025. Behavioural Financial - Pitfalls Of The Irrational Mind

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.

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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.