The human side of investing

Buy low. Sell high. That's what a smart, rational investor is supposed to do. And most of us want to do that. But it's not that simple.

Emotions often get in the way. And that's what behavioural finance - the study of decision making in investors - tells us. People, it turns out, are not as predictable as once thought when it comes to finance.

'Under risk and uncertainty people make decisions differently,' said Lynn Pi, adjunct associate professor of the School of Business and Management at the Hong Kong University of Science and Technology. That is why people may know they will lose money but still invest.

'Studies in the financial markets found that there are anomalies and unresolved puzzles that cannot be explained or contradict traditional finance theories,' said Dr Pi.

In traditional finance when there's risk and uncertainty, people demand a premium. A lot of the risk and return trade-off analysis follows this. It is understood that people would demand a higher return or a higher premium to compensate for a higher risk.

This had been going on for a long time until people found inconsistencies with this established model of behaviour. It was also believed that people always prefer less risk than higher risk. That's also not the case.

For example, let's say that a person was given the choice of either paying HK$100 up front for a loss. They are then given an alternative scenario where they can toss a coin and not pay anything if the coin landed with the head side up, but they will have to pay HK$200 if it landed the other way.

Traditional models of investor behaviour tell us that most people would choose to pay the HK$100 upfront, because the latter scenario carries the risk of a bigger loss. However, behavioural finance says that sometimes investors would prefer to take the chance to incur no losses at all.

Also, in behavioural finance people treat gain or loss differently. People tend to assign a greater significance to loss that is of the same magnitude as a corresponding win. That is, if they lost HK$5, they tend to feel that is a more significant change in their financial position than if they had won HK$5.

'There are different reference points for gain and loss,' said Dr Pi.

Prospect Theory is the most widely cited behavioural finance model to explain the anomalies and inconsistencies in behaviour. A few of the points under the model include:

Heuristics Simplifying when a person simplifies problems and goes for the 'quick and dirty' answer instead of spending time getting the more precise and right answers.

Representative Bias when people may develop a bias towards a 'hot stock' because it is being talked about all the time. They may end up buying it without doing their own homework.

Availability when information is so readily available it easily influences investor decisions.

Loss Aversion when a person puts more weight on loss than gain, meaning he has a much higher level of unhappiness with a small loss when compared to the level of happiness he gets from the same level of gain.

Mental Accounting when people sell the winners and keep the losers in their portfolio, not taking into account the future returns of the winners are higher than the potential gains of the losers.

Instant Gratification when investors put more weight on benefits that are considered closer in terms of time.

Optimism when a person sees the market going up and tends to see there is a high chance that it will continue to go up.

'These are all basically just human shortcomings,' said Dr Pi. 'But these are all behavioural characteristics of human beings.'

Dr Pi acknowledged that the usefulness of the information in finance was limited as it could only provide an explanation for some inconsistent behaviour, but it couldn't measure it. But this knowledge could be useful in financial planning.

'We are all human beings, we are subject to emotional ups and downs so we cannot make a lot of these decisions logically and rationally,' said Dr Pi. 'So financial advising would be helpful to remind people or clients that behaviour is not logical at this point or not rational.'

'I think our job is to help reduce the impact of emotional biases of investors,' said Catherine Cheung, head of investment strategy and research at Citibank.

A recent study done by the bank found that in an up market, those who invested against the market had annualised returns of 9 per cent, while those who invested independent of the market had zero returns and those who went with the market suffered a loss of 10 per cent. For a down market, the numbers were all negative with those investing with the market suffering the biggest losses at 17 per cent. Ms Cheung said that diversification was the key to a more balanced portfolio. 'It is helpful to establish a long-term financial plan to help keep goals in site and to not make rash decisions.'