Saturday, October 18, 2008

Behavioral Finance

I had learnt an important lesson about investment during this bear market. Having started my career at the beginning of the bull market in 2003, I had seen how greed make the stock market go higher daily without reason why it should do down. Uncles and Aunties are boasting how much they made and analyst keep predicting how much further the market can head north. Things always looks so positive that it seems stupid not to invest.

At the start of this bear market last year, greed was still prevalent and many people pumped in more money thinking that the market will rebound very quickly. They take it as a gamble and don't care what company they are buying into as long as trading volume is high and its volatile enough by percentage so that they can profit within days.
Fear started to creep in as bad news emerges from every directions. Market plunged because everyone fear losing money. From here, I had seen the other half of the market and half of what I learnt in behaviorial finance. Today, I just like to share what I had learnt about this topic.

What is Behavioral Finance?
* Traditional finance theory assumes that investors act rationally to maximize profit.
* Behavioral finance considers how human psychological traits can affect the way the market react and moves over time.
* Having some understanding of Behaviorial Finance, we can try to identify anomalies that can be explained by investor behavioral traits, and to identify opportunities to profit from exploiting the biases of other investors.

1) Loss Aversion
* One of the most common behaviour of investors that affects almost everyone
* Research has shown that the pain from loss is almost twice the pleasure from gain. This will strongly deter people to invest in the bear market due to the fear factor.
* For example,
If there is a 50% chance that one may lose $100 in an investment and 50% chance of winning $100, people will not invest. Unless the rewards increased to $200, then they may start to invest.

2) Escalation Bias
* The tendency to continue putting money into a losing investment to "Average Down" the average prices in the hope that the stock price need to rise lesser in order not to lose money.
* Averaging down is not wrong but it must not be emotional when we put in more money. People who fall under this category feel angry and responsible for the loss and just want to make good as soon as possible.
* Instead, we must evaluate the portfolio to understand why we should put in more money and if this will continue to make a good investment.

3) Mean Reversion
* The concept where people expect a reversal to occur quicker or more frequently than it actually happens. Also called the "Gambler's Fallancy".
* Example
- The indexes dropped for 3 days straight, it will surely shoot up tomorrow.
- The China market performed the worst last year. This year should be the best performing.
* The problem with mean reversion is that you may be fully committed way too early before the reversal happens

4) Overconfidence and Confirmation Bias
* Overconfidence basis happens when investors over-estimate the growth potential of certain sector or company. As a result, they tend to over-emphasize the good news and under-emphasize bad news related to such firms or sector.
* Confirmation Bias happens when they hear more good news about the firm, it will add confirmation to their pre-existing opinion.
* This is what happens during bull market. Nobody believe in bad news. Nobody believes in overvaluation, etc.

5) Herd Behavior / Crowding Effect
* This is a very powerful effect and explain why market can move in such volatility.
* This effect occurs when everybody suddenly agrees with each other at the same time and over-emphasize a positive or pessimistic news about a market.
* This effect is contagious and can spread like wild fire.

1 comment:

Anonymous said...

add one more to that post: rarely do people care about portfolio allocation and diversification during a bull market.

Talk about the above 2 to your clients now, I guarantee clients will forget once the bull takes off!