ONE of the first things an investor learns is to "buy low, sell high". He knows the goal, but, more often than not, ends up doing the opposite.
It is common sense: buy when an asset is priced low and sell when it is priced high; yet investors routinely buy and sell in precisely the opposite manner. This is an ageless and eternal problem.
What stories do we tell ourselves when an investment doesn't work out? What psychological tendencies do we follow again and again when we play the investment game? There is a field of study called behavioural finance that combines the disciplines of human psychology and finance to explain investing behaviour.
Traditional finance assumes that by and large, human beings will act rationally, and that markets are efficient. Behavioural finance, however, assumes that investors can behave in ways that seem irrational and tries to figure out why they behave the way they do.
Certain tendencies have been identified by psychologists in this field, after analysing the mental process investors go through to come to a response, when they receive a stimulus.
It is my hope that by familiarising investors with these tendencies, they will be better able to consciously identify these traits and in future, better control their behaviour during difficult market periods. Once the awareness is there, then the possibility of true change exists.
Myopic Loss Aversion
Financial decisions spark activity in the limbic system, the part of our brain that deals with risk and reward. Researchers have discovered that people feel the sting of a loss twice as acutely as they feel the pleasure of a gain. This fear is only made worse by the financial media. Television channels are devoted to following the financial markets' every move worldwide, 24 hours a day, seven days a week. Countless websites, books, magazines and newspapers are devoted to feeding us investment information continuously. Popular wisdom says that investment decisions must be made objectively, taking into account the latest possible market information as often as possible. Is this true? The research says it's not.
Myopic loss aversion is the combination of greater sensitivity to losses than to gains and a tendency to evaluate and analyse our results frequently. Myopia means short-sightedness. Loss aversion is the strong tendency of people to avoid losses rather than acquire gains. This tendency has been found to be a general feature of the human condition; however, this feature does not produce good decision-making.
An experiment conducted in 1997 found that investors who received the most frequent feedback on how their investment was performing, or the most information and were able to change their investment allocation the most often, took the least risk and earned the least money. It turned out that investors who were updated on a monthly basis did worse in terms of money earned compared to those who were updated annually and those updated every five years. What can we take away from this finding? Investors who continually seek out frequent feedback about how their investments are doing are likely to act on their worst tendencies if they cannot control them consciously.
Order Preference
Order preference is the tendency for people to insist on certain things in a certain order for no other reason than societal convention. It causes investors to focus on the performance of individual components rather than the overall performance of the whole portfolio. Logically, investors should aim to pursue a long term, diversified asset allocation. Taking this approach will mean that the portfolio components will definitely not all perform well at all times. However when they examine their portfolios, investors tend to want each and every part of their portfolio to give a superior performance.
Even with a benchmark index like the Kuala Lumpur Composite Index (KLCI), you have stocks that performed spectacularly and those that were duds in 2007. However, taken as a whole, the KLCI was up 37.8 per cent in 2007 (Source: Bloomberg). Hypothetically, it doesn't matter that some component stocks were down 15 per cent or that other stocks climbed over 30 per cent. In total, the portfolio is up 15 per cent, which is what matters. It is the performance of the whole portfolio that impacts an investor's net worth. Investors should take caution not to focus on the individual parts to the point where they lose sight of what is important.
Confirmation Bias
Confirmation bias is the tendency to search for or interpret new information in a way that confirms one's preconceptions and avoid information and interpretations which contradict prior beliefs. An investor will tend to seek out supporting evidence of his pre-existing notions. Two investors can look at the same data and yet come up with two completely different conclusions.
For example, take the recent market volatility. There are investors who say this heralds an imminent slowdown, yet there are others who are equally convinced that this is a temporary blip and that Malaysia is still on track to perform. Sometimes, an investor will seek out a big name who says the same things he believes and relies on the big name as an authority for why he should do what he already wants to do.
To put it simply, whatever you believe, there are plenty of seemingly credible authorities to support what you believe. When it comes to investing, an investor should always carefully examine and weigh information and interpretations which contradict his prior beliefs.
Hindsight Bias
Hindsight bias is the inclination to see events that have occurred as more predictable than they in fact were before they took place. Hindsight bias has been demonstrated experimentally in a variety of settings, including in politics, games and medicine. In psychological experiments of hindsight bias, subjects also tend to remember their predictions of future events as having been stronger than they actually were, in those cases where those predictions turn out correct.
Investors deceive themselves into believing they have some special ability or knowledge that led to a good outcome. Everyone's vision is 20/20. Hindsight bias also leads us to presume prior patterns persist - the stock or asset class that did well will continue to be a star and the one that did not perform will
continue to underperform. It's a tendency to project the past into the future. This is why it's important to note that past performance is not necessarily an indication of future performance.
Overconfidence
Overconfidence is the tendency for an investor to overestimate his skill or knowledge. This may lead investors to trade too frequently, day-trade, or become overweight in a "hot" industry or sector. Overconfidence may lead an investor to concentrate his investments in one place and not properly diversify.
Remember Enron? Many lifelong Enron employees had regularly invested thousands, even millions of dollars in Enron stock to fund their retirement. The overconfidence of Enron employees in their company's prospects to the point where most of their retirement funds were invested in the company's stock is to blame for the near-total loss of their retirement accounts. This situation could have been completely preventable had they only diversified their investment holdings for retirement.
Conclusion
Investors need to be aware that all these tendencies don't work in isolation- they also work cooperatively, making completely nonsensical investment decisions seem rational even while investors make them. It does seem as if our minds are our own worst enemies, especially when it comes to investing.
Having these natural human tendencies doesn't mean you are destined to continually suffer the financial consequences. There are simple ways to curb these tendencies.
Actively control how often you update yourself on your investments and how often you follow the investment news. Make sure you're looking at things from the right perspective: taking a long-term view and analysing your portfolio as a whole, not by its individual parts. Seek out the opinions and conclusions of investors that you do not agree with and see if they have merit.
As in the area of medicine, it helps to get a second opinion. Realise that past performance is not necessarily an indicator of future performance. Finally, always properly diversify, even if you think one company or one industry is the one that will get you wealth beyond your dreams. It is essential that investors not let the primal human drives of fear and greed crowd out logic and judgment.
Datuk Noripah Kamso is the chief executive officer of CIMB-Principal Asset Management Bhd
