Use wisdom of psychology to counter irrationality

  • Business
  • Saturday, 18 Apr 2009

COMMON sense need not be common practice. I picked up this phrase from a fellow speaker at a recent seminar and I am in total agreement. In all aspects of life, even in personal finance and investing, one may be expected to be at least reasonably rational. But in reality, it is seldom so.

If there are different opportunities to make the same amount of profit, we should expect investors to be indifferent as to which opportunity they opt for. The reverse should also hold true for potential losses.

Logical? Not quite. In fact, where money is concerned, sometimes an investor actually prefers an option that gives a slightly lower expected profit! For this seemingly ironical analysis, I tap on the wisdom of Nobel laureate Daniel Kahneman, a professor of psychology.

Let me illustrate with a game, starting with Round 1:

·Door A – 100% chance of winning RM800

·Door B – 80% chance of winning RM1,000

Which door would you choose? Mathematically, there should be no difference as the expected gains in both cases are identical – RM800. So if we test a large group of people, we should have roughly the same number of people choosing Door A and Door B.

Funnily, that doesn’t quite happen. When I test this in seminars, invariably about 80% or more choose Door A! Even when I up the prize of Door B by 10%, more people still choose Door A. This reflects a preference for certainty despite Door B being a superior option when the prize is increased. Rationality fails.

Let’s reverse the game and consider losses instead, in Round 2:

·Door C – 100% chance of losing RM800

·Door D – 80% chance of losing RM1,000

Again, the mathematical results are the same behind both doors, that is, the expected loss is RM800. You probably guessed it, most people (in fact, almost 100%) choose Door D. When faced with the certainly of losing, it is in our nature to bet on a chance of not losing any money at all. People are loss-averse.

In a nutshell, people are not as rational as we expected. I would not be so audacious as to call everybody irrational, but certainly we are not always rational because of our emotions. The heart can and does confuse the head!

Let’s push the boundary a bit more, in Round 3:

·Door E – 100% chance of winning RM1

·Door F – 0.1% chance of winning RM900

When the prize money is reduced to a relatively “insignificant” amount that does not matter to most people, the results are actually reversed from those of Round 1! In Round 3, more choose Door F! A rational investor should actually choose Door E as the expected returns of Door E is RM1, while the expected returns on Door F is only 90 sen. Most people preferred the “inferior” option!

This explains why even conservative investors would bet on lottery or gamble regularly, despite knowing that the odds are against them.

In application, it is very tough to make rational choices because we have to fight strong emotions such as fear and greed, and love and hatred. When it comes to your hard-earned money, how can you remove all emotional factors?

I suggest fighting emotions with emotions. If you start to hate equities, I would prescribe some love. If you start to fear investing, I would recommend some greed.

Here’s my approach. How would you like to be able to play golf, go fishing and play with your kids or grandchildren every day for the next three to five years without any worries? A lot of love is generated with that imagery.

And how much would you “pay” and invest for a chance to realise this love? You must be prepared to completely forgo this pot of money. According to Kahneman, you probably would not worry if the amount is not more than 10% of your total wealth.

So what if this investment goes off tangent? There’s still the 90% or the bulk of your wealth. To him, this amount of money is not as affected by your emotions and can be more rationally invested. Without the emotions, the rational choice is more optimal.

The psychology professor argues that if a person is worth (including all assets) RM1mil, then he can set aside RM100,000 (and forget about it for three to five years!).

For that RM100,000, or whatever that 10% amounts to, here is some advice on investing:

(1) Choose a high-risk market in which you have long-term confidence. It can be the Malaysian stock market, China, oil, properties or whatever. Of course, this is subject to your own risk profile, as some people are so conservative that they are not suitable for investing in any high-risk markets.

(2) Take this 10%, either through a lump sum or over a period of months, and invest in the chosen market, without any further thoughts or feelings.

(3) Don’t worry, go and play golf, until three to five years later. This also means that you do not check your statements.

A caveat though. I am not suggesting timing the market, or that three to five years is what it takes for markets to recover. However, I believe in learning from the wisdom of such an eminent scholar to prescribe practical pointers.

Our “destructive” emotions can often prevent us from choosing a superior investment option. It can inhibit us from looking beyond today to weed out short-term shocks. So we must counter such emotions with emotions to hopefully arrive at a more rational approach to investing that is superior in the long run.

·Tay is senior vice-president and senior head of UOB’s personal financial services division

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