Recognising Investors Behavioural Flaws: It’s All in the Mind
As investors, we are often influenced by behavioural perspectives that hinder us from making wise decisions. What are the common behavioral flaws and how can we overcome them?
Our investment decisions are invariably influenced by our psychological perspectives as we are not always rational decision makers, especially in periods of significant market turbulence. In fact, behavioural finance, which is the study of how our behavioural biases get in the way of making sound investment decisions has shed new light on investor psychology and how the human mind responds to market cycles. By understanding our most common behavioural biases, we can hopefully make better investment decisions in a more rational and disciplined way.
What are the most common behavioural biases?
- Anchoring: Depending on past information
Anchoring occurs when you base your decisions solely on the past. Be it the buying price, selling price or index levels of a market, you tend to pay a lot of attention to what happened in the past and make your investment decisions accordingly.
For example, a certain market index traded at an all-time high of 200 points but has since fallen by 35% to its current level of 130 points. Investors whose perceptions of the market is anchored by its high of 200 points may still be hoping that the market will return to its high in the future. The problem with anchoring is that the past is, well, the past. Just as you cannot drive a car looking at the rear-view mirror, you cannot manage your portfolio of investments by looking at the past prices of your holdings.
- Herd: Following the Majority
Investors tend to follow the trend of the majority group regardless whether it is irrational or rational. They believe that the majority can’t go wrong. Consequently, they buy into the newest or hottest investment trends as they focus on following the actions of the majority group. Warren Buffet once said: “You are neither right nor wrong because the crowd agrees or disagrees with you. You are right because your data and reasoning are right.”
- Overconfidence: I know It Best!
Investors often overestimate their ability and are overconfident about their investment knowledge, thinking they have full control over the market situation. They then conduct more trades as they believe they are capable of selecting the right investments at the right time. Investors who attempt to time the market are often driven by overconfidence in themselves. The philosopher Socrates once said that “A wise person is one who is humbly conscious of what he does not know”.
- Prospect Theory: Gains versus Losses
Psychologically, investors value gains and losses differently whereby losses have more of a negative impact emotionally compared to the happiness derived from making gains. Investors’ attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses.
Table 1: Choices investors make pertaining to investment gains and losses
||Option A: 100 % chance of gaining RM 100
|Option B: 50% chance of gaining RM 250 vs. 50% chance of zero returns (Either gain RM 250 or nothing)
||Option A: 100% chance of losing RM 100
|Option B: 50 % chance of losing RM 250 vs. 50% chance of zero loss (Either lose RM 250 or nothing)
When given the choice of choosing between an investment offering a “definite gain” and an “uncertain but larger gain”, most investors tend to choose the former option. This is a perfectly reasonable behaviour that is described as risk aversion. However, when confronted with a “definite loss” versus a “50-50 chance between a larger loss or break even position”, the same investors tend to choose the latter option in order to avoid a definite loss. This is called loss aversion behaviour.
Investors were willing to settle for a reasonable amount of gain but were prepared to engage in risk seeking behaviour when it comes to losses. In other words, investors typically feel the pain of a loss more intensely as losses are psychologically weighted more heavily than the equivalent amount of gains. That is why investors tend to base their decisions on avoiding losses, which explains their risk temperament.
If market conditions are volatile, risk adverse investors tend to shy away from investing in the market given the fear of losses. On the contrary, investors should remain focused on their long term objectives and continue with their investment plans, despite uncertain market conditions. Ultimately, a disciplined approach to investment can be achieved by overcoming the common behavioural flaws simply by practising several investment strategies such as Ringgit Cost Averaging and Portfolio Rebalancing.
Ringgit Cost Averaging
Under Ringgit Cost Averaging (RCA), investors invest a fixed sum of money into a selected investment over a period of time, regardless of market conditions. More units are purchased when markets decline, and fewer units are purchased when market prices are high. In doing so, investors are rewarded with bigger gains when the market recovers as the long-term upward trend allows the investments to eventually increase in value.
In terms of behavioural finance, RCA helps investors to overcome the behavioural habits of anchoring (looking at the past prices as a valid benchmark), herd mentality (following the latest trends of the market) and loss aversion (as explained by prospect theory). Having a disciplined mindset to spread a fixed investment over a period of time rather than putting it all in one lump sum is one of the keys to long-term investment success.
Portfolio rebalancing also helps investors overcome the dangers of overconfidence and following the herd. When a certain asset class such as equities has rallied strongly over time, investors may be tempted to increase their exposure to that asset class as it may still be the most popular investment of the day. To avoid these pitfalls, investors are advised to rebalance their portfolios regularly at least once a year to ensure that their portfolio allocation reflects their investment objectives and risk profiles. Thus if, as a result of an uptrend in stock prices, an investor’s equity exposure has exceeded a level consistent with his risk tolerance, he can trim a portion of the equity funds and switch into bond or money market funds to rebalance the asset allocation accordingly. Maintaining a target asset allocation reduces the risk that the portfolio becomes too concentrated in a single asset class.
In other words, disciplined portfolio rebalancing reduces biasness by helping investors to stay focused on their asset allocation rather than be influenced by the emotions of recent successes or failures.
The lessons of behavioural finance can help investors make sound decisions by knowing their inherent psychological tendencies. Investors need to be patient by putting aside their emotions and learn not to be influenced by the herd mentality. Using RCA throughout a bear market has proven to be a prudent course for long-term investors as they benefit the most when the market recovers over the long term. In addition, regular portfolio rebalancing effectively helps investors to remain focused on the long term horizon and prevents them from over-reacting to short term movements of the stock market. Both these strategies are indeed a great stepping stone in helping investors achieve investment goals and overcome behavioural mistakes in investing.
This article is prepared solely for educational and awareness purposes and should not be construed as an offer or a solicitation of an offer to purchase or subscribe to products offered by Public Mutual. No representation or warranty is made by Public Mutual, nor is there acceptance of any responsibility or liability as to the accuracy, completeness or correctness of the information contained herein.