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

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

Availability Bias

Starting from this week I am going to introduce to my readers the different types of mental bias that will hider successful trading in us. Today’s topic is “Availability Bias”, a behavioural finance theory that is based on Kahneman and Tversky’s famous literature – Judgement Under Uncertainty: Heuristics and Biases in 1974.

According to the availability bias theory, people pay attention to anything in the media that supports their fear and perception and ignore the other side of the story. In short, availability bias makes people less objective when making decisions.

For instance, many people have misconception about investing in the stock market. When asked why they rather put their money in the bank than in the stock market, they said: “Why? Because I don’t want to lose all my savings”.

People typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. They tend to become more optimistic when the market goes up and more pessimistic when the markets are down. These people probably heard one or two stories about people losing all of their savings in the stock market, but they ignore other facts about the stories – maybe those people invested on speculative stocks or they put all their eggs into one fragile basket. These people do not realise that by doing some research, they can find some safe and sound investment that produce greater returns than the bank rate.

So the next time when you need to make a decision on stocks, remember not to fall trap into this mental mistake, instead we need to apply statistics, reasoning and probability into our thinking.



Happy investing,

Pauline Yong

Are You A Rational Investor?

Let me start by introducing to you what is Behavioural Finance. It is the study of the influence of psychology on the behaviour of investors and their subsequent effect on markets. It combined the discipline of psychology and economics to explain why and how people make irrational or illogical decisions when they make investment decisions.

For example, many investors know that before they invest in a particular stock, the first thing they should do is: RESEARCH! But honestly how many of us actually perform this step? You may be surprised that there are many investors who have the ability to do analysis on stocks but often find themselves making rush decisions based on tips and advice of their so-call expert friends. So in behavioural finance perspective, these investors are ‘irrational’.

Irrational investors are easily swayed by emotions, they do little planning, lack of savings and have low risk tolerance. Interestingly, according to statistics, there is a relationship between risk tolerance and capital base. Large capital based investors tend to have higher risk tolerance, think long term and they are more rational as compared to small capital base investors. So that means if we understand the mindset of a successful rational trader, we can actually produce the same winning strategies that have been proven for years and decades for them. All we need is to establish some ground rules for our portfolio.

Here is a summary of the six reasonable guidelines that we know work for irrational investors:

1. Never attempt to time the markets; it's impossible
2. Live below your means and save regularly
3. Asset allocation is the key to a winning portfolio
4. Buy and hold quality, and buy intending never to sell
5. Compounding guarantees long-term wealth-building
6. Do it yourself; millions do, especially millionaires

Bottom line: Nobody wants to think of themselves as an irrational investor. But the chances are four out of five that you are, and that you're probably in denial if you still believe you're rational.

Bottom line No. 2: Paradoxically, the biggest secret of the "Rational Investor" is that they know they're irrational! So they use the six rules to protect their portfolio from their own worst enemy, their brains.


Happy investing,

Pauline Yong

Can You Write Your Own Will?

Yes, you can, but that doesn’t mean you should!

A Will is an important legal document that contains your instructions and wishes for distributing your properties and assets after you die. This document contains the names of the people you want to benefit, your beneficiaries, as well as details about your home, land, vehicles, bank accounts, investments, jewelry, artwork, and other possessions. Your Will also allows you to choose a personal guardian to care for your children if you should die when they are still minors. Your Will should be written carefully, correctly and in compliance with the laws to be sure your beneficiaries will be taken care of when you are gone.

In order for your Will to be valid, and accepted by the court, it must, with some exceptions, be in writing, signed with your signature, and witnessed by at least two witnesses who are neither relatives nor beneficiaries. Otherwise, the court may not accept your Will, and it may be unenforceable. If your Will is found invalid, the court may distribute your assets as if there were no Will (or intestate), and the court will distribute your asset according to the Distribution Act 1958 (amended 1997).


For fast and easy will, please visit my website:
http://www.stocktips123.com/financialplanning/will_steps.html

Investmen Policy Statement

I always tell people to invest rationally and prudently. Then you may ask: “But how?” To be honest with you, I was once ‘lost’ in the stock market before, I found myself investing aimlessly, invested in one counter then sold quickly when I heard some bad news or when I was not sure about the stock; or sometimes I found myself buying into a counter without any research at all like I was buying into a hurry, worried that if I delay the stock price would rally further! Then I realized I was not investing at all, I was simply speculating, ‘hoping’ the price will go higher after I bought which in fact it usually didn’t because I bought when everyone else were buying too which was already in an overbought position.

So I finally looked into what all the experts have been saying: “Create an investment plan first”. I’ve heard so many times but I never followed this important step. I hope by sharing with you will help you to be a wiser investor. Below is a copy of a sample investment policy statement. An investment policy statement defines your goals and objectives and sets the guidelines for your investment activities. Most importantly, it provides the necessary disciplinary function of the investing business that any rational investor needed most. It is by far the most important step of the investment process however, most investors fail to recognize it.

Investment Policy Statement for Mr. Market, aged 40

Objective of Portfolio
The objective of this portfolio is to provide steady growth of capital until retirement and an inflation-adjusted of RM50,000 every year for 20 years in retirement.

Return Expectations
Return expectations are: 3% for cash, 8% for unit trust, 10% for stocks. In which the returns for unit trust and stocks include dividend yields.

Time Horizon
My target retirement date is 2030 when I am 60 years old. My initial investment is RM200,000, supplemented by annual periodic investment of RM12,000 per year or RM1,000 per month for until 2030.

Asset Allocation
Cash – 20%, Malaysia Equities – 30%, Singapore Equities – 40%, US Equities – 10%

Rebalancing
The investment portfolio will be rebalanced to the target asset allocation when new money is added. The portfolio’s asset allocation will be checked once every 6 months on June 1st and Dec 1st. I will rebalance back to the target by selling whatever has gone up and buying whatever has gone down.

Investment Vehicles
Cash will be held in either Fixed Deposit accounts or Merdeka Bonds if applicable. Local equities and foreign markets equities may include direct purchase from the relevant stock markets or through unit trust/ mutual funds run by well reputable fund managers. My portfolio will avoid: investing in options, futures and other derivatives, illiquid companies with average daily volume below 500,000 shares, and companies without proven track records.

Benchmark and Review
The benchmark for Malaysian equities – KLCI; Singapore – Straits Times Index (STI); U.S.- Dow Jones Index(DJI), Hong Kong- Hang Seng Index(HIS)


Note: This is just a sample investment policy for illustration purpose only. You can customize based on your goals and needs. A good investment policy will be as detail as possible.

Be Prepared !

Be prepared to see some selling pressure in the next 3 weeks. Short term view is still bearish, however the long term view is still bullish as the KLCI is still trading above the 200-day Moving Average.