Loss-averse, overconfident..that's me

Loss-averse, overconfident..that's me

One of the biggest ongoing debates in economics is the validity of homo economicus: the idea that human beings are rational and act in their own interests.

This concept, which underpins many economic theories and models, assumes consumers and investors make logical decisions for the sole purpose of maximising their happiness and profits.

As a consumer, I think I am fairly rational. As an investor, however, I may be one of the least sensible people ever.

There are many well-documented biases that investors are prone to, and unfortunately most of them apply to me.

Confirmation bias, for instance: I often make up my mind about which stock to buy and then look for proof to support my decision.

I also suffer from overconfidence bias - believing that I am right more often than I really am - not just in investments, but generally in life.

But my biggest failings are with regard to risks and potential losses. I am highly loss-averse, which means I feel the loss of $100 much more keenly than a gain of $100.

Worse than that, I am afflicted by the so-called "disposition effect", which is the tendency to sell shares that are rising in value but hold on to those that have fallen, in the stubborn hope that they will one day claw their way back into positive territory.

In other words, I lack one of the most basic investing skills: I am psychologically unable to cut my losses. There are, sadly, plenty of examples to illustrate this, but I shall give just one. In 2011, I bought one lot of shipping company Neptune Orient Lines (NOL) at slightly more than $1.40 per share.

In lieu of exhaustive analysis, I had simply noted that NOL's price had recently suffered a steep drop from what I thought of as its "usual" price of around $2, the value it had held over the previous year.

This is also a bias, known as "anchoring", in which an initial approximation of an object's value affects one's perception of its subsequent values. Because I thought NOL shares were worth around $2, $1.40 looked cheap to me.

To cut a painful story short, NOL's price continued to fall after my purchase and is now struggling to stay at around $1.10.

Despite valid grounds to bite the bullet and sell the stock - continuing red ink, a challenging industry outlook, possible better use of my money elsewhere - I simply find it too painful to convert my paper loss into a real one.

As I see it, there is a variety of reasons people like me shy from cutting our losses.

One is the unshakeable belief that stocks go up and down in cycles, and that if you just hang on long enough, your loss-making stock will eventually turn into a profitable one.

But this argument has two problems. The first is that not all stocks regain their past highs no matter how long you wait, and a falling share price is often indicative of deeper troubles that portend even further price drops.

The second problem is that the money that is tied up in your languishing investment could be invested more wisely in other assets and make up for having to cut your losses.

The $300 or so I've lost on NOL, for instance, could easily have been made back by now if I had bought shares in any Singapore bank.

The other reasons for failing to cut losses are even less justifiable.

Sometimes investors just do not like to admit when they have been wrong.

If their paper loss is never realised, technically the stock can still do a U-turn and prove them right for holding on so long.

There is also inertia: People tend to monitor their well-performing stocks, but ignore those that have deteriorated beyond a certain threshold.

I offer my investing story as a cautionary tale.

To avoid following in my footsteps, I suggest setting a clear limit for cutting losses and remembering that after a stock has lost 50 per cent of its value, it needs to rise by 100 per cent for you to just break even.

If all else fails, knowing your own biases can at least help you formulate a better investment strategy.

I now bank on blue-chip dividend yield plays, so even if the counter falls, my total return may not be a complete write-off.

The really tragic part of this whole story is that, according to recent research done by students at the Nanyang Technological University's Nanyang Business School, my investing habits resemble those of an old man.

Messrs Chiang Jia Bing, Joel Siew and Raymond Toh and their supervisor, Dr Kong Yoon Kee, polled 221 Singapore investors and found that age and gender are correlated to certain decision-making biases.

Specifically, they found that the disposition effect is a quirk of older male investors, although it is also the most prevalent bias among all investors and particularly affects the higher-educated.

"Cutting losses protects one's capital should the investment go awry," say the students.

"It is good practice to set cut-loss levels when initiating investments and be disciplined in keeping to them, rather than reasoning that adverse market movements are temporary and reversible,"

Wise advice indeed. Now if only I could overcome my bias against accepting counsel from those younger than me.

fiochan@sph.com.sg


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