When Emotions Get The Better Of Investment Plans

Foreword from ShareInvestor

This article “When Emotions Get The Better Of Investment Plans” by Lorna Tan was first published in The Sunday Times on 16 Sep 2018 and is reproduced in this blog in its entirety.

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Investment process – a roller coaster of emotions

We like to believe we make rational investment decisions all the time but in reality, our actions are usually affected by emotions and biases – with the inevitable financial hit somewhere down the line.

The impulses to put our cash in this fund or that share come from any number of sources, whether individual feelings, perceptions, past experiences, information from peers, or just out of greed or fear.

Naturally the boffins have cottoned on to what they term behavioural finance, which studies the influence of psychology on an individual’s financial choices and the subsequent effect on markets.

Mr Vasu Menon, OCBC’s vice-president and senior investment strategist, wealth management Singapore, notes that it is not easy to take emotions out of investing but being aware of behavioural biases can help us make less emotional decisions and better choices.

Ms Chan San-San, head of wealth management and segments at Citibank Singapore, says relationship managers can help to spot such traits in investors and prevent costly mistakes.

The Sunday Times highlights nine common behavioural biases and ways to offset them.

1. Overconfidence

Investors typically overestimate their investment ability, says Ms Teh Hooi Ling, portfolio manager of Inclusif Value Fund at Swiss-Asia Financial Services.

“Few investors would rate their stock-picking accuracy as below average,” she notes.

“Overly confident investors may hold portfolios that are too concentrated, despite the obvious benefits of portfolio diversification.

“Believing that they can predict how prices move, these investors may also incur high costs due to excessive trading.”

Mr Menon cites one sign of an overconfidence bias: An investor trades a stock and consistently makes good profits from his initial trades. Thinking he is unbeatable, he takes on bigger and bigger bets as his confidence grows and the stock price heads higher.

When he becomes overconfident, he makes a sizeable purchase hoping for a hefty gain. Yet conventional wisdom would have called for caution, given that the already significant rise in the share price would have made valuations less compelling.

Mr Menon adds: “Then markets suddenly turn against him due to an external shock like a global financial crisis. However, he refuses to accept reality and holds on to his position or, worse still, adds on to it as markets fall.

“He also finds it hard to cut his losses because cutting losses would mean wiping out all his gains from his initial trades and it’s something he can’t accept.”

Advice

Investors need to stay objective and not take on excessive and concentrated risk because they are sure-minded about their prognosis. Careful research and diversification are ways to reduce risks that come with overconfidence bias.

2. Confirmation bias

This occurs when investors seek information that supports their beliefs and ignore data that is contradictory, leading to a one-sided decision-making process.

For instance, an investor buys a stock and pays attention to positive news and reports while ignoring anything that is negative. That could lead to his sticking to his one-sided view and buying more of the stock despite warning signs, says Mr Deepak Khanna, head of wealth development at HSBC Bank (Singapore).

Advice

Ms Teh says that while it is important for investors to conduct research to validate their investment thesis, it is equally important to look for counter-arguments and evaluate them honestly.

Mr Menon encourages investors to read widely and consider information from multiple sources to overcome this bias.

“It is important to be objective when evaluating an investment and to keep an open mind about alternative views that may contradict your belief,” he adds.

“Bouncing your investment ideas off a financial adviser may be helpful in getting an alternative view.”

3. Endowment bias

Investors tend to place an unjustified premium on the stocks that they already own, says Ms Teh. This makes them hold on to assets that no longer make economic sense instead of redeploying the capital to new investment ideas.

Advice

Investors should instead ask themselves if they would be willing to buy the asset at the prevailing price. If the answer is no, then they should not own it.

4. Home-country bias

There is a tendency for investors to invest in stocks, bonds and financial assets in their own country because of familiarity with companies in their own backyard.

Investors often confuse familiarity with knowledge, and therefore suffer from overconfidence with investments they are more familiar with, says Mr Menon.

Advice

Never put all your eggs into one basket because things can go wrong with the economy and financial markets at home, and it makes sense to reduce this risk by diversifying geographically.

“This is especially so if you are employed in your home country and have bought a house there and invested in other properties as well,” Mr Menon adds.

“In this case, you already have significant exposure and may be inadvertently taking on more risk than you realise when you tilt your portfolio towards stocks and bonds listed at home.

“There could also be attractive global investment opportunities you are missing out on by being too home-centric.”

5. Anchoring

Anchoring occurs when there is a fixation on a data point, usually the price of shares or funds.

An investor may have invested in a fund at a certain price per unit and then sold for a decent profit.

That price becomes an anchor price and the investor develops an unwillingness to invest at a higher one, though the fund may have grown over the years and is the best vehicle for the current market.

Advice

To reduce this bias, we have to show that the price is relative to the value of the investment.

Comparing past and present data on elements such as quality of assets, cash flows and dividend yields will make the value of the investment more apparent and dispel the notion that the price is too high, notes Ms Chan.

6. Loss aversion

Mr Brandon Lam, Singapore head of the financial planning group at DBS Bank, says the brain is wired to avoid all threats, including financial pain. It is common in all business decisions, and when decisions need to be revisited and reviewed, he says.

Loss aversion can manifest in being more prudent with your portfolio and choosing to invest in “safer” investment instruments such as insurance, he adds.

Individuals tend to be more sensitive to losses than gains, feeling the pain from losses more acutely than the joy from gains, notes Ms Chan.

“The fear of losses can lead to a focus on an inappropriately short horizon. It can also result in the inability of investors to cut their losses, such as holding on to funds even though the likelihood of a recovery in value is low,” she says.

Advice

It is important to help investors understand the reasons behind a loss. If it is due to a significant deterioration in the fundamentals underlying the investment, then the position is likely to worsen further and it is necessary to exit and avoid further losses.

In such cases, Ms Chan says she helps investors visualise a better allocation of resources by presenting alternative investments with stronger fundamentals that can improve the portfolio performance.

Mr Menon suggests doing careful research before investing. Do not overinvest in anything and stay diversified across asset classes and over time (say, via dollar-cost averaging) to reduce risk.

And do not focus only on returns when making an investment. Be mindful of the risks as well and buy only products that suit your risk appetite, he adds.

7. Mental accounting

Investors also tend to separate their money into different accounts, which may lead them to make irrational decisions.

Ms Teh recalls a friend who would have the amount she owed to credit card companies rolled over every month at interest rates of at least 15 per cent a year even though she had money in her savings account to pay off the bills entirely.

“Her reasoning: She likes to see cash in her bank account! Related to loss aversion, investors also have a tendency to sell their winners too early and keep their losers too long,” she adds.

Advice

Ms Teh says we should look at money matters holistically.

“Money is money no matter where it’s from and where it’s lost… When it comes to investing, investors should take a portfolio approach.

“It is impossible to make money in every single decision. But as long as you make more than you lose, and on a portfolio basis you are able to generate returns way in excess of inflation, you are all right,” she adds.

 

8. Herd mentality

Some investors take comfort from the fact that many others are piling into an investment, so they follow the herd without doing careful research first or assessing if the investment suits them.

Cryptocurrencies are an example of how herd mentality can result in substantial losses. The bitcoin rage last year sent the digital currency’s unit price rallying sharply to a high of about US$19,000 in December.

Mr Menon said: “Those who were drawn to the cryptocurrency mania would have suffered substantial losses as the unit price fell by nearly 70 per cent this year after the speculative bubble burst.

“We had warned investors about bitcoin and cryptocurrencies as we felt they lacked fundamental support and were largely speculative in nature.”

Advice

It is important to stop and ask yourself why you are making an investment and look to see if it aligns with your risk appetite and financial plan. Be extra careful when you hear too much hype about an investment that has already rallied sharply. Be fearful when others are greedy and don’t let greed get the better of you.

If you must speculate, keep your purchase small and buy only what you can afford to lose altogether, advises Mr Menon.

9. Recency bias

Ms Chan notes that investors tend to latch onto the direction of market movements during periods of strong momentum, jumping to the conclusion that this momentum is “unstoppable”.

They may even project past performance linearly into the future, even though markets usually do not move in a linear fashion.

“Recency bias is why some investors are very open to investments that have recent positive performance, even if they are not projected to perform as well in the future,” says Mr Chan.

“It is also why some investors are not keen on investments that have not performed well recently but are likely to do well in the future as the market transitions to a new phase.”

Advice

To counter recency bias, investors need to take a longer view of their investments and not put too much emphasis on recent events. They should also understand how different asset classes perform through economic and market cycles.

A firm grasp of the relative value of the asset class in the current cycle and its likely performance in the coming phase will give investors the confidence needed to invest for the long term.