Investment Strategy by Behavioural Finance
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Introduction
Traditional economic and finance literature assumes that investors approach risk and return rationally. However, in real life, the emotions drive investors to make many fundamental missteps during investment. After study Behavioral Finance this year, I understand how people actually make decisions and ways in which they tend to deviate from full rationality. Understanding of these biases can help me to avoid some common pitfalls and position my portfolios to best fit my personality. In long term, I believe it will enhance the performance and reduce the risk of my investment. Behavior Biases affect my Investment Decision
Before planning for the long-term investment strategy, I should review which behavior bias affecting my investment decisions in the past so that I can avoid them in future. In below sections, I will explain what mistakes I have committed and how behavior biases affected me. Home Bias and Ambiguity Aversion
You
are required to suggest: ACC 3131 Performance Measurement And Control
1. There are so many stocks in the market. Just like other investors, when I
choose the stock from the pool, I always go with the stock name that I am
familiar with. For example, when I wanted to buy the shares which is a
tele-communication company, the first stock name which appeared in my mind is
China Mobile Limited (941). It was because I was currently using the service
provided by it. I did not consider other companies in the same industry and
compare their financial information thoroughly before I bought China Mobile. 2.
For the shares I bought now, all of them are traded in Hong Kong Stock Market.
I do not invest in any stocks which traded in foreign stock market, even though
it is every convenient to trade foreign stocks through trading in Internet. 3.
My company, HSBC, provides share options to us every year. I execute the share
options every year. Now the value of the HSBC shares which I hold equals around
20% of my total portfolio. I ignored the double hit to my financial security
that the problems in the company would cause. All these investing decisions
which I made before are typically influenced by Home Bias. When an investor
feels that he fully understands the benefits and risks involved in investing in
foreign assets, he is more willing to invest in foreign securities. In
contrast, when an investor feels less competent, he is more likely to avoid
foreign assets. Investors always prefer the familiar to the unfamiliar and are
also afraid of ambiguity. Snake Bite effect and Loss Aversion
In 2000, when I earned a few thousand dollars in the first summer intern job, my parents told me to utilize the money to do something meaningful instead of spending it for leisure. Eventually I decided to invest in stock market. At that time, I did not have any direction which stocks I should choose. I tried to read the newspaper and some magazines to see any hints. During that time, most of the people talked about Stocks with IT background. Much news mentioned the stock price of those Dot.Com company rose to historical high. Eventually I chose to buy the stock of Sunevision (8008), which was a company provide Internet service. This decision was purely based on the recommendation from the media without doing any fundamental analysis In the first two months, the stock price increased to historical high. I still hoped that it would continue to increase. I did not have any plan to sell it to gain the profit. At the end, the Dot.Com bubble burst, the stock price dropped more than 80%, even lower than my purchase price. Up to now, I still refused or think of to invest into any company with IT background because the previous experience frightened me. It was the Snake Bite effect. This effect can also be explained by a behavioral bias called Loss Aversion. People generally feel a stronger impulse to avoid losses than to acquire gains. People weigh all potential gains and losses in relation to some benchmark reference point. The value function across losses and gains is not symmetric. If investors are confronted with equal amounts of $100 dollars gain and loss, the pain they experience from loss is nearly twice with the gain. This bias makes us unable to see that the risks and rewards of the sector are completely different now than they were at the beginning of the century. In my case, it prevented me from taking advantage of strong growth opportunities for buying the IT stock, eg. Tencent (0700). Herding
Like other social animals, humans instinctively follow the behaviors and opinions of the majority to feel safer and to avoid conflict. If the majority of the group starts to move in one direction, the others instinctively follow. From the above section, my investment decision to Sunevision was influenced by Herding effect. This behavior can be easily found in other individual investors in Hong Kong. According to one survey result in 2012, there were around 32% out of the 471 respondents, who invested in HK stock market in past year, did not know the nature of the company before buying that stocks. 62% of the respondents bought the shares due to the recommendation in the newspaper and TV program. Only 21% of people read the financial report of that company before investment. (Source: http://paper.wenweipo.com/2012/06/27/HK1206270066.htm) This story told me NOT to trust the recommendations from the famous “Financial actors” in the media. We should perform the fundamental analysis to the company to determine whether that stocks are worth to buy. Mental Accounting, Selling Winners and Holding Losers
Individual investors always separate money and financial risk into ‘mental accounts’, just like putting our wealth into various buckets on a specific goals or time horizon. My original investment strategy is putting 50% of the money into Stocks for growth while I treat remaining more conservatively, just keep as time deposit or cash. When I review this strategy now, it makes me to focus on the individual buckets rather than thinking broadly, in terms of our entire wealth position. I should review the portfolio diversification and consider other type of investment other than equity in my long run investment strategy. Moreover, in the list of equities that I currently hold, some of them are bought when they were sold as IPO. The price of those stocks dropped gradually every year, eventually dropped under the IPO price. However, I held on those losing shares and hoped that it will recover their losses. It is a “Holding Losers” behavior, which can be explained by the “Mental Accounting” theory. According to “Mental Accounting” theory, it explains why loss-averse investors are reluctant to sell under-performing securities, not only tying up money that could be more profitably invested elsewhere. This happens because they weigh the loss solely against the security’s purchase price, and selling would put that balance sheet in the red. It also helps to explain why investors tend to sell their strong performers too soon. Instead of considering the gains a profitable security could add to their overall wealth, they sell because they can book the transaction in the plus column. New Investment Strategy to overcome Behavioral Biases
There’s nothing wrong with making mistakes. What we need to aware is NOT making the same mistake over and over. After understanding what behavioral biases affect my investment decision, I can consider how to overcome them to improve my investment performance, no matter in short-term and long-term. Understand my Risk Profile
Before considering the investment strategy, I need to know what my risk tolerance level is. I have taken the risk profiling questionnaire provided in HSBC website to provide me the indication of my risk tolerance level and my investment characteristics. The result shows me I am “Adventurous”. I should be comfortable with achieving a high level of return potential on my investment coupled with high level of risk. <Source: www.hsbc.com.hk/1/2/hk/wealthmanagement/risk> With this risk profile, it can guide me to structure my portfolio of broadly diversified equity investments chosen for their
long-term
promise and
help me
identify the
appropriate
role for the
more fluid
and more
actively managed group of
 investments that
supplements or enhances that core. Develop an effective investment strategy
Diversify my Overall Portfolio:
In 2000, when I earned a few thousand dollars in the first summer intern job, my parents told me to utilize the money to do something meaningful instead of spending it for leisure. Eventually I decided to invest in stock market. At that time, I did not have any direction which stocks I should choose. I tried to read the newspaper and some magazines to see any hints. During that time, most of the people talked about Stocks with IT background. Much news mentioned the stock price of those Dot.Com company rose to historical high. Eventually I chose to buy the stock of Sunevision (8008), which was a company provide Internet service. This decision was purely based on the recommendation from the media without doing any fundamental analysis In the first two months, the stock price increased to historical high. I still hoped that it would continue to increase. I did not have any plan to sell it to gain the profit. At the end, the Dot.Com bubble burst, the stock price dropped more than 80%, even lower than my purchase price. Up to now, I still refused or think of to invest into any company with IT background because the previous experience frightened me. It was the Snake Bite effect. This effect can also be explained by a behavioral bias called Loss Aversion. People generally feel a stronger impulse to avoid losses than to acquire gains. People weigh all potential gains and losses in relation to some benchmark reference point. The value function across losses and gains is not symmetric. If investors are confronted with equal amounts of $100 dollars gain and loss, the pain they experience from loss is nearly twice with the gain. This bias makes us unable to see that the risks and rewards of the sector are completely different now than they were at the beginning of the century. In my case, it prevented me from taking advantage of strong growth opportunities for buying the IT stock, eg. Tencent (0700). Herding
Like other social animals, humans instinctively follow the behaviors and opinions of the majority to feel safer and to avoid conflict. If the majority of the group starts to move in one direction, the others instinctively follow. From the above section, my investment decision to Sunevision was influenced by Herding effect. This behavior can be easily found in other individual investors in Hong Kong. According to one survey result in 2012, there were around 32% out of the 471 respondents, who invested in HK stock market in past year, did not know the nature of the company before buying that stocks. 62% of the respondents bought the shares due to the recommendation in the newspaper and TV program. Only 21% of people read the financial report of that company before investment. (Source: http://paper.wenweipo.com/2012/06/27/HK1206270066.htm) This story told me NOT to trust the recommendations from the famous “Financial actors” in the media. We should perform the fundamental analysis to the company to determine whether that stocks are worth to buy. Mental Accounting, Selling Winners and Holding Losers
Individual investors always separate money and financial risk into ‘mental accounts’, just like putting our wealth into various buckets on a specific goals or time horizon. My original investment strategy is putting 50% of the money into Stocks for growth while I treat remaining more conservatively, just keep as time deposit or cash. When I review this strategy now, it makes me to focus on the individual buckets rather than thinking broadly, in terms of our entire wealth position. I should review the portfolio diversification and consider other type of investment other than equity in my long run investment strategy. Moreover, in the list of equities that I currently hold, some of them are bought when they were sold as IPO. The price of those stocks dropped gradually every year, eventually dropped under the IPO price. However, I held on those losing shares and hoped that it will recover their losses. It is a “Holding Losers” behavior, which can be explained by the “Mental Accounting” theory. According to “Mental Accounting” theory, it explains why loss-averse investors are reluctant to sell under-performing securities, not only tying up money that could be more profitably invested elsewhere. This happens because they weigh the loss solely against the security’s purchase price, and selling would put that balance sheet in the red. It also helps to explain why investors tend to sell their strong performers too soon. Instead of considering the gains a profitable security could add to their overall wealth, they sell because they can book the transaction in the plus column. New Investment Strategy to overcome Behavioral Biases
There’s nothing wrong with making mistakes. What we need to aware is NOT making the same mistake over and over. After understanding what behavioral biases affect my investment decision, I can consider how to overcome them to improve my investment performance, no matter in short-term and long-term. Understand my Risk Profile
Before considering the investment strategy, I need to know what my risk tolerance level is. I have taken the risk profiling questionnaire provided in HSBC website to provide me the indication of my risk tolerance level and my investment characteristics. The result shows me I am “Adventurous”. I should be comfortable with achieving a high level of return potential on my investment coupled with high level of risk. <Source: www.hsbc.com.hk/1/2/hk/wealthmanagement/risk> With this risk profile, it can guide me to structure my portfolio of broadly diversified equity investments chosen for their
long-term
promise and
help me
identify the
appropriate
role for the
more fluid
and more
actively managed group of
 investments that
supplements or enhances that core. Develop an effective investment strategy
Diversify my Overall Portfolio:
To tackle the loss aversion biases, I should broaden the concept of invested wealth to include not only stocks as single asset class. I will consider different type of asset, such as bonds, foreign exchange, fund or even investing in real estate. Each wealth category can suffer from losses within a long period of time. But different wealth categories are not perfectly correlated. While one type of assets may suffer losses, another assets class may gain and offset the losses. In this broader overall portfolio diversification context, the investment in Stock market may seem more appealing and less like isolated gambles when considered. Even though I loss some money in equity investment, I may gain from other asset investment. Because I am an “Adventurous” investor, I will allocate 60% of the capital into risky assets, including Stocks or Commodity, 30% into less risky asset, like government or corporate bond, and 10% into cash in bank for deposit.
Diversification within my Risky Assets Portfolio
Currently I hold lots of my company stock in my portfolio. In addition, all the equities which I hold now only focus in single sector and single market. My portfolio is under-diversified. To overcome this home bias, I will consider rebalance the equities in different stock market. The investment in equity will not be concentrated into single stock, single sector or single market. I will sell part of the equities in Hong Kong market, especially my company stocks. I will broaden my investment into international stock market, like US. Apart from equities, I will start changing part of my asset into foreign currency, into Renmanbi and Australia dollars. In addition, I will consider buying gold and silver, which further diversify my overall portfolio. I am not a professional and full-time investor. I cannot spend days and night to read the financial report, analyze individual stock background and track its performance. However, I will not commit the same mistake of just follow the recommendations from the “Financial actors” to make investment decisions. As a passive investor, investing into well-diversified exchange-traded funds (ETF) to Stock Market Index or Commodity Index or mutual fund, may be a good option to me. Figure 1 shows an example of Mutual fund that focus in global market and Figure 2 shows an example of ETF which focus in single sector of different brand in different countries. They can provide downside protection in volatile markets and may help increase investor comfort around investing in risky assets. The holdings of the equity in mutual fund or ETF are located into different countries and different sectors. The risks are well-diversified, that help deliver better long-term risk adjusted returns than simple market capitalization-weighted indices.
Putting my Expectation in Long-Term Perspective
Checking the market day-to-day or even hour-to-hour makes investor frustrated and nervous all the time. This behavior feeds investor fear or greed, that eventually lead us to make some illogical investment decisions, like “Selling Winners and Holding Losers”. I should bear in mind that the investment is for longer term. The evaluation of the investment performance should be periodically rather than continuously. While stock markets can be highly volatile over short horizons, increasing our own discomfort around potential losses, time has tended to smooth out fluctuations. In below figure, the worst annualized return of S& P within 1 month time period is around -200%. However, the loss is flattened to -50% within 1 year, becomes -4% in 10 years and +8% in 20 years.
With this long-term investment perspective, it minimizes the investment volatility. When we only see the long-term performance, it is less fluctuated which reduce our discomfort feeling. As a result, there are less chance to make any emotional investment decisions.
Rules and Discipline
Setup investing rules and disciplines can help to provide focus and ensures emotions are held in check when making investment decisions. Setup Clear Plan when to sell
Of course the purpose of buying a stock is to sell it for a profit. But most of the time we buy the stocks without a clear plan what the investment goal is and when I should sell it. This can be brutal on my portfolio. Without a clear plan, it is easy to commit “Sell the Winners and Hold the Losers” bias again. For stock trading, I will set my maximum loss at 15% to stop me from making emotionally incorrect decisions. Cooling off
Most of the investors overreact to some good news and are affected by own emotions. It will easily commit mistake and it is harmful to the their wealth. To overcome these biases, I will wait 1-2 days after making a major financial decision. If I do not change my mind after few days, I can go ahead to implement it. The objective of this practice is to reduce emotional trading. Setup monthly investment schema
Setup automatic investment scheme into ETF fund or mutual fund can be effectively counteract investor’s inertia, loss aversion and self-control issues. Using the auto investment schedule to guide decisions can help me to avoid being swayed by current market conditions, such as the recent performance of a ‘hot’ investment. Regular investing to the Stock or Bond also helps the investor tends to accumulate more units or shares of an investment when markets are low than when they are high.
Rebalance:
Some investors committed the problem of inertia which stop them make necessary changes to their investment and forego timely rebalancing, while some people trade excessively, which may lead to any investment profits getting eaten up by trading costs. It is important to review our portfolio semi-annually and set up scheduled rebalancing to ensure allocations remain in target range. Once allocations have moved away from the target by a predetermined percentage, I should rebalance it. Below is an example how rebalance improves the overall portfolio performance. A 4 years investment horizon is examined with a beginning portfolio allocation, using my predefined ratio (60% in equity, 30% in bonds, and 10% in cash). In the first year, assume that the returns are 20% on the equity, -5% on the bonds, and 1% on cash and the initial investment is $100. In Figure 4, we stick to the original allocation 60/30/10 (with rebalancing each year) and lets the investment ride for the next 3 years. In Figure 5, we avoid any rebalance and lets the investment ride for the next 3 years. In Figure 6, if we base on recent performance and naturally reallocate the funds from bonds into equity for a 90%/0%/10% portfolio allocation then the investor maintains the investment (with rebalancing) for the next 3 years.
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Some related topices are here: Evaluation of Accounting Research Application
Accounting Roles in the CompanySome related topices are here: Evaluation of Accounting Research Application
Reference:
1. An advisor's guide to behavioral finance
http://ing.us/rri/file_repository/94/advisors_guide.pdf
2. Breaking Bad behaviors
http://us.ishares.com/content/stream.jsp?url=/content/en_us/repository/resource/market_perspectives_feb_2013.pdf 3. Portfolio Rebalancing to Overcome Behavioral Mistakes in Investing http:// www.aabri.com/manuscripts/08055.pdf
http://us.ishares.com/content/stream.jsp?url=/content/en_us/repository/resource/market_perspectives_feb_2013.pdf 3. Portfolio Rebalancing to Overcome Behavioral Mistakes in Investing http:// www.aabri.com/manuscripts/08055.pdf
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