference for
investments familiar to them despite seemingly obvious gains from
diversification. A result of familiarity bias is that investors end up
holding portfolios that aren't as diverse as they should be.
BIAS BLIND SPOT: We know that everyone is biased and recognised the
impact of biases on the judgment of others. But we don't think we
ourselves are, and fail to see its impact on our own judgment.
RECENCY BIAS: People tend to extrapolate recent events into the future
indefinitely. A Bloomberg survey of market strategists revealed that
peak recommendations of stock weighting came just after the peak of the
Internet bubble in early 2001, while the lowest recommendations of stock
weighting came just after the lows of the 2008 financial crisis.
HINDSIGHT BIAS: After an event happens, we believe it was predictable
even though it could not have been reasonably anticipated. According to
psychologists, this is because we feel a need for order in the world,
hence create explanations that make it seems like such events are
predictable. One such example is the bubbles that develop. It is claimed
that any bubble in financial history had been predicted, but they
wouldn't have occurred if they really had been.
