Wednesday, January 19, 2011

Mental Accounting

Suppose you are going to a movie and as you enter the cinema, you discover that you have lost your movie ticket you’ve just paid RM10 for. Would you spend another RM10 to get a new one? If you are like most people, you would probably think twice because you will feel that you will end up paying RM20 for a movie actually worth RM10!

Now let’s construct the scenario differently. You are going to see a movie. On your way to the movie theatre you drop a RM10 note on the bus. You are disappointed, of course, but would this affect your decision to buy the movie ticket? You will probably say to yourself: “Damn it! That’s my luck!” Arriving at the cinema, you will forget about the incident and stand in line to get a movie ticket.

In fact, the above research was conducted by some psychologists who discovered that only 46 percent of those who lost a ticket were willing to buy a replacement ticket, whereas 88 percent of those who lost an equivalent amount of cash were willing to buy a ticket. Since the lost ticket and the lost cash had the same value, their loss should have been experienced in the same way, but why were there twice as many people willing to ignore the lost cash but not the lost ticket? Why is it that you feel more pain in losing the movie ticket than the ten-dollar note?

This is due to a psychological phenomenon proposed by the famous psychologist, Richard Thaler, known as mental accounting. It says that people tend to separate and categorise income and expenses into different accounts in their heads. For example, you might have an entertainment fund, an investment fund, an education fund for children and so on.

Losing a movie ticket and having to buy a second one takes RM20 out of your entertainment fund when you planned to take only RM10, so it’s “out of my budget”!

Many of us commit this mental mistake in our daily lives without realising it. For example, we treat the company bonuses, capital gains from selling stocks, dividends and tax refunds as a “windfall” source other than our normal source of income. We splurge on luxury items such as LV bags, Caribbean Cruise and Rolex watches with this “windfall” money in spite of having a housing loan and a car loan due for payments.

Somehow we have grouped our income and expenditure into separate mental “funds” or “budgets” that are not easily combined. Money received as part of our salary is treated differently from money received as a bonus. Similarly, money spent to buy a fixed asset is viewed differently from the same amount of money spent to treat ourselves to a dinner at a luxury restaurant.

From an economic perspective, these mental accounting rules violate the economic principle of “fungibility”, which means that all money is equal. A dollar is still a dollar whether you get it as a gift from a friend or from your salary. Hence, when the principle of fungibility is violated, people act in economically irrational ways.

Stock investors often apply mental accounting when making investment decisions. We have the tendency to treat capital gains as windfall money and indulge in luxury goods with the profits. Imagine how much money we can accumulate if we simply reinvest the money into various forms of investment and let our money grow for us.

Wednesday, January 12, 2011

Anchoring Bias

In Professor Kahneman and Tversky’s 1974 paper, they describe anchoring bias as this:

“In many situations, people make estimates by starting from an initial value that is adjusted to yield the final answer. The initial value, or starting point, may be suggested by the formulation of the problem, or it may be the result of a partial computation. In either case, adjustments are typically insufficient. That is, different starting points yield different estimates, which are biased toward the initial values. We call this phenomenon anchoring.”

An experiment was done to prove this theory. There were two groups of students given the following arithmetical expressions respectively and were to give an estimate within 5 seconds.

Group A: 1 x 2 x 3 x 4 x 5 x 6 x 7 x 8

Group B: 8 x 7 x 6 x 5 x 4 x 3 x 2 x 1

Group A made a median estimate of 512, while group B made a median estimate of 2,250. The motivating hypothesis was that students would try to multiply the first few factors of the product, then adjust upward. In both cases the adjustments were insufficient, relative to the true value of 40,320; but the group A’s guesses were much more insufficient because they started from a lower anchor.

Similarly, investors always look at the historical price of a stock as the reference point and act on it. Proton used to be the darling of the stock market with prices around RM8 - RM10 in the early 2000. However, due to Asean Free Trade Agreement (AFTA) and other competition, Proton’s market share has plunged from 60% to 24% since 2000. When the stock price declined to RM6 in January 2006 many investors thought it was a bargain (as they reference from the high of RM10) and started to accumulate the stocks. Little did these investors know that Proton later fell to below RM2 two years later.

In another example, investors like to anchor on the 52-week high and 52-week low of stocks and make reference from these two numbers. They tend to think that a stock has the potential to get back to its 52 week high which often leads them buying into over-valued stocks.

Investors like to predict stock prices based on their past performance. However, if you are the proponent of efficient market hypothesis where it says stock price follows “Random Walk” theory, there is no way you can predict the future price. Just like the fair coin game, the previous flips have no relation to the subsequent future flips.

Happy investing,

Pauline Yong

Wednesday, January 5, 2011

Representative Bias

Happy New Year 2011! Hope this year is another fruitful year for our local stock market!

Today I’ll continue with last week’s topic on behavioural finance. Today I’m going to talk about “Representative Bias”. Representative bias refers to the human bias in us that we often stereotype certain things with similar characteristics with similar outcome. For example, whenever we see a beggar, he or she must be poor, that’s our first thought. However, there are cases where some of them live in big houses! Another example, bad drivers – if you see a bad driver, it must be a lady! So all these are stereotyping!

When this theory applies to our stock market it becomes like: politically linked stocks but no profits, buy! Because it sure goes up! Datuk so and so’s company – buy! He usually “goreng” his own stocks! Hence we tend to stereotype the stocks with similar nature such as traits like politically linked or owned by some famous VIP, their stocks usually can soar very high, and we neglected other important facts about those stocks!

The outcome of this type of investing style is that you’ll see your own profit going through big ups and downs. I’m not saying this is wrong, in fact when it comes to investing styles, there is no right or wrong strategies because different individuals with different risk preference and resources, will choose the strategies that suit them most. But however, if you are a value investor, this may not be the right style for you because value investors focus on the true value or the intrinsic value of the particular company.

Investment is an art, not a science. There are no fixed rules, different market condition you’ll employ different strategies, but no matter how you invest, you must have some basic principles. The main difference between rules and principles is that rules refer to some detail fundamental and technical analysis such as financial ratios and technical indicators. However, principles of investment refer to the bigger picture of investment, it guides you what you are going to do with your investment “as a whole”. For example, must diversify your portfolio, must not invest with borrowed money, and so on.

Hence, the next time you want to buy a particular stock because of its superficial information, make sure that you are just diversifying ‘some’ of your money not ‘all’ into it!

Happy investing,

Pauline Yong