Anxiety over the European debt crisis, the cooling of China’s growth, the US market still in the doldrums and Singapore’s GDP forecast lower in 2012, have created skittish markets and squeamish investors. No question, we are in financial crisis mode, again. But, why is it so tough to fix your portfolio?

It’s a common dilemma: You know you have the wrong mix of investments, but you cannot bring yourself to fix the mess. Why is it so difficult to change? At issue, and perhaps central to how investors think is a relatively new school of thought dubbed “Behavioural Finance”. It argues that the sprawling literature on trading strategies has missed a larger and more important point – the rationality of investors.

At its core, behavioural finance attempts to explain and increase understanding of the reasoning processes involved and the degree to which they influence the decision-making process. For instance, behavioural finance studies financial markets as well as providing explanations to many stock market anomalies (such as the January effect), speculative market bubbles (the sub-prime mortgage debacle that led to the Great Recession of 2008), and crashes (The Great Depression of 1987 and Recession of 2008). Lastly, behavioural finance studies the psychological and sociological factors that influence the financial decision making process of individuals, groups, and entities as illustrated below.

This series of articles seek to provide a general overview of the area of behavioural finance along with some major themes and concepts in relation to you, the individual investor. In addition, it will make a preliminary attempt to answer the two following questions:
1. “How can investors take into account the biases inherent in the investment decisions they make?”
2. “How can investors ‘know themselves better’ so they can develop better Rules of Thumb?”

In essence, the main purpose of these two questions is to provide a starting point to assist investors to develop their “own tools” (trading strategy and investment philosophy) by using the concepts of behavioural finance.

Before we can address the dilemma, we need to first examine some of the information-processing and behavioural irrationalities uncovered by psychologists in other contexts and show how these tendencies when applied to financial markets might result in less than favourable investment returns.

Be Wary If You’re Overconfident
Remember the last time you sat for a written test and left the exam hall feeling you did pretty well for that test, only to be subsequently disappointed with the results? Yes, it’s called overconfidence. In short, people tend to overestimate their abilities, and they tend to overestimate the probabilities for a set of events. In one famous survey, 90% of drivers in Sweden ranked themselves as better-than-average drivers.

Such overconfidence may be responsible for the prevalence of active investment management. Despite the growing popularity of indexing, only a small percentage of the equity in the mutual fund industry is held in indexed accounts. The dominance of active management in the face of the typical underperformance of such strategies is consistent with a tendency to overestimate ability. Casual comparisons of the performance of the Wilshire 5000 (corresponds to a simple passive investment strategy: Buy all the shares in the index in proportion to their outstanding market value) versus that of professionally managed mutual funds reveal disappointing results for active managers. The average return on diversified equity funds was below the return on the Wilshire index in 21 of the 37 years from 1971 to 2007. The average annual return on the index was 12.8%, which was 1% greater than that of the average mutual fund.

The gender bias is another area under overconfidence that has received some scrutiny by economists. The work of Barber and Odean has produced some interesting findings with regards to the trading habits according to an investor’s gender. In the study, they found that men (in particular, single men) trade far more actively than women, consistent with the greater overconfidence among men well documented in psychology literature. As a result, men not only sell their investments at the wrong time but also experience higher trading costs than their female counterparts. Trading costs reduced men’s net returns by 2.5% per year compared with 1.72% for women. Overall, the top 20% of accounts ranked by portfolio turnover had average returns of seven percentage points lower than the 20% of the accounts with the lowest turnover rates. As they conclude, “trading (and by implication, overconfidence) is hazardous to your wealth”.

Financial Cognitive Dissonance
Sounds quite a mouthful, doesn’t it? But the lowdown on this theory is basically the tension and anxiety you feel when you are faced with contradicting views. Think of the last time you were faced with the age old conflict of having chicken or vegetables. Okay, that was pushing it a bit, but you get the picture. As individuals, we attempt to reduce our inner conflict (decrease our dissonance) in one of two ways:

1. We change our past values, feelings or opinions (Chicken used to taste great, but you’re not so sure now…).
2. We attempt to justify or rationalise our choice (You love chicken, but the doctor said you have to get more fibre into your diet…).

This theory may apply to investors or traders in the stock market who attempt to rationalise contradictory behaviours, so that they seem to follow personal values or viewpoints. How does this work, you ask?

While it would be nice to delve head first into the ramifications of financial cognitive dissonance, it is prudent at this point to conclude this first part of this series to provide some time to digest the previous points. We shall discuss further about behavioural finance and how it might affect your other investment decisions in the next issue. Stay tuned!