Friday, February 01, 2008

Book reflections on "Investment madness" by John R.Nofsinger

It’s been a while since I reviewed any book, so let me do so now. The book I’m reviewing is that by John R. Nofsinger, titled “Investment madness”. This book is about the psychological biases that investors make. The following are the things to be aware of. I find the following are not just important for investment – it applies to life as well.

1. Overconfidence

Overconfidence causes us to overestimate our knowledge yet underestimate the risks involved. A few things can cause us to be overconfident:

a. Choice – Having an active choice makes you feel you’re in control, hence it leads to overconfidence. If I choose china milk myself, compared to someone telling me china milk is good, I will have active control over my investment choices. I don’t think I have this flaw because most likely I’d feel more confident on other people’s suggestion. Perhaps it’s due to my past failure to make consistent money from the market

b. Outcome sequence – the way an outcomes affects the illusion of control. If it’s the first time I play with warrants and I earned some money, I’d feel more confident. Conversely, if it’s the first time I played warrant and I lost (especially a lot), I might even give up.

c. Task familiarity – familiarity breeds control. The more I do a task, the more familiar I become at it and the more confident I feel about it. If I’ve been staring at charts for 2 years, I feel confident about reading it. Hope it’s not overconfidence though.

d. Information – Information is not equal to knowledge or fact. If I go to cna forum under say Pac andes thread, there is a wealth of information there. The fact that there are so many people who are discussing pac andes there makes an investor more confident about it. But are those information validated and checked by you? Perhaps yes, but most likely not. I recognize the effects of information in my blog, especially the chatbox – it might cause us to be overconfident of a trade because we see information as knowledge or facts.

e. Active involvement – the more involved I am with the task, the more confident I’ll be. It’s like people feel they have a greater chance of winning a coin flip if they are the ones flipping it. Again, I do not have this flaw.

2. Status quo

When faced with new options, people often stick with what they have. Routine feels good I suppose. People have a tendency to keep what they had instead of doing something to it. As a result, we tend to hold onto the investment that we already have, be it insurance, individual stocks, a job etc. In fact, due to attachment bias, the longer you hold an investment, the more you can attached to it and might even see it through rose-coloured glasses. Another effect of this is what I called analysis paralysis. Sometimes while waiting for a good deal, we just keep on delaying it, while all the time thinking that the deal will become better. For example, when HSBC dropped from 137 to 120, I thought that is a good deal but I delayed buying it. When it dropped to 100 I thought it’s a better deal, but I also didn’t buy it. Inability to act when the situation calls for it.

3. Seeking pride and avoiding regret

People avoid actions that create regret and seek actions that cause pride. Regret happens when a decision you made turned out badly. Pride is when a decision made turns out to be a good decision. This kind of emotion can also us to sell winners (to feel proud and boast it) and avoid selling losers (to avoid regret in case it rebounds or avoid telling people you lost money or it spoils your track record). Having a blog amplifies this as I feel I have a need to tell people how good my record is – that’s my honest realization. Have you ever sold your winners too soon and held your losers too long?

How to avoid this? Learn to take losses and hate to take your gains. You wouldn’t want to end up with a portfolio full of losers right?

4. Double or nothing

People tend to use a past outcome as a factor in evaluating a current risky situation. They are more willing to take risk after gains and less risk after losses. A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise. These few effects are important:

a. House money effect – After winning, people are more willing to take risk. This money earned is called house money – money that hasn’t been integrated with their own money and it feels like betting with someone’s money. Last time when I was actively trading warrant, I committed plenty of this flaw. I earned some money and straight away plow it into another, since I haven’t fully integrated that winning with my own money yet.

b. Snake bit effect – after experiencing a financial loss, people are less willing to take risk. After having been unlucky enough to lose money, people often feel that they will continue to be unlucky, hence the risk aversion. I think it’s happening to me right now. If the snake bit effect is strong enough, it can cause a person to quit the stock market entirely

c. Break-even effect – this is interesting. Some people take more risk after they’ve lost money – and they take more risk that they normally wouldn’t take in order to break even. I’m glad I don’t have this flaw because of the potentially bankruptcy potential.

5. Social aspects of investing

Investing is not just an individual thing but it is becoming a social event – those cocktail conversations that put you up ‘there’ with the others. While walking around the streets, I often come into encounters with people on trains or buses or coffee joints talking about the latest stock. Some are teaching others while some are boastful about their gains or their losses. This can cause us to become herd investors. The problem with this is that it magnifies the psychological biases and cause us to make decisions that are based on the feel of the herd instead of the rigor of analysis. Cna forum and blogs are social investing. Psychological biases are magnified in those places, do beware.

6. Mental accounting

People who do not have a proper accounting of their money will use mental accounting system. Each decision, action and/or outcome is placed in a separate mental folder that is deemed to have nothing to do with each other (independent events). Here are some effects of it:

a. Mental budgeting – the brain uses mental budgets to associate the benefits of consumption with the costs in each mental account. There is this matching between the costs to the benefits of a decision. This means if the benefit is for a long term, people prefer paying over the long term. Conversely if the benefit is for the short term, people prefer paying it immediately. For example, if I’m going to a trip to Europe, I prefer paying it immediately because the benefit is to be enjoyed now. If I pay after the trip had been taken, the pleasure is somewhat diminished because I’ll be thinking of how much I have to pay during the trip. Another example is when I buy a car, I don’t pay everything upfront since the benefit is over a long period of time. Somehow…doesn’t really apply to me.

b. Sunk cost effect – people consider historic, nonrecoverable costs when making decision about the future. When time or money has been invested, there is more commitment to a decision made, though rationally, one should consider the present and future costs and benefits associated with that decision. Size and time affects the sunk cost effect. If I paid $5000 to a stock, even though it’s losing, I’ll be more likely to keep it then if I paid $100…that’s the size. If I paid $5000 yesterday to a losing stock, compared to paying $5000 to a losing stock made 1 year ago, I’ll be more likely to keep the more recent one…that’s timing. Somehow, the pain of closing a mental account without a benefit decreases over time, making it easier to make decision more rationally.

I think it’s important to merge all the mental accounts of your investment – insurance, bonds, savings, MMF, cpf – as one instead of mentally attributing them to different accounts. I mean one should consider one’s money as 1 single portfolio, instead of concentrating solely on investment or solely on MMF. Then do whatever decisions necessary to shift your money to the right category in order to earn a higher return for your single portfolio.

7. Memory

Human memory is not a factual recording of events (unless you’re a special few). It’s the perception of how events unfolded that is recorded as your memory. As a result, our memory can recall selective parts of the events according to our perceptions, which can change.

a. Boiled frog parable – The saying goes that if a frog is thrown into boiling water, it will jump out and escape. If the same frog is thrown into water that is slowly boiling, the frog will not notice because the effect is slower. Memory of a falling stock can do that to us too. If yzj fell 40% in a day, we feel the loss associated with the stock and will avoid it in future. If yzj fell 40% over a span of 10 years, it’s a different thing altogether

b. Cognitive dissonance – we tend to do things which reinforce our positive self image. To avoid this dissonance, people tend to reject, ignore or minimize any information that conflicts with their positive self image. Evidence that cannot be denied is accommodated by a change in beliefs – which will be consistent with past decisions so as to feel you’ve made the right decision in the past. This can have two effects – one is failing to make important decisions because it is too uncomfortable to contemplate the situation. For example, I might not want to learn how to do FA because it conjures up images of me looking stupid in front of others, hence I would not even pick up FA at all to avoid this cognitive dissonance. The other effect is that of filtering new information that therefore limiting my ability to evaluate and monitor investment decisions. For example, if I think that ABC stock is a good stock, I will ignore all information pointing otherwise.

c. Memory and socialization – when more people talk about the stock market, they become self reinforcing in their own beliefs while ignoring all the bad news and over emphasizing the good news.

d. Anchoring – we subconsciously set a reference point to compare present price. For example, I bought hsbc at 137, which becomes my anchor point to view the current price. But it happened a while ago, so my new anchor point is the recent low of 100. If it goes near 100, I’ll be more likely to enter. Before that, my last two anchor points are 120, and 115. Anchor point determines the pleasure of obtaining a profit or the pain of a loss. Anchoring effect makes it harder to cut loss or to take profit, and when combined with the pride of winning and the regret of losing, it becomes a powerful money degenerator, especially for traders.

8. Mental shortcuts

The brain uses shortcuts to reduce the complexity of analyzing information. These shortcuts allow the brain to process vast amount of information without fully digesting it. The advantage is that we won’t be paralysed by the barrage of information that hits us every second, yet the disadvantage is that it makes it hard for investors to correctly analyse new investments and can lead to inaccurate conclusions.

a. Representativeness – is the judgement based on stereotypes. If you had been hit in 1997 stock market and tell that stock market is very risky can lose a lot of money, the next time an opportunity come for you to enter it again, you will not take it. The decision is made on the assumption that market made you lost money hence will do it again and this is easier than to analysis the present market situation or to analyse why you lost money in the first place. I lost money a lot on longcheer before, hence I would be predisposed to ignore it even though the situation for it might have changed now.

b. Familiarity – people prefer things that you have some knowledge or is more familiar to you than another which is new. Most people will be stuck in local Singapore shares because as local investors, we definitely know more about it than say HK or US shares. The brain will rather not analyse foreign stocks even though there might be better opportunities than local ones because it is not familiar.

The brain is inherently lazy. My rule is this: if you’re feeling too comfortable in any situation, it’s time to move on to newer pastures. Always challenge yourself.

I believe each one of us do commit at least a portion of the psychological biases that are listed here. The more of these you committed the more human you are (yea!) and the poorer your investment returns will be (boo!).


Solomon Grey said...

Spot some things that I think I should mention:

1.) Shouldn't it be "familiarity breeds contempt" instead of "familiarity breeds control"?

2.) You said "Learn to take losses and hate to take your gains.", but I think that's only half right; You shouldn't hate to take gains, but instead learn to take your gains at the right time;