Pitfalls of the irrational mind – Part 3

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What can investors do to avoid making irrational decisions? In the final part of the series, Dr Subramaniam Pillay, an associate professor at Taylor’s Business School, Taylor’s University gives a few pointers.
 

Take a long-term view

Besides making the effort to confront opinions that are in conflict with your own, perhaps the most valuable thing for investors are their own mistakes.

“You have to develop the capacity to learn from mistakes: why you made the bad decision, what went wrong and what biases you were operating under, and how you can avoid making the same mistake in future,” Subramaniam says.

“You will get better if you keep doing that. There is no perfect investor. Even the best ones make wrong decisions. Warren Buffett admitted he made a mistake by investing in Tesco — and you cannot be a better investor than him!”

Investors also need to overcome the desire for instant gratification and adopt a long-term outlook. Instant gratification is the impulse created by media and advertising, prompting investors take a short-term view, says Subramaniam.

Long-term investors should not panic when things go wrong or get too thrilled when things go well. “Take a long-term focus. Choose a diversified portfolio without being too influenced by noise. Don’t sell just because stock prices are going down. Long-term investors will not let their short-term emotions get in the way,” he says.

While a diversified portfolio is used by investors to spread investment risk, Subramaniam cites a strategy by Nassim Nicholas Taleb, author of The Black Swan: The Impact of the Highly Improbable, to hedge against common psychological traps.

In his 2012 book, Antifragile: Things That Gain From Disorder, Taleb advocates the dumbbell strategy. This means putting most of your money in very safe, albeit dull, investments and a small amount in extremely risky investments to handle “black swan” incidents. Taleb’s black swan theory describes rare, unexpected events that occur without warning and leave a major impact.

“So most of your investments are safe, and if [the risky investments] turn out positively, you make a big return. But if not, you’ll just lose that. This sounds interesting to me because it satisfies two human emotional needs — security, but also some fun,” says Subramaniam, who stresses the importance of portfolio diversification.

“Many Malaysians invest in only one class of assets — property. They don’t diversify. That’s because, again, of the confirmation and anchoring bias,” he points out.

The new wave of Malaysian investors today is from Generation Y, which Subramaniam says grew up without ever seeing property prices decline. “If you were an adult in the 1980s, you would have seen them decline. Property prices peaked before going down in 1981, hitting rock bottom in 1988. Since then, we haven’t really had a property decline,” he adds.

“That is almost three decades ago. So they will all tell you that you cannot make a mistake from buying property. I find that younger people are taking huge leverage on property and their cash flows are very tight. I think this is a very big risk because if prices stop rising and there is a glut, rents will go down. And if they are cash tight to begin with, they will be in trouble.”

Not everyone believes in the concept of behavioural finance. Behavioural economists attribute financial market imperfections to psychological traps and biases, such as those mentioned by Subramaniam. Its critics, however, are advocates of the efficient market hypothesis, or those who believe wholly in market efficiencies.

Then there is the perpetual debate: Does the market control our psychology, or does our psychology control the market? 

Subramaniam believes market fundamentals and behavioural finance can co-exist. “I believe behavioural biases play a big role in the market, but I also believe in fundamental analysis. It’s not a contradiction. In the long run, market fundamentals work. But in the short term, it’s the behavioural biases that dominate. 

“But let me end with a small caution. As economist John Maynard Keynes pointed out about market behaviour in the short term: ‘The market can stay irrational longer than you can stay solvent’.”

 

This article first appeared in personalwealth, a section of The Edge Malaysia, on February 2 - 8, 2015.