How To Apply Behavioural Finance To Value Investing

“Investing is not a game where the guy with the 160 IQ beats the guy with
the 130 IQ… Once you have ordinary intelligence, what you need is the
temperament to control the urges that get other people into trouble in
investing.” — Warren Buffett

In the stock market, a small percentage of investors consistently outperforms the market in the long run, whereas the majority of investors, in spite of occasional wins, don’t make any money or end up losers in the long run.

An investing strategy taught to 100 investors will yield different results from each of them. In the long run some of them will be very successful at it, some will be mediocre while the rest, will fail. Why is that so?

Because we have our own methods of making decisions and this is largely due to behavioural biases. Every individual is unique and has each own biases, these biases are formed by our own experiences over time.

We make judgments about companies, its management team, government policies and, of course, the markets. When we make investment decisions without knowing these biases, we pre-framed our observations based upon our own experiences and are selective about what we want to see or hear. In other words, you choose want you want to see or hear regardless of opposing facts.

For example as a loyal customer of Amazon, I am biased with the fact that Amazon is an amazing company and this bias will eventually affect my decision to be an Amazon shareholder regardless of factors that says otherwise.

The stock market reflects the cumulative biases of investors and this is what drives the market from highs to lows, vice versa.

As the market sways between greed and fear, we usually become greedy and bid up and buy stocks at very high valuations instead we should buy stocks when everyone has become fearful.

It is the behavioural traits of the investor and crowd behavior of the market in general which is responsible for extreme bull and bear markets.

Believe it or not, these biases are predictable and can be explained by behavioural finance.

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What is behavioural finance?

Behavioural finance is a psychology-based approach which explains stock market movements by understanding emotions and behaviour of investors. The emotions and behaviour of investors are simply based upon biases that influence investment decisions as well as market outcomes.

Cycle of market emotions
Cycle of market emotions

Behavioural finance studies different psychological biases that investors display when investing in the stock market. These biases which are simply human nature, often leads to irrational investment decisions. This is the reason why bubbles and panics occur.

Traditional Finance vs Behavioural Finance:

Traditional Finance vs Behavioural Finance

Why is it important?

These biases can influence decision-making, especially when it concerns money and investing. The biases influence how we process information to reach decisions and the preferences we have. Behavioural biases can potentially affect your investing decisions. By understanding behavioural biases, you may be able to moderate or adapt to the biases and as a result improve your investment returns.

“The investor’s chief problem—and even his worst enemy—is likely to be himself.”
– Benjamin Graham

George Soros once said ‘investors are fallible’, which means that we are prone to errors. It is also human nature that we tend to repeat the same mistakes. These mistakes often reflects in various stages of the market cycles. When market consensus are too bullish on a stock, investors will re-rate its price to all time-highs. As soon as the company misses expectations, it triggers a knee-jerk reaction and causing investors to panic sell because everyone realises that they’ve made a mistake.

Just take a look at FB’s share price after the company reported a lower than expected earnings on July 2018.

facebook stock
Source: Yahoo Finance

As you can see, FB’s stock price reaches all-time highs before plunging 24% the next day after the company reported its quarterly earnings. This phenomenon repeats again and again throughout the history of the stock market and the intelligent investors will take the opportunity to ‘fade’ against the investing crowd.

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In order to make better investment decisions, it is important that we first understand what these biases are and how we can avoid them. So here are 5 most common biases in investing:

#1 – Overconfidence

Overconfidence is the most common biases among investors. It is the tendency investors have to be more confident in their own abilities. Overconfident investors believe they have more control over their investments than they truly do. Overconfident investors may overestimate their abilities to outperform the market.

Unfortunately, even experts are prone to overconfidence from time to time. In a recent example, my all-time favourite value investor, Warren Buffett, admits his mistake on Kraft-Heinz. He said “I was wrong in a couple of ways about Kraft Heinz,” Buffett tells CNBC. “We overpaid for Kraft.” Kraft’s write-down sent the stock plummeting more than 27 percent and Berkshire is one of Kraft Heinz’s biggest shareholders.

Most professional investors believe that their stock-picking abilities are a source of alpha and it gives them an edge over the investing crowd. In fact, experts often overestimate their own abilities more than the average investor does.

James Cordier, a hedge fund manager who trades options with clients’ money. Not too long ago, Cordier posted a 10-min video, apologising to investors after his hedge fund lost all of its clients’ capital during an extremely volatile period of trading natural gas. His hedge fund was wiped out as a result of overconfidence

Overconfidence may be a factor in today’s market. Given the 10-year long bull market, most investors have not experienced a serious market drawdown and are probably not prepared for it. As Buffett once said “Only when the tide goes out, do you discover who has been swimming naked”.

#2 – Herd Behaviour (Chasing late-stage trends)

One of the most recent market bubble was the crypto-mania of 2017-2018, where we saw bitcoin jump almost 20 fold – it started the year at about $1000 per unit and topped off at $19k++ end 2017. The crypto bubble burst in 2018 and bitcoin plunged 80% from its highs. I know die-hard crypto investors would love to argue with me on this, but this was a classic market bubble. This was not the first time that events like this have taken place in the markets, and it’s unlikely to be the last. The question, then, is how could something as catastrophic as this happen over and over again?

As they say, history repeats. Humans are fallible and this is a classic example of herd behaviour. Although I believe that blockchain technology and cryptocurrencies will be game-changers, most ‘investors’ who bought crypto overpaid for them and were merely speculating for its price to go higher. These speculators have the fear of missing out or ‘FOMO’ as they conformed to social pressure.

Another reason for herd behavior is growing social proof. This means that the more people made profits from crypto, the more others will jump in for quick profits as well – even if he/she believes that the action is irrational.

#3 – Loss Aversion (Fear of loss)

Consider these scenarios:

Scenario 1 >> You have $1,000 and you must pick one of the following options:

Option A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0.

Option B: You have a 100% chance of gaining $500.

Scenario 2 >> You have $2,000 and you must pick one of the following options:

Option A: You have a 50% chance of losing $1,000, and a 50% chance of losing $0.

Option B: You have a 100% chance of losing $500.

In both scenarios, you could only choose either Option A or B. If you are a rational and risk averse investor, you should choose Option B for both scenarios because Option B is 100% certain of its outcome. Risk averse investors hates uncertainty and risk.

On the contrary, as predicted by behavioural finance, if you are a risk averse investor, you would probably have chosen Option B in scenario 1 and Option A in scenario 2.

Am I right? (Comment below if this is true)

Now if you have chosen Option B in scenario 1 and Option A in scenario 2, you’ve just displayed the perfect example of loss aversion. Loss aversion refers to investor’s tendency to prefer avoiding losses than to acquire equivalent gains. In this scenario, you have chosen not to lose $1000 (50% chance of losing $0) than to gain $1000.

By going for Option B in scenario 1, you’ve limited your maximum upside at $500 and choosing Option A in scenario 2, you’re exposed to a maximum downside of $1000. Now how does this relate to investing?

The loss aversion bias suggest that investors are willing to settle for small gains even if there is a possibility of earning more, but they are more likely to engage in risk-seeking behaviors in situations in which they can reduce their losses. Have you ever been in a situation where you were quick to take 10-20% profits off the market, but in a losing position, were willing to face a 50% drawdown in hopes of stock prices recovering to breakeven point? I’ll be honest, I was once guilty of that.

Your reluctance to take a loss led you to gamble the possibility of suffering a greater loss on investment. This is the reason why investors end up with losses far greater than what they had imagined, which is why investors are always late in cutting losses.

#4 – Anchoring

“When I bought something at X and it went up to X and 1/8th, I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored. I cost us about $10 billion [by not buying enough Wal-Mart]. I set out to buy 100 million shares, pre-split, at $23. We bought a little and it moved up a bit and I thought it might come back a bit – who knows? That thumb-sucking, the reluctance to pay a little more, cost us a lot.” – Warren Buffett

We always like to anchor our investment decisions to a price set in the past. For example, if stock ABC was trading at $1 yesterday and it’s now trading at $1.3, we are less willing to pay for the stock since it has increased by 30%.

Similarly, if we bought a stock at $5, and it has now plunged to $2.5. We tend to hold the stock in hopes of break-even at the risk of losing more. This type of price anchoring also relates to loss aversion.

Another common anchoring bias especially among value investors, is our reluctance to buy more of a stock as price goes higher. But we are more willing to buy more of a stock as it goes lower than our initial purchase price.

This means that you’re likely to overweight on loss-making positions and underweight on profitable positions, this often results in inconsistent performance or worse, losing money in the long run.

Investors often anchor their decisions on the first source of information that they see such as an initial purchase price of a stock and have difficulty adjusting their views to new information.

#5 – Confirmation Bias

It is often said that seeing is believing, but what we see may not be a true reflection of reality. Sometimes, we see the things we choose to see because they support our opinions, this is called confirmation bias.

An investor is more likely to look for information that supports he’s original ideas about an investment, rather than look for information that contradicts it.

If we identify a stock with an attractive dividend yield of 10%, we are likely to find information to prove that the stock is truly a bargain. Our brain will only filter information that confirms it’s investment potential.

For example, we will start looking for information in the financial statements, and extrapolate historical performance such as ROE, consistent EPS, low debt etc. And we tend to underweight red flags such as increasing competition or loss of major customer.

There are four ways in which confirmation bias affects investors:

  • Biased search for information. This means that the confirmation bias causes investors to search for information that confirms their existing beliefs, and to ignore information that contradicts them.
  • Biased favouring of information. This means that the confirmation bias causes investors to give more weight to information that supports their beliefs, and less weight to information that contradicts them.
  • Biased interpretation of information. This means that the confirmation bias causes investors to interpret information in a way that confirms their beliefs, even if the information could be interpreted in a way that contradicts them.
  • Biased recall of information. This means that the confirmation bias causes investors to remember information that supports their beliefs and to forget information that contradicts them, or to incorrectly remember contradictory information as having supported their beliefs.

Confirmation bias explains why markets do not always behave rationally. In fact, behavioural finance largely contradicts the Efficient Market Theory, according to the theory, stock markets are efficient, investors make rational decisions, they are sophisticated, informed and act only on available information. If markets are efficient, it means that prices always reflect all information, so there’s no way you’ll ever be able to buy a stock at a bargain price.

However, as you’d already know by now that our human biases hinders our ability to make rational and informed decisions. Emotion and psychology play a role when we make decisions, sometimes causing us to behave in unpredictable or irrational ways. I’m very certain that most investors have unknowingly or knowingly experienced these biases that I’ve mentioned above. So the question is…

How Can We Avoid Them To Improve Our Investing Skills?

So how does the ordinary investor try to overcome these biases?

The first step, of course, is to acknowledge these biases and understand that it is human nature for us to have them. Next, you need to note down the biases (overconfidence, herd behaviour, anchoring etc) that you’ve had in the past. Lastly, create a checklist to consult before you decide to invest in a stock. Few investments will meet all your own criteria, but most should meet most – and your checklist will help filter out many of the above biases. Overall, it’s important to develop your own investment checklist to make your decisions as objectively as possible.

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The biggest factor to consider as a retail investor is how you’ll adhere to the rules and investment plan that you’ve set. Self-discipline to the rules you yourself set is the biggest single challenge here.

As Anthony Bolton says; “if you are very emotional you may not make a good investor as you will be too influenced by the prevailing investment climate.”

Many investors especially beginners focus on numbers when investing, it is human nature that we like to see things that are tangible and quantifiable. However, these numbers are available to everyone and it doesn’t give you an edge in investing. What determines your success is your mind and temperament, and your ability to control them.

Here’s what you can do to avoid investing biases:

  1. Manage emotions. Investors tend to be emotional when investing in large sums of money. Adjust your capital allocation for each stock according to your risk tolerance, if you’re risk averse, perhaps you might consider allocating 1-2% of your portfolio into each stock. Gradually, increase capital allocation as you gain more investing experience.
  2. Seek contrary opinions. Confirmation bias is the tendency to seek information support an existing point of view. Open your mind to opinions of others. You can begin my reading research reports and blogger opinions on stocks that you want to invest in, but ensure that you’ve already done your own research before search for external sources.
  3. Don’t chase hot and promising stocks, avoid crowded trades. Unless you’ve done prior research and are confident that the stock remains undervalued in spite of its price, you should never chase hot stocks. Popular trades have a way of becoming too popular, as investors burned by the tech bubble and the crypto craze have discovered. I’m pretty sure you don’t want to be the last one holding the hot potato! Following the herd can be a bad idea, and investors should do their homework before joining a crowded trade.
  4. Be a critical thinker. The best way to avoid anchoring in your investment practices is to engage in rigorous critical thinking. The most successful investors don’t base their decision on just one or two benchmarks (eg low P/E or high Div %). Rather, they evaluate each company from a variety of perspectives in order to understand the investment potential at hand.

We all make investing mistakes. Accepting them, learning from them and trying to prevent their recurrence is what this is all about. Understanding behavioural finance can help value investors break bad investing habits and possibly, use it to your advantage.

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