Human beings are affected by a myriad of social, psychological and emotional factors which often make them behave irrationally and illogically.
Behavioural finance tries to explain why and how investors make suboptimal decisions, which create anomalies, such as during stock market bubbles and crashes.
By understanding the cause of irrational behaviour, investment returns can hopefully be improved. Losses are more painful than gains, so investors prefer to lock into a guaranteed modest gain and avoid a sure loss.
In a series of 1980s articles by Amos Tversky and Daniel Kahneman, 150 people were asked to make two decisions: The first was to choose between (a) a sure gain of S$240 (HK$1,485) or (b) a 25 per cent chance of gaining $1,000.
Or second: to choose between (c) a sure loss of $740 or (d) 75 per cent chance of losing $1,000.
The result was that 84 per cent and 87 per cent of the respondents chose (a) and (d), respectively, even though (b) and (c) would result in higher expected values (i.e the gain or loss multiplied by the respective probability).
People also indulge in mental accounting, separating profitable investments from loss-making ones. This is despite the fact that the total net worth remains the same.
Mental accounting and loss aversion cause investors to refuse to sell at a loss, costing them the chance to switch to more profitable investments to recoup the loss.
Another common mistake is anchoring investment decisions on irrelevant price points, such as the price level when one starts monitoring a stock. When the actual price falls below the anchor price, an investment is made, as it is considered cheap. If the anchor price is exceeded, the stock is then regarded as too expensive to buy. Whether an investment is expensive or cheap should be evaluated against fundamental factors, such as earnings and cash flows.
Some feel that they need to sell if the price is rising, since it cannot go up for ever. Galaxy's share price increased from a low of 55 HK cents in November 2008 to HK$20 at present as it managed to get financing to start its Cotai project in Macau. Others hold on, hoping for a rebound. Espirit's share price plummeted from a high of over HK$125 in October 2007 to a low of HK$8 over three years as profits dropped. Investors are typically overconfident in their ability to buy and sell at the best price and exit before a crash. This can lead to too much leverage, excessive trading and a portfolio containing a few large positions. Nick Lesson of Barings, Jerome Kerviel of Societe Generale and Kweku Adoboli of UBS are just some examples.
The dotcom bubble is a good example of herd instinct, when investors lapped up expensive internet stocks, many with dubious business plans and no track record.
Buy low, sell high, sounds simple, but many investors panic in bear markets and sell, even though it may be time to pick up some bargains. How many investors would be gutsy enough to pick up HSBC's shares at HK$33 or Esprit at HK$8? Investors become overly optimistic during bull markets and feel much more comfortable investing, instead of taking profit.
Investors often overreact. Companies with good news risk being overbought and subject to a subsequent correction when investors, reading the good news too much into the future, overreact before realising that they have been too sanguine.
Conversely, a company with bad news may become oversold before its share price recovers when investors realise things are not so bad after all.
Overconfidence, herd instinct, excessive pessimism or optimism and overreaction exacerbate market swings, and lead to market bubbles and crashes.
Whitney Tilson, of T2 Partners, who manages several hedge and mutual funds says decisions must be grounded on hard-headed fundamental and technical analysis.
Do not rely on random anchor prices, price movements, preconceived notions or the heart.
There is no point refusing to sell at a loss. It can be better to reinvest.
Few investors can consistently beat the markets. Do not be out to make a quick buck. Think longer term, maintain a diversified portfolio and keep leverage manageable. Do not make an investment just because others are doing so. Perform your own independent analysis and seek contrary opinions. Finally, focus on the big picture and long term.
The loss French bank Societe Generale suffered as a result of unauthorised trading by Jerome Kerviel in 2007 and 2008