Wednesday, July 15, 2015

Are You A Rational Investor

When you were asked: “Are you a rational investor?” You would probably answer: “Well, yes! I guess. At least I THINK I am rational when making investment decisions.” Not according to Bayes’ Theorem. The definition for rationality according to Bayes’ rule is:  Logical thinking should involve probabilities, hypothesis and statistics to one’s belief. In other words, one should use statistical evidence to quantify his or her belief.

In the classical financial market efficiency theory, it is assumed that investors are rational with perfect information. Rational investors make decisions or judgement using reasoned thinking, based on facts, applying rules. However, in the real world, those described above do exist, but only for the minority. The majority of the market participants are irrational, at least according to the Bayes’ rule. If you look around people around you, you would notice that when faced with investment decisions, they prefer to listen to rumours and tips, rather than spending time doing the research themselves.

This ‘misbehave’ of humankind is actually discovered by the Nobel Prize winner, Professor Kahneman, who started the Behavioural Finance theory with Tversky in the late 70’s.  When conducting statistical research with a group of professional statisticians, they discovered that these experienced statisticians do not apply rules, but their own intuitions when it comes to simple problems given to them.

Likewise, when we need to make investment decisions, we may encounter some mental biases that prevent us from thinking rationally. In the following section, we shall discuss what are those and how we can overcome them.


This is the most documented of all psychological errors that people tend to be overly optimistic. Most people do not see the need to improve the way they make decisions, as they believe that they are already making excellent decisions. The unwarranted belief that we are correct is a major real-life barrier to critical thinking. Overconfidence often results in investors being fooled by small gains in a few trades, feeling much more in control of a situation than they are. Money managers, advisors and investors are consistently overconfident in their ability to outperform the market, but fail to do so.

Example: After a few small gains, investor A decided to invest a bigger sum on a particular stock. In the end, the stock encountered a major bad news that caused its stock price to plunge. Investor A has over-estimated his knowledge, and under estimated the risk involved by putting all the eggs in one basket. 

Remedy:  At the event of assessing an investment, it is crucial to assess the risk involved. Try to think for the worse case scenario, what is your contingency plan should it happens. Practice diversification of portfolios.

Herd Mentality

The phenomemon of the herd mentality can be useful in many ways. For example, researh shows that although 5% of the animals in a herd know the location of the water source, the entire herd is able to find it. In our dsily lives, we use this instinct to navigate the exit in the cinemas and crowded streets.We have to admit that herding is our human instinct. Herding always make us feel comfortable, and being the odd one out make us feel uneasy. We are programmed to to feel that the consensus view must be the correct one, and this mistaken belief has led to many distastrous decisions.

Example: During the 2000 dotcom bubble, despite the mean price earning ratio for the US technology companies is 156, investors still think the valuation of those dotcom stocks were "reasonable". They believed the majority was correct but infact it was not.

Remedy: It is not wrong to go with the trend. In fact, for trading, it is always good to trade with trends. However, we must know when to follow and when not to follow. To overcome this, we need to have an open mind, be able to see things in different perspectives. When investing, it is always good to ask for different opinions and to gather information form different perspectives. In view of other perspectives, we must be firm to our own beliefs, because when it comes to investing, there is no absolute right or wrong. As long as we focus on the fundamentals, we will be able to resist herd mentality.

Confirmation Bias

Confirmation bias is very common in us. We always have the tendency to select and filter information that fit into our beliefs. We ignore information or news that go against our beliefs.

Example: Miss A was choosing which stock to invest, Malayan Bank or Public Bank. After much consideration, she decided to buy Malayan Bank. After she bought the stock, she read an analyst report that Public Bank was better than Malayan Bank in terms of valuation, Miss A felt discomfort in her mind because this report was against her belief. In order to relief the discomfort, she would tend to disregard the news and went all the way to seek out information that confirms her belief. 

Remedy: Confirmation bias is a kind of "self- deception". To overcome this, we must constantly remind ourselves that when facing problems, we must seek out information from different perspectives. If necessarary, we must be willing to reassess our portfolio accordingly to the new information.

Intuitively, a "rational" or "unbiased" answer will include the consensus of the majority of the population. What is perceived as rational in one person may be considered irrational in another person, just like people from an African tribe wearing leater shoes is seen as "crazy", whereas it is perfectly normal to the rest of the world. A 90% survival rate for breast cancer in the developed countries is considered as normal but become unrealistic in the developing countries. Hence, we must learn how to see things in different angles to make more rational and unbiased decisions.