Investors should learn about psychological biases
MOST standard courses on investing are aimed at improving the individual’s ability to make informed decisions in the hope this will lead to better financial health. Students are taught to know their investment horizons and risk profiles; create suitably diversified portfolios by using fundamental analysis; look at earnings; employ dollar-cost averaging; and to buy and hold for the long term rather than indulge in short-term trading.
These are tried and trusted principles of investing – at least in theory. In practice though, many people make all sorts of mistakes when it comes to their finances – they buy high and hope to sell higher, hold on to losing positions for too long before cutting losses and succumb to herd instinct, probably driven by FOMO (fear of missing out).
The root problem is that standard financial and economic theory assumes all people are governed by perfect self-interest, perfect rationality and perfect information. These assumptions are relaxed to some degree in certain models, but by and large, most standard economic frameworks rely on humans being rational and selfish, and markets being efficient.
In the past 20 years, however, a branch of finance theory known as behavioural finance has grown in significance in terms of guiding investors to understand how they make decisions. It acknowledges that most people cannot be expected to behave rationally all the time.
Instead, people are modelled as “normal people” who can behave irrationally. It examines behaviours or biases of individual investors that distinguish them from the “rational actors” in classical theory.
For instance, when newly acquired information conflicts with pre-existing understandings, people often experience “cognitive dissonance’’ that can cause them to hold on to lousy positions for too long and go to great lengths to rationalise why they embarked on failed investments in the first place.
Individuals are also prone to confirmation bias – wherein they seek out only information that confirms their beliefs about an investment and avoid information that may contradict those beliefs.
Yet another is “anchoring’’ where the mind fixates on a particular “anchor’’. Suppose a person bought a stock for S$1, didn’t sell it when it rose to S$2 and it now trades for S$1.50. Even though the person is still 50 per cent better off, chances are he or she will feel they’ve “lost” S$0.50 and would prefer to wait for it to return to the mental anchor of S$2 before selling.
In a 2018 paper on behavioural insights in financial literacy, the Organisation for Economic Cooperation and Development (OECD) stated that after undergoing a financial course, “there is a range of cognitive, social and psychological factors or barriers that may prevent people from using their newly acquired knowledge to make satisfactory or rational financial choices’’. It noted that “insights from behavioural sciences are especially relevant to securities regulators and policymakers seeking to improve levels of financial literacy, due to the complexity and long-term nature of many financial products, the need for investors to make judgements about the risk inherent in these products, and the impact of biases, ... and other factors affecting investor decision-making’’.
Recognising psychological biases and then learning how to overcome them would surely make for more well-rounded investors. Those who conduct financial training courses should take note.
The writer is a former journalist who is now senior editor and trainer at the Securities Investors Association (Singapore) (Sias)
