Saturday, June 14, 2008

Behavioural Finance Part 3 - Over-Reaction Bias

To continue with this series on behavioural finance, I now touch on the concept of over-reaction bias. The first two parts dealt with the problems of mental accounting (compartmentalization of money into distinct and discrete "accounts") and over-confidence (a typical human trait where most people feel that they are infallible). Over-reaction bias is a type of behaviour which results in human beings over-reacting to certain news, which is another way of saying you "let your emotions override your good sense".

When applied to the stock market, over-reaction bias typically causes investors to over-react to BAD news, and react too slowly to good news. Why could this be so ? This is due to human being's tendency to panic and let fear grip him; thus over-reacting to bad news or negative information. Note that this is a natural human tendency which, from our caveman days, would have saved us from mortal danger as our bodies tend to respond to such negative stimuli by producing more adrenaline (yes, the fight or flight hormone), thus it allows us to have heightened senses and more energy to run in case we encounter danger (e.g. predators in prehistoric times). It is always better to over-react to real physical danger as we only have one life; but in the market, over-reaction bias can cause us to lose our rationality by conveying a similar "fight or flight" response. Since there is no one to "fight", most people will choose "flight" instead and sell away their investment when there is any small hint of negative news !

When viewed objectively and rationally, this might seem a very foolish, downright silly choice. After all, negative news flows in all the time and one cannot predict the sequence, extent or nature of such news accurately. On one day, it might be record inflation; on another day, it could be high oil prices and on yet another day, it may be increased unemployment or shrinking GDP growth. The point is that bad news is supposed to be part and parcel of investing and one cannot live in a fantasy world expecting nothing negative to happen to one's investments. By mentally insulating oneself from such mental shocks, one can develop better fortitude when hearing such negative news. Even for my own investments, I had recently encountered negative news in the form of record inflation in Vietnam (which affects my investment in Ezra as they have 2 yards in Vietnam) as well as a recent fire at Kreuz Shipyard which is 100% owned by Swiber.

My first reaction upon hearing this news was to calmly examine the facts of the case and to objectively assess the economic impact of the bad news. As an investor, one should be mindful of over-reaction bias causing the bad news to seem a lot worse than it sometimes is. In my case, it turns out that I discovered that Ezra's shipyards are securing contracts in USD, thus mitigating the risk of the depreciating VND; though one consideration is still rising costs of manpower as inflation kicks in. The impact will be minimal and is not likely to be long-lasting. For Kreuz, the incident was regrettable but will also not cause any serious economic harm to the company or its business. Thus, by objectively and rationally reviewing the facts of the case and delving into some research, one can pinpoint whether the bad news may have a permanent detrimental impact on one's investments; hence making the decision on whether to sell a more logical, rational one. Most of the time, if one had done sufficient research and due dilligence, I would conclude that most bad news is temporary in nature and should have already been factored in one's risk assessment when one purchases a company. Only if a black swan event occurs should it give a very compelling reason to sell an investment immediately (e.g. natural disasters destroying key assets).

To conclude, over-reaction bias is a pervasive mental force when one invests. To avoid its effects, one should always keep their wits about them when faced with bad news, and move on to objectively and coolly assess the news before taking any action. Actions taken during an adrenaline rush are usually ill-thought out and one is more prone to make costly mistakes. Always ensure that decisions made with regards to buying and selling investments are approached in a busines-like manner, which is how investing should be viewed.


Simon said...

anyone knows what happen to kleer, the blogger for extraordinary profits? he hasn't posted a thing for a month....he found a job or something?

musicwhiz said...

Hi Simon,

I have no idea what happened to Kleer. I have checked back at his blog periodically but the last update was May 8, 2008. Some people have also left comments on his last post wondering what happened. I guess we'll just have to wait. :)


8percentpa said...

Actually the market usually overreacts to good news as well. That's why we have bubbles forming all the time.

musicwhiz said...

Hi 8percentpa,

Haha I dare say the markets react more often to unfavourable news rather than favourable. It's part of human psychology. Also, the magnitude of reaction is often much greater for bad news than it is for good news.