This is the first of seven fortnightly articles on investing. In this series, UOB-OSK Asset Management Sdn Bhd provides an introduction to some of the considerations when making long-term investment decisions.
INVESTING requires the making of decisions under conditions of uncertainty. This means judgment is needed. What influences investment judgment? Investors would like to believe it is a thrilling mixture of skill, knowledge and guts.
Humans are, however, known to suffer from cognitive illusions and emotional weaknesses, and these shortcomings introduce a systematic bias into our judgment.
I’m better at it than you are
One common finding in the psychology of judgment is over-confidence. Surveys show that the majority of car drivers, for example, think they are better than average. Don’t you think so yourself? Clearly, many of us are wrong.
In a similar manner, when an investor buys an asset, he believes, certainly at the moment of purchase, that he will be able to sell it for a higher price, to someone less astute.
Some investors will indeed be right but some will also be wrong. Many investors will be right some of the time and wrong some of the time.
The problem is that it is possible for investors to lose more money when they are wrong than to make when they are right.
Only good things happen
Another common trait found in people is optimism. Self-confidence concerns things over which you have personal control, like how well you drive.
Optimism is related to matters over which you have no control, such as the flooding of roads. Optimists assign low probability to unfavourable outcomes and high probability to favourable outcomes, disregarding their true probabilities.
This love of long shots accounts for the perennial popularity of lotteries, betting and casinos. The probability of winning the first prize in 4-D is 1/10,000 but there is no shortage of optimists every week.
Instances of optimism are found regularly in financial markets. As a bull run gathers momentum, more and more investors typically jump in, under the optimistic belief that markets will just keep rising. Not infrequently asset bubbles emerge.
Take up weather forecasting
Fortunately, another aspect of humans is the ability to learn. One group of professionals who appears not to suffer from over-confidence and undue optimism is meteorologists.
There are three important aspects of what they do. They face the same kind of problem every day. They are forced to state the probabilities of their forecast. And the feedback they receive is immediate and precise.
Many professional investors assign explicit probabilities to their expectations and specify a time frame as well. It is, however, more rare for individual investors to possess a similar level of discipline.
Apart from believing that we have more ability than we actually posses, there appears another cluster of psychological biases that can affect our investment behaviour. These relate to losses.
Decision-making is often governed by a reference point. When financial decisions are concerned, there is often no easy way to value an asset and reference points, or anchor values tend to be arbitrary.
Discount sales in shops appear very attractive because shoppers can make a simple comparison with the original price of the item.
In investing, the price an investor pays for a stock or bond or property often ends up as the anchor price – below which investors are usually highly reluctant to sell. This is the poorest kind of investing.
The decision to sell should be based on the expected future value of the asset and should have absolutely nothing to do with the price paid for it.
Anything but lose money
The extreme difficulty people face in selling their investment at a loss is part of a more general problem of loss aversion. People simply hate the thought of losing.
Gamblers who encounter a bad run often raise the stakes in an attempt to recoup their losses. Investors hold on to shares whose price has declined in the hope that they will bounce back.
This inclination to let losses run is one reason why investors often lose more money than they make.
Successful investing is still possible
These are a few of the psychological aspects to keep in mind when investing. These biases do not mean that successful investing is an elusive goal and or that overcoming our biases is impossible.
Most investors will probably continue to suffer a measure of these biases but being aware of them can help us recognise the situations in which these errors are likely to occur.