Friday, 31 October 2014

Behavioral Finance - We always believe less than we know...

Since from school days, I have grown enormous interests in behavioral finance. To me, it is the most fascinating branch of all finance theories, as it studies the one market factor that is most powerful and unreliable: the human psychology. 

Sometimes, you ventured an investment idea or you learned it from some guru, but could not be sure. So you study, check around and found out that not only one guru, two gurus, but three gurus all hold the similar idea and some have taken actions already! Well, it can not be wrong. Great minds think alike. We must make money together. So you become a guru too and inspires more to jump into the river. This is herding behavior. We are more courageous when we are in a group. but group think can be vital. Think of lemmings, the cute little animal that follow one another to jump into the oceans. Do hundreds of sheep together make them stronger and unafraid of a single wolf? As it says, "In the market, Bull can survive. Bear can survive. Sheep and pigs get slaughtered. "

The market is full of well educated investors. But only few can make consistent right decisions and actions. Investing is alluring. The red and green price fluctuates on the screen every second, opportunities abound. Many get rich fast. Many left after epic failure. Still many are eager to jump in with their hard earned money. But as it can be very rewarding, investing can be a very risky and unforgiving game. For many investors including myself, the problem is not that we don't know enough, but we always believe less than we know, and we always act less than we believe. 


Human psychology is very complex. The pain caused by losing money is more intensely felt than the joy brought by gaining the same amount of money. This probably explains why so many investors hesitate to cut losing positions, or even worse, buy more losing positions, simply because they do not like to cut loss and accept the pain. It is unsurprising that the persons who tend to hold losing trade, also tend to close winning trade too prematurely, like they say:" Brave to lose, Timid to win." 

Recently a friend told me that he still holds large amount of NOL stock he bought in back before GFC! I was so shocked and could not utter a word when I heard that. Of course he regretted deeply that he should not chase the counter when it was so high at that time. ( You can't blame him too much. Back then the economy was so rosy, international trade was exploding, and shipping business seemed so promising. All brokers encouraged you to buy. All analysis concurred that despite the strong advance in  the stock price, there is still much room to go even higher. One can not afford not to ride the trend. Do those words sound familiar all the time? ) He convinced himself that as long as he doesn't sell, it is only paper loss. ( A textbook example of unable to cut loss). Should he cut loss and re-invested the amount in the market, given the stock market performance since GFC, highly probably the loss had been covered already, if not making profits.

I tried to divert the conversation and asked him: did you short EUR/USD last quarter? ( It seemed a good trade when EUR/USD monthly chart saw the MA dead cross forming while ECB meeting minutes called for weak euro. All indicator agreed downward trend.)  He said yes and thanked me for tips. I went on and asked him: how many pips did you catch? He said he opened at 1.33 and closed at 1.325 or so. Clearly he missed the majority of the trend from 1.35 to 1.25. It seemed that he only held the winning position for less a week. I did not ask further. I presumed it is because he is uncomfortable to see so much unrealized paper profits. So he had to close it and transfer the profits  to safe bank account.  " Brave to lose, Timid to win" .  Is he ignorant? Absolutely not! He graduated top in our class. He is ever so cheerful and caring, not to mention that he is tall, athletic-built and good-looking. His career and life makes one envy too. At early 30, he is playing manager's role. He is happily married with one cute daughter, living in a nice new condo in the west. 

This is not uncommon. One senior FX broker once said, if you check, many exploded accounts belong to very successful people. They are managers, professors, doctors, lawyers, etc. Clearly, success in other profession is not a guarantee in investment. To be successful in investment, some different traits are required. 


We all heard the saying " Never catch a falling knife", or something similar. But how many times we fell into the trap? 

When the quality stock under watch has finally break down its narrow trading range and make a move downward. Opportunity emerges? Instead of jumping in on the first sign like an amateur, you wait and you hold your fire. The movement proves to be temporary and the breakout is a fake. The price reverts to its normal levels. Emmm...:) Similar drama repeats a few times. Your preferred price level seems to be too ideal to be realized. You start to lose patience. This time, you decide that you can not be so indecisive when opportunity presents itself again. Oh! Too bad. This time the break out is for real. The price keeps dropping. You tell yourself: It is Ok. I only invested a nimble, and you are self convinced that I should only buy more when price drops further  as if the market is wrong and you are right. Well, you get what you want, the price goes down further, and you keep your promise to buy more. Miracle happens! The price rebounds! See, like I was saying...  But then the price changes its direction to south again, the price chart draws another diving line .... 

More than often the retail investors and even professionals found themselves jump in and "buy the dip" too early before the base forms. How to avoid a big failure? You can test the water with a nimble position if you feel the price is indeed in the oversold region. But you should not buy any more if the price drops further. You must either cut the test position or hold and see if the price really rebound or it just rebounds for preparation of next wave of diving.

Remember, for most quality stocks, rising is bumpy and slow, dropping is ferocious and fast. Hence, you should hold winning position with conviction and patience, while cut losing position decisively and fast. However, in real life, many investors do the exact opposite. When they lose, they drag too long to act, when they win, they quickly get out.

The above is a vivid and somewhat sarcastic display of investor psychology. 

Overconfident investors seems to have the urge to capture every price move and/or overreact to the price move. In the end, they often miss the big trend. Again think of nature's hunters. The lions hide and wait until the best opportunity to strike. Should the lions strike at every sign, they will be exhausted and miss the real treat. 

Nothing speaks louder than success. To stand out, one needs to capture at least one good trade in life, in your profession or investment or any endeavor your pursue. To remember, the most dangerous factor in market is yourself. Many spend efforts to know the market, but fail to know one selves. The one who knows others is intelligent. The one who knows himself is enlightened. ( Lao Zi)


  1. Very refreshing article, especially like the following statement : To remember, the most dangerous factor in market is yourself


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