Why Singaporeans should check bias in investor attitudes

When investment professionals and individual pension investors start investing, they are inadvertently exposing themselves to the strange and interesting world of behavioural finance. It will affect every decision you make even if it is subconsciously.

So a better understanding of behavioural finance could be invaluable if Singaporeans are to make "good" investment decisions.

Behavioural finance is a relatively new concept that seeks to marry behavioural and cognitive psychological theory with conventional economics and finance. In this way it accounts for anomalies that would otherwise be missed by conventional models, which assume investors are rational when investing, such as the capital asset pricing model (CAPM) and efficient market hypothesis (EMH).

Understanding the hidden bias and attitudes of investors enables financial planners to gain a better understanding of their (clients') propensity for loss and gain and make investment recommendations that more accurately reflect investor appetites.

Fear and loss
Based on research by Nobel Prize-winning psychologist Daniel Kahneman and his colleague Amos Tversky, they discovered that humans do not feel loss and gain in the same way - our feelings to loss and gain are asymmetrical.

Further research carried out by behavioural economists Shlomo Benartzi and Richard H Thaler suggested that investors are more sensitive to small negative fluctuations than to small positive ones. This is called loss aversion and results in more risk aversion and potentially suboptimal investment decisions.

If we take Singapore as an example, the special Hong Bao Draw run annually by the Singapore Pools during the Chinese New Year, it works on the concept of enticing people who don't normally bet into playing. With one ticket costing 50 cents and a top prize of SGD13 million, the draw creates the desired buying frenzy. The prospective pain of loss, one's natural risk aversion is overcome by the possibility of the massive win.

In the West, the average household spends US$1000 a year on lottery tickets but astonishingly - get ready to hang your heads in shame - in Singapore the equivalent average household spends US$4,000 on lotto tickets every year. Other findings have also found that the poorest members of society often bet more on the lotto.

The gambler's fallacy
Under the gambler's fallacy investors wrongly believe that past events can influence the probability of whether these events will occur again in the future. So because a stock has been going up for a number of years an investor's interpretation of probability becomes warped. Unfortunately under those circumstances the investors view becomes irrational.

Let's examine how professional managers make decisions. Crucially, they ignore past patterns and performance and instead they decide to hold or sell based on their analysis at that point in time.

Back in the 1990s, most managers bought technology, media, and telecoms (TMT) stocks and so buying and holding in this sector was a no brainer. In that environment 'irrational exuberance' started to grip investors and two behavioural finance red signs started to influence investors' judgement.

First, investors entered into the market with a false mindset, with an illusion of control. Second, when an investor is overconfident his decision-making starts to be afflicted by another bias known as excessive extrapolation. Excessive extrapolation is the tendency to overweigh recent positive results and underweigh long-term information.

You want to recognise the signs and be more of a Neil Woodford than an Abby Joseph Cohen, chief investment strategist at Goldman Sachs. During his time as a fund manager at fund management group Invesco Perpetual, Mr Woodford shunned internet shares, and bought stocks that were deeply out of favour, such as tobacco companies. In contrast, Mrs Cohen was every inch the hyper-perma bull and repeatedly told investors go for it; this is a "buying opportunity".

Have you herd the word?
Let's look at another idea from behavioural finance; herd behaviour, it exists in both bull and bear markets, but fascinatingly it is more prevalent in falling markets. Academics Andrea Devenow and Ivo Welch believe that herd characteristics may be a key factor in the disproportionate ups and downs in stock prices.

Imagine you meet an old university buddy for dinner and he tells you he has done well from buying semiconductor manufacturer Avago Technologies. You check it out and the stock has done very well, it looks a good company but the stock price is very expensive.

Despite the price your desire to buy is irrational because you are ignoring the efficient market hypothesis. EMH explains that the value of Avago Technologies is already realised by the market and the stock is priced accordingly.

William G Christie, Professor of Management in Finance, and his colleague Roger D Huang (1995) studied investor herding. They made the discovery that during periods of market stress, it is very likely that individual investors will suppress their own beliefs and follow the market consensus.

The father of economics John Maynard Keynes said as much in his book, 'General Theory and Accumulation' where he highlighted confidence as a key driver of ownership. Simply put, when the market expects a stock to go up in value, everyone jumps on the gravy train.

Rising stock
Hindsight bias is a psychological phenomenon in which past events seem to be more prominent than they appeared while they were occurring. It's a problem because the past helps to trick you that stock moves in the future will be more predictable. That false confidence can make you become more risky with investment choices.

Imagine you bought shares in the bakery franchise BreadTalk back in 2001. It would have been a perfect time to invest as BreadTalk won "Singapore's Most Distinctive Brand Award 2003-2004". From 2002 to 2004, the business also won "Singapore Promising Brand Award" and correspondingly the stock went from strength to strength.

As such you continued to hold the stock, Thai retailer Minor International increased its allocation, perhaps as a prelude to a takeover, and you upped your exposure again. But things in the markets can change for no reason; data provider Bloomberg recommended selling the stock in April 2014 because it looked overvalued.

The reason you didn't sell was because you were confident in your belief in how the stock was going to behave. You were sure its meteoric trajectory had more legs to run, and you congratulated yourself on being a genius stock-picker.

It's similar when people refuse to sell their homes in a falling market. They often defer doing so and end up losing more money through their delay.

These animal instincts were studied by Brad Barber, Director of the Center for Investor Welfare, and Terrance Odean, Professor of Finance at the Haas School of Business, California. They discovered the remarkable 'disposition effect'.

Their work recognised that an investor under the disposition effect will tend to sell winners and hold losers and this of course hurts their returns. The disposition effect explains why an individual investor might continue to hold BreadTalk despite the fact that most other people are worrying about the stock.

Ultimately, humans struggle to make good decisions. If a fund manager has sifted his top buy stocks down to two, it is very hard for him to think in absolute terms about which one to buy. Interestingly when investing your attitude to winning is not as important as how you feel when you lose money.

This phenomenon is not unique to money managers, humans universally struggle to analyse in absolute terms. It is far easier for us to evaluate decisions by thinking in relative terms. When thinking in relative terms you compare the two and think if I invest in stock 'A', I'm going to get a better return than if I would if I had invested in stock 'B'.

At the end of the day, having a clearer understanding of behavioural finance and the role it plays in market movements will allow financial advisors to make better investment decisions on behalf of their clients.

The future financial advisor needs to be able to detect bias in investor attitudes and communicate the value of investment products that accurately match the investor's risk profile while providing better investment guidance contrary to "rational" market mentality.