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Why We Are Our Worst Enemies When It Comes To Investing
Education | 16 December 2009
By: jason.liew
Articles (66) Profile

Are we our own worst enemies when it comes to investing? The answer seems to be a resounding “Yes”, if we are to believe the work done by psychologists in the field of behavioural finance. To put it very briefly, people and as a result investors, tend to exhibit cognitive biases such as overconfidence, biased judgements, herd mentality and loss aversion, that impair their ability to make sound investment decisions.

Overconfidence is one of the most pervasive of cognitive biases. Research has shown time and again that people tend to be overconfident about beliefs and abilities and over optimistic about assessments of the future.

Biased Judgement
Psychologists have also identified the tendency for individuals to be fooled by the illusion that they have some control over situations when in fact none exists. This is compounded by the fact that people mistake “similarity” as a proxy for sound probabilistic thinking. Just because most good footballers are Brazilians, that does not mean most Brazilians are good footballers.

Herd Mentality
In generally true that “two heads are better than one” when it comes to making decisions. If more information is shared and if differing view points are considered, informed discussion of the group improves the decision making process. But the ‘Hello Kitty’ bubble, showed us that once in a while, social pressure could cause groups of people to think that the incorrect view is in fact the correct one.

Loss Aversion
Daniel Kahneman and Amos Tversky, two important contributors to the realm of behavioural finance, showed that losses were more than twice as undesirable than equivalent gains.

In one experiment, consider the following two alternatives:

1.    A sure loss of $750.
2.    A 75% chance to lose $1,000 and a 25% chance to lose nothing.

Almost 90% of the subjects in the experiment chose alternative (2), the gamble, even though the expected returns from both alternatives are the same, a loss of $750. This also implies that when faced with a loss, investors tend to take on more risks.

How We Can Save Ourselves From Ourselves
According to Burton Malkiel, author of “A Random Walk Down Wall Street”, the first step in dealing with the pernicious effects of our behavioural foibles is to recognise them. Although he is famous for advocating the buying of passive index funds, there are steps investors, who have a penchant for picking stocks, he suggests can take.

Avoid Herd Behaviour
Avoid any investment that has become a topic of widespread conversation. Recent examples include buying a stock because it is a “potential dual-listing/ADR/TDR/RTO” counter. Unless you have access to insider information and can trade on it (which is illegal), buying a stock because it appeared on television programme, or that it is a hot topic on the online forum, or your relatives say so, is a guaranteed way of parting with your hard earned money.

Avoid Overtrading
As a result of overconfidence, many individuals are mistakenly convinced that they too can beat the market. As a result, they speculate more than they should and trade too much. In one well quoted example, men tend to be poor traders than women, not because women are better traders, but because men traded more often, leading to poorer returns when transaction costs are factored. Considering that a round trip of commission costs at least $56 for most retail investors, the more you trade, means you have to work harder for your money.

Be Wary Of New Issues
Burton Malkiel says investors should not buy IPOs at offer price, and never (emphasis his) just after it begins trading. He points out that historically, 5 years after their issuance, total IPOs in America under performed the broader stock market by about 4% per year. He further noted that poor performance starts about 6 months after the IPO. This is when the “lock-up” period is lifted, and insiders can start selling their stock on the open market.

It is quite evident that these insights do not help readers make money from the stock market. But the stock market is close to a zero sum game. For every winner, there has to be a loser. But by avoiding making the mistakes identified, it tips the odds in your favour in the investment game.

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