Behavioural Finance

Source : My paper (31st Aug 2007)

Behavioural finance is a science that studies how people’s psyches and behaviours affect the way they invest. In this article, Professor Frank Ashe mentioned that investors tend to panic and over-react when they see market slows down. This result to sell-offs and markets tumble further.

Medulla Oblongata which is linked to our emotional and basic instincts is used to make these impulse decisions. Prof Ashe advised that investors should use the Neocortex layer of the brain as it controls our complex, rational thinking. This will enable investors to make long term decisions.

Prof Ashe listed the 3 major mistakes investors commonly committed:
1. Over-confidence
This is correlated to age and gender. Based on statistics, single females investing tend to make 1.1% more than males and the risk faced is much lower. (Expected but such phenomenon is not really true for all as nowadays females like fast cars too i.e. risks, and I know of males who are low risk takers.)

He advised investors to listen to the different ponts of views and be ready to make changes all the time. He also has an interesting solution for the single guy - to get married and ask their wife to invest for them. Haha I doubt it will work though because most females would not even invest much haha.

2. Following herding instincts
“Monkey see, monkey do”. So you just keep following what people say and buy. This is risky because the actual performance of the stock is not accurately reflected due to the high buy volume.

Prof Ashe advised that different people have different pockets and different needs. Thus do not discuss too much with your counterparts on what stocks to buy. Most importantly, exercise self-control and think rationally.

3. Limited Rationality
If you keep thinking only one direction, you might accidentally turn on your auto pilot mode. An auto pilot mode example is when you head home but realise you have no memory of what has happened on the road because of your fatigue.

A test was done on this auto pilot syndrome. A group of people who are trying to lose weight were split into 2 teams. Team A needs to remember 5 numbers while Team B needs to remember 10 numbers. Both teams had to pass through a long corridor to give the list of numbers to the person at the other end. Along the corridor is a box of sweets. The results show that the Team B is more likely to take the sweets than Team A because they have used more memory to remember the extra 5 numbers, and ended up taking the sweets on their auto-pilot mode.

This is also the reason why supermarkets like to put sweets and chocolates and cigarettes near the cashiers because shoppers tend to be tired by then and might pick up these items out of natural instinct. Gosh, and I always thought it is because these were sellable items or items identified based on Market Basket Analysis.

Prof Ashe advised that one should plan investments in the mornings on weekends as the mind is rested and fresh. And do not make short term investments.

Lastly, he said there are two types of bias:
1. Confirmation bias
Keeps believing in certain trend e.g. a bullish market and refuse to do anything until it is clear that it is not a bullish market.
2. Representative/availability bias
The stocks you trust most is most probably the stock you last saw because you only believed the latest things you seen are the most accurate.