In Part 2 of this documentary, market practitioners reveal some of the key behavioural biases which Asian investors suffer, and explain how advisers can try to help their clients overcome them.
Date: Sept 2010
Tags: Behavioural finance, Portfolio construction, Risk, Bias
Explaining behavioural biases
According to Tao Lin, assistant professor in the School of Economics and Finance at The University of Hong Kong, investors suffer various biases that affect their buying decisions.
One of these, she said, is representativeness bias. This happens when investors see a pattern and look to extrapolate it, rather than sticking to an original financial strategy.
For example, she explained, they see a stock price continuing to go up so eventually see a pattern and try to rationalise it and think it will go on rising. On other hand, if investors see a stock price falling for a while, they think this will carry on and will sell.
This creates problems for advisers because clients will not be able to remember their original plan, nor will they listen to their advisers. As a result, said Lin, they will lose money overall when they could make money over the longer term.
In Asia in particular, there is a big bias in favour of property, said Arun Abey, chairman of ipac Securities.
One of the reasons for this, he explained, is the fact that it is a very tangible asset. Also, he added, despite the property market being as inherently volatile as the equity markets, it is not marked to market. So on a daily basis, the fluctuations are not easily visible.
While this helps to overcome the fear of loss aversion, on the flipside it leads to people over-investing in property, which in turn leads to bubbles.
To make the most of their wealth, Abey said Asian investors need to learn how to overcome their property bias and develop more sensible equities strategies.
According to Lin, there is a puzzle in the world of finance called the Equity Premium Puzzle. This says that despite a particular stock offering on average way too high a return than its risk warrants, a lot of people are not participating in the market.
She said there are several explanations for this, one of which is status quo bias. This means that if an investor hasn’t already participated in the market, it is very difficult to change their current status.
Another reason is loss aversion, said Lin, which says that even though there are potential gains, investors are afraid to lose money.
In fact, explained Abey, most people feel two-and-a-half times more pain from losing a dollar than they do from winning a dollar.
This is a problem when investing in the share market, for example, given how volatile the market is – which leads to people buying after the market has gone up and selling after it has fallen.
Another reason to explain the Equity Premium Puzzle, said Lin, is regret aversion. This says that if the markets don’t perform as expected, investors will feel a lot of regret.
When it comes to the issue of investors’ rationality, this can be explained by the disposition effect, said Sidney Sze, president of the Society of Registered Financial Planners in Hong Kong.
This means an investor cannot deal with losses rationally. Instead they are in love with a particular stock and have a special relationship with it.
Lin added that for their portfolios, this means investors tend to sell winners too soon, and their losers too late. As a result, when they look at their portfolios, if need to consume now then they will sell the stocks which are performing well, rather than sell the losing stocks.
Yet the winners will continue to be the winners, and the losers will continue to be the losers, she explained.
Investors are in general over-confident, added Lin. Research has shown, for example, that when asked if they are better than average drivers, most people will say that they are. People incorrectly credit their own ability and are confident in the way they see markets.
This creates a problem, she said, because over-confident investors will trade too much.
This can be seen in Hong Kong, for example, where the average holding period for mutual funds is three months, compared with three years in markets like the UK or the US, said Sze.
In general, Lin said that the more trades people put on, the worse their performance will be.
Another bias closely related to such over-confidence, she added, is self-attribution bias. This means that when investors make profit, they think it is due to their own ability, but when they make losses, they think it is because of bad luck. The danger, she explained, is that this bias can make people even more confident in the investment process.
These biases show some of the unique characteristics of Asian investors, who tend to behave much more like gamblers than investors in Europe or North America, for instance.
Indeed, said Lin, research has shown that the disposition effect is stronger for Asian people.
A further behavioural bias is anchoring, she added. This occurs if an individual bases a decision on information they have heard previously, so in turn anchor their view in something which is not always relevant. This can mean an investor would use past performance to drive future strategy.
Investors also often have self-control issues, said Lin. For instance, while they might want to consume, they don’t want to use their principal to do so. As a result, if they invest in a stock which pays low or zero dividends, then they think their consumption is in jeopardy. By extension, they are not integrating their dividend into their total wealth.
This, she explained, is mental accounting, where people create separate accounts mentally – where different amounts of money are allocated to different uses. This only exists in behavioural finance, said Lin – in traditional finance there aren’t accounts for survival, or mortgage, or retirement. There are only accounts for wealth.
Lin said there is another bias called illusion of control, where if investors can control something, then they feel more comfortable and competent.
For example, they think that if they trade online, then since they are executing orders themselves they have more control over the prices. This leads them to trade more actively. However, this means they pay higher transaction fees, and their ultimate performance is not as good as phone-banking investors. Related to the control bias, Lin said investors also like to place limit orders as they can specify the price so think they have more control.
Breeding more risk
A key concern relating to behavioural finance is that behaviour is very much related to risk, said Lin.
Because investors suffer various biases, they might not realise their real level of risk tolerance, she explained. This might lead them to blame their advisers.
A common thing which happens, said Mark George, director and authorised representative at Australian-based independent advisory firm Positive Financial Solutions, is that advisers use risk-profile questionnaires to assess the type of investor an individual might be.
However, he said, people tend to answer such questions differently in a boom market compared with how they answer them in a negative market.
Due to framing bias which investors suffer, sometimes they seem to like taking risks whereas at other times they dislike taking risks. But they don’t realise that they are being inconsistent.
Or, said Lin, investors might as a result also set impractical or unrealistic goals for themselves – and then get disappointed later on.
This can adversely affect the relationships and the trust they have with their wealth managers
How to tackle investor biases
When it comes to advisers being able to guide their clients appropriately in trying to know what they want, mapping out their goals and measuring their risk tolerance, Lin said there are various issues that behavioural finance suggests advisers should be aware of. Once they know these, they can then help their clients understand the impact of their behaviour on their investment strategy and portfolios in various ways.
For example, she explained, clients’ goals are inconsistent over time, so advisers should try to create scenarios to serve as references and see how an individual would react in different situations, and to gauge their risk preferences.
Being able to connect with clients more deeply is also important, said Abey, as this can create a degree of trust to help overcome behavioural biases.
Part of this involves advisers anticipating what could go wrong, added Lin, yet at the same time being fully aware that their clients are likely to change in the future.
Advisers also need to avoid inserting their own biases into the process, said Abey. In most cases, it is the advisers which panic first during declining markets. Clients then realise the adviser is nervous so panic in response, and sell.
To overcome this, Abey said advisers need strong investment philosophies and principles which they really understand and believe in.
The more research which advisers have either done themselves on the underlying investments, or have access to, they can then impart greater confidence to their clients.
This goes to the heart of advisers having sound foundations for the investments in the portfolio they are recommending, and a sound way of constructing the portfolio, he explained. And then being confident that the portfolio really matches the client’s needs.
In these cases, then regardless of any turbulent periods, Abey said advisers have the ability to show the client a certain confidence and leadership, and use the trust which has been built up over a period of time to get the client to stay in that portfolio.
According to Lin, empirical research has shown that the more frequently people check on their portfolios, the worse they perform. So while advisers need to regularly communicate with their clients, they need to be aware of the potential for their clients to sell winning stocks too early, and hold losing stocks too long – so advisers should constantly remind the clients about the potential implications of their actions on their long-run financial well-being.
A big mistake which financial advisers make in Asia is to position themselves in the short-term to take advantage of the fear-and-greed cycle to increase transaction revenue, said Abey.
Instead, he said they should focus on how to build long-term relationships and use behavioural research to show genuine concern for that client and be more patient.
Another way that advisers can help investors is in terms of regret aversion, added Lin, by taking responsibility for the investment decision. For example, she said, if an Asian investor makes a loss from a decision which he or she thinks an adviser made, this will not create as negative a feeling.
If advisers can adopt an approach where they are not trying to time the market to get the best returns in as short a timeframe as possible, but rather are taking a longer-term portfolio view, this in itself is a way to differentiate and overcome certain biases.
Advisers should also learn about their clients’ investment history and past performances, said Lin, to uncover biases based on how they have reacted in the past and show investors how they feel in certain situations.
In particular, added Abey, Asian investors need to change their expectations when getting financial advice, and not just look for hot investment tips, especially since advisers are generally not a good source of such tips.
In general, said Lin, advisers can use behavioural finance to help their clients increase their overall wealth.
For example, there might be times when advisers can encourage risk-averse investors to buy into an investment, she explained, or they can discourage risk-loving investors from a certain investment.
Key to this is for advisers to always tell their clients when they might be suffering biases to steer them back in the right direction.
