By Pramod Veturi, Managing Director And Head, Wealth Management, Standard Chartered Bank Malaysia
Thus, supported by a mature industry, retail investors should be able to do better than the average. The reality though, is quite the opposite. There is growing evidence that actual investor returns are significantly lagging in the benchmark indices across markets by seven percentage points. Why is this so?
The answer is: error-prone behaviour of perfectly smart and logical investors.
Behavioural economists point to the irrationality of decision-making by perfectly rational humans in certain scenarios, called ‘behavioural biases’. These are biases which, if acknowledged and remedied, can significantly improve the odds of meeting benchmark returns.
The first of these is the principle of loss aversion.
According to standard financial theory, most investors are risk-averse and prefer certainty of any upside, as opposed to uncertainty. However, seemingly counter-intuitively when it comes to losses, investors prefer uncertain losses compared to certain losses.
For example, between a certain loss of MYR500 versus a fifty-fifty chance of losing nothing or MYR1,000, most investors choose to go with the uncertain prospect. This is despite a significantly higher potential loss.
Putting it differently, most investors are not willing to take the risk for a chance of gains, but are willing to take a risk to avoid losses. The unwillingness to exit loss positions, and increased allocation to riskier asset classes to recoup loss positions, are typical emotional responses associated with loss aversion behaviours. Thus, when facing a market downturn situation, most investors are likely to end up with a behavioural bias to double up on their risk-taking, which impacts their asset allocation strategies.
The second of these is the endowment effect.
In 1990, Economics Nobel Prize winner Richard Thaler did a very interesting experiment. He distributed coffee mugs to a group of university students. Students who were given mugs were asked to set a selling price, and those without were asked to set a buying price.
The results were unexpected; the sellers wanted nearly twice what the buyers were willing to pay. The results of this experiment led Thaler to coin the term ‘endowment effect’ to refer to the behaviour bias where we tend to assign a greater value to something we own, regardless of its objective market value.
As investors, we need to watch out for our own endowment effect, which can lead us to hold on to assets when there is an opportunity to book profits and look for new investment opportunities. In rising markets, this bias becomes more pronounced as investors keep ignoring their individual risk reward expectations and hold onto investments, in the hope of riding the wave of growth.
The last is the availability heuristic.
This principle suggests that people are more likely to make decisions based on how readily information is available to them. Investors tend to pour money into markets after they are exposed to an overdose of positive news about markets and asset classes.
Financial planners often tell me that clients hate to invest into assets that show negative returns over a period of time. They seem comfortable investing into assets that had a track record of significant growth, only to have their savings eroded when there is sharp correction.
While investing is mainly a deliberate and rational process, decisions made are irrational and governed by emotions, thanks to behavioural biases.
There are three factors to keep in mind to avoid these pitfalls.
First, have a clear financial goal. Focusing on the end goal helps moderate the insidious impact of bias and keeps you insulated from getting emotionally entangled into the daily gyrations of a market and from the bias of loss aversion.
Investors should also stick to a schedule. Do not attempt to time the market – remembering that adage of ‘the house will always win’. It is therefore more effective to manage your investment decisions according to an agreed schedule. This simple step will protect you from the bias of the availability heuristic.
Finally, invest systematically. Investing, say, MYR 1,000 a month, every month into a portfolio of equities will avoid the crisis of buying high and selling low.
In conclusion, the key is in being aware of emotional biases, and putting in place guard rails against the impact of emotions and irrationality.