Lessons From Behavioural Finance

Foreword from ShareInvestor

This article “Lessons From Behavioural Finance” by Cai HaoXiang was first published in The Business Times on 30 Mar 2015 and is reproduced in this blog in its entirety.

The study of cognitive and emotional biases can help you become a better investor

“I’m waiting for a crash before I buy,” people like to say.

But when a drop in prices actually happens, they say: “It could go lower. I’ll wait a little bit longer.”

We know what happens next. When you next check the price of a stock you were eyeing, it is far above what you last saw.

In the last six years since the end of the global financial crisis, many investors were paralysed from taking action by a similar sense of inertia.

Stocks have indeed dropped many times. But every time they did, they recovered to end up higher than where they were.

Today, many investors are still left on the sidelines. That prices have gone up is besides the point. Valuations are much richer than they used to be, by historical standards. Yet at the same time, nobody dares to call a market top. We are still in an environment of abundant liquidity.

What investors missed out on were the dividends paid by perfectly sound businesses they could have owned. Cash still yields close to nothing in the bank.

It is a mistake, in hindsight, not to have done anything with one’s money over six years – a reasonably long period of time.

In recent years, people have been paying more attention to how they can avoid making the wrong move, through examining one’s thought processes and emotions.

That is the study of behavioural finance.

Staying Objective

In traditional financial and economic theory, investors are assumed to be rational and markets, efficient.

Rational investors make decisions based on maximising the value those decisions bring to them.

Faced with various choices, given a well-defined objective, a rational investor will always make the same decision.

Similarly, markets are supposedly efficient because they are populated by rational investors who instantaneously incorporate all new information into their bid and ask prices.

The rise of behavioural finance can be seen as an attempt to explain why markets seem to deviate from this framework.

One way that it does so is to explain human behaviour as riddled with psychological biases.

There are two main categories of biases: cognitive biases, which are errors of one’s thought processes; and emotional biases, where people make decisions based on emotions rather than facts.

Cognitive biases are thought to be easier to overcome, so let’s start with them.

A number of cognitive biases cause people to hold certain opinions for longer than they should. This makes it difficult for them to change their investment strategies when circumstances change.

In other words, they are not nimble enough.

One of the more well-known cognitive biases is the confirmation bias. Humans actively seek out information that agrees with their point of view, distort information in order to support their opinions, and avoid processing information that runs counter to their views.

For example, when flipping the newspaper pages every day or surfing the Internet, you might pick up only positive information on your stock. You feel good, and ignore other worrying industry trends that might also be reported.

The confirmation bias causes people to put too much money into an asset, or hold it for too long, in the mistaken belief that it is the best investment out there.

To counter its effects, investors should actively seek out contradictory information and weigh it carefully, instead of quickly dismissing alternative viewpoints as biased or ill conceived.

Another major cognitive bias is known as the anchoring bias. This describes a scenario where investors place too much importance on numbers like the initial price they bought a stock at, or a stock’s 52-week high or low.

The problem is that you are obsessed with that particular price or estimate and do not adjust your views in line with new information.

For example, you might have bought a stock at S$1. The stock is now trading at S$1.10, 10 per cent above your purchase price. Looks good, but could be better, you think.

Actually, the S$1.10 price might be double its long-term average valuation when one considers fundamentals. But because you are anchored to the S$1 price, you do not think that S$1.10 is an overvalued position, and you hang on to the stock. Conversely, when it falls way below S$1, you buy some more, thinking you are getting a good deal because you are buying below your original price. But the stock never goes back to S$1.

Or you might be up 20 per cent on an investment and think it is a good time to sell, because you’ve never made more than 20 per cent before.

You sell, and miss out on the 200 per cent run that follows.

Meanwhile, analysts might get too anchored to their target prices, or discount rates and financial ratios derived from market prices, to react fast enough when something has changed that does not justify these variables.

Staying Decisive

Sometimes, people are also too slow to react and update their views only long after circumstances have changed.

This conservatism bias can be seen in some analyst reports, where downgrades in a stock’s target price come only after the market has already reacted, and vice versa.

Alternatively, faced with complex new circumstances, an investor might avoid thinking or acting on the matter. Conversely, he will cling on to information that he can understand, instead of properly weighing the new information. An investor avoids investing altogether, instead of taking decisive action when, for example, stocks look statistically cheap.

Or they hold on to a losing stock for too long.

The conservatism bias is also linked to some other emotional biases to explain why people don’t take action to buy or sell.

One such bias is the endowment effect. This is when people value what they own more than what they don’t own, due to an irrational attachment to what they own.

For example, I might always expect to sell my stocks at a price that is higher than a price that I am willing to pay for them on the market.

Even if the time is right for me to sell, I do not, holding out for a higher price that never comes.

If I own a house, it will take a lot of money before someone persuades me to part with its ownership in a reverse mortgage deal.

People also exhibit regret-aversion, such that they do nothing for fear of regretting or being disappointed by their actions. This leads to people staying away from risky assets like stocks.

Conversely, people also fear missing out on gains, when everybody else is buying. This leads to a so-called herd mentality.

Daring To Take Risks

People also tend to hold on to a losing stock for too long to avoid realising a loss.

In behavioural finance, there is an emotional bias that explains why this happens.

The phenomenon is known as loss aversion. Experiments have shown how people feel more pain at losing money than when they gain money. People also weigh the prospect of a sure gain more than uncertainty.

Say you offer people a game in the toss of a coin: heads, they win S$100; or tails, they lose S$50. The expected return of this game is the sum of the probability of each outcome times the monetary reward, or (0.5*S$100) + (0.5*-S$50) = S$25.

Offer people another toss of a coin: heads, they win S$40; or tails, they win and lose nothing. The expected return is S$20, less than the first game.

However, which game would people rather play? Many people would choose the second, because they don’t want to lose money.

The rational investor, however, would play the first game as he is likely to come out ahead.

Oddly enough, while people don’t want to lose money, they take bigger risks when confronted with the prospect of losing money.

Back to the coin game: would you rather play: (i) heads, you win S$80; or tails, you lose S$200; or (ii) lose S$50 no matter which way you flip?

People tend to pick the first option. They would rather gamble for the chance to avoid losing some money, with an expected loss of S$60, instead of taking the statistically sounder option, where they have a sure loss of S$50.

However, some have argued that loss aversion applies only to inexperienced investors. And given repeated rounds of experimenting with coin tosses, for example, loss aversion might be reduced.

Nevertheless, loss aversion remains a significant emotional bias.

Other than explaining why people sell too late, loss aversion (or, more generally, risk aversion) has also been used to explain why investors would rather hold cash and have their savings eroded by inflation than invest in the volatile stock market.

Lessons From The Brain

To sum up, investors are affected by cognitive biases and emotional biases that cause them to act on various feelings rather than rational thoughts. We have outlined a few today.

Cognitive biases include biases that cause people to stick to their prior beliefs and hold an investment for too long, like the conservatism and confirmation biases. The anchoring bias, meanwhile, distorts the way they think.

Meanwhile, emotional biases can prevent risk-taking, like loss-aversion, the endowment effect, and regret-aversion.

What can one learn from all these biases, to become a better investor?

Awareness is important; just knowing of the existence of these biases will help.

One can also implement a process to systematically screen investment decisions for signs of these biases.

Some questions you can ask yourself with every trade are:

  • Am I dependent on my initial purchase price?
  • Am I avoiding analysing something because it is too complicated?
  • Am I ignoring negative information?
  • Am I afraid of selling at a loss?
  • Would I make the same investment if I had the equivalent amount of money in cash?

Ultimately, we should understand that developments in behavioural theory can help us become more critical of our own thought processes.

And we should not be afraid of contradictions.

Here’s a poser.

For example, if you are still not invested in the stock market, is this the right time to start?

Another Buffett quote comes to mind: “Holding cash is uncomfortable, but not as uncomfortable as doing something stupid.”

Perhaps trying not to be stupid is a goal we can all aspire to.