Part 2 of my investing recap will focus on the psychological, mental and emotional aspects of investing, which are arguably just as important (if not more) than the quantitative and qualitative aspects of analysis into a Company and its business model. This is because having the wrong psychology can often scuttle an investor’s best intentions, even if he is a certified expert in analysis. The inability to control and master destructive emotions can cause significant losses for an investor and result in him not being able to preserve capital. Behavioural Finance is a very new field which combines finance theories with psychology to come up with models of investor behaviour which deviate from the rational and logical “standard” model. I will be touching on aspects of behavioural finance research with quotes and simple examples from the book “Investing and the Irrational Mind” by Robert Koppel. At the same time, I will also elaborate on some of the emotional and psychological attributes necessary for an investor to be successful in achieving a decent long-run return.
Patience, Discipline and Fortitude
The above attributes relate to the mental state of the investor as he observes Mr. Market’s erratic price fluctuations. It also embodies the attitude an investor should have when confronting investments which may look attractive from an analytical standpoint, but unattractive from a valuation standpoint. Patience is a key trait which investors should have, as there is always the temptation to swing for the fences even though one may not be prepared. Impetuous behaviour often leads to grief, and the ability to stand still while others are moving like whirling dervishes shows the strength of one’s conviction.
Discipline is needed to ensure that one stays true to investment principles and philosophies, and does not stray off the well-trodden path. Often, Mr. Market’s exciting gyrations will entice the unwary investor to cross over to the gilded path of speculation, wherein he may feel that it is harmless enough to commit a small portion of his wealth to speculative activities; all in the name of feeling the pulse of the market and to experience the adrenaline rush which comes from placing a gamble. In order to cultivate discipline, one must shut out the noise and “advice” which comes daily in the form of recommendations, exhortations and forecasts. To be disciplined also means strictly following your original plan for investment and not deviating from it, as this may mean an erosion of capital.
Fortitude is defined as the “mental and emotional strength in facing difficulty, adversity, danger or temptation”. This is probably the hardest mental and emotional quality to have as a paper loss can feel extremely painful due to the human tendency for loss aversion. Having fortitude means being able to overcome the mental anguish that you may have made a bad decision and to soldier on even though the odds seem against you. It is a character trait which is honed through many years of being in the market and getting used to Mr. Market’s manic mood swings. By focusing on the business of the Company, one can build up fortitude and be more emotionally resistant to such adversities and difficulties.
Calm, Rational and Realistic
An investor needs to maintain a calm attitude when approaching investing, and not get unduly excited, panicky or exuberant. Calmness helps one to think more objectively and to evaluate possible courses of action in a rational manner. This trait also means that one should logically think through all potential outcomes, including the so-called “Black Swan” ones, and be mentally prepared for significant losses should these events come to pass. If one is certain of committing capital, then the calm investor should proceed to do so only after considering all the possibilities.
A rational investor is more likely to react more calmly should any unexpected events occur, as he can maintain his sense of balance amid turbulence and uncertainty. In order to remain rational and objective, it is necessary to cultivate a mindset which does not react adversely to sporadic and unexpected events which most certainly will crop up in an investor’s lifetime, be they a sudden terror attack, a large drop in earnings or a natural disaster just to name a few.
Finally, an investor must learn to be realistic about companies. In the world of business, nothing is certain and sometimes the best laid plans and strategies may be fruitless if a new competitor or complementary technology/product is introduced. Hence, an investor must learn not to be too optimistic – according higher valuations to a company which is supposedly the next big growth engine or with the next new groundbreaking product or technology. Neither should the investor be unduly pessimistic and see only dark clouds ahead, which may cause him to unnecessarily divest of his holdings when the setback may just be temporary or transitional. These extreme emotions should be tempered by realism and business sense, which would allow an investor to logically and rationally assess the business prospects of the companies within his portfolio.
Behavioural Finance – Heuristics, Biases, Fallacies and Illusions
Now we come to the area of behavioural finance, which in recent years has been the subject of extensive and groundbreaking research. This is because it is a new field which can determine investors’ behaviour outside of the standard economic model of rational behaviour and profit maximization. Apparently, a lot of what we do actually runs counter to common sense and some of it even actively destroys our wealth! I shall not go in depth into the above four aspects but will just touch briefly on them. My reference is Robert Koppel’s book “Investing and The Irrational Mind”.
Heuristics simply refers to rules of thumb – shortcuts which our mind uses to arrive at conclusions. In any activity (investing included), our brains are hardwired to look for shortcuts which would make like easier and make decision-making quicker (though not necessarily more efficient!). For investing, we need to ensure that we rely on the correct and accurate heuristics in order to support our conclusions, and must actively avoid shortcuts which may results in flawed decisions.
Biases are cognitive and psychological in nature, and refer to a particular form of behaviour which arises due to personality traits inherent in human beings. Examples are over-reaction bias, endowment effects, hindsight bias and anchoring bias just to name a few. Over-reaction bias exaggerates the effects of bad news and makes us over-react to events, thus bad news is magnified in terms of emotional impact while the effects of positive news is muted. Endowment effects make it seem like what we own is more valuable than what we do not own, and is usually used to describe the fact that once one owns shares in a company, they would seem more valuable to him than an outsider viewing the same shares. Hindsight bias is one of the most pernicious and common biases and relates to people thinking that they would know what was going to happen, after the fact! This fools people into believing that they could predict what was going to occur. Finally, anchoring bias causes our minds to anchor on a specific price or event and we tend to use this as a benchmark even after it is long obsolete or irrelevant. For more info, please borrow or buy Robert Koppel’s book.
Fallacies are misconceptions resulting from incorrect reasoning that often triggers an emotional response (Koppel, 2011). Some of those discussed in the book include the Fallacy of Accident (Black Swan Theory), Gambler’s Fallacy and Psychologist’s Fallacy. The Fallacy of Accident is a fallacy based on the faulty logic of a generalization that disregards exceptions, thus this applies to assessment of companies without considering scenarios which seem too “impossible” to occur, even though there may be a reasonable chance of it occurring. Gambler’s Fallacy was discussed before in one of my posts, and I shall not dwell on this further. Psychologists Fallacy is interesting because it is the case where the observer assumes that others have the same information and perceptions of the world as he does, and thus he bases his assumptions and logic based on this.
Illusions are pretty interesting phenomena, and this was the first time I had stumbled upon such an extensive array of illusions which can play tricks on our minds. Basically, an illusion is defined as perceptions which differ from objective reality. There are several discussed in the book, but the two worth mentioning (in my opinion) are “jumping to conclusions” and “clustering illusion”. Jumping to conclusions is a case where one believes they possess superior knowledge, therefore they take shortcuts with respect to decision-making, which may end up costing them an arm and a leg. Clustering illusion is the belief in the existence of patterns where none exist, and can usually be found among chart readers who swear by a certain pattern, though nothing may actually exist. I liken this to seeing picture of animals or familiar shapes in clouds, whereas everyone knows clouds are just random collections of water droplets.
Conclusion
The above is a very summarized list of the psychological and mental attributes which an investor should strive to possess in order to manage the “softer” aspects of investing. While having a firm foundation for analysis is important, it is also equally important that the investor does not neglect the emotional aspect of investing. This is because as humans, we do not always behave rationally and with cold logic (like a computer), therefore it is important to understand these emotions and harness them to make better investment decisions.
My next post (my second-last post) will focus on my four and a half year investment journey, and what I had learnt along the way, mistakes made and lessons learnt. I will also pay tribute to value investors who had inspired me as well as people (including bloggers) who had taught me about life, personal finance, wealth building and money management.
Showing posts with label Behavioural Finance. Show all posts
Showing posts with label Behavioural Finance. Show all posts
Friday, January 20, 2012
Sunday, September 27, 2009
Behavioural Finance Part 5 - Gambler’s Fallacy
After a long hiatus, it’s time to get back to discussing the interesting and volatile aspects of human behaviour, and how this influences our decision-making processes concerning our investments and money. Behavioural Finance is a growing field and incorporates principles of human psychology to see how it influences the way we perceive and handle money. Interestingly, I had always noticed that one of the more intriguing aspects of human behaviour concerns gambling, as noted by occasional news reports of casino or lottery winners; and also of gamblers having to pawn and sell all their belongings just to avoid bankruptcy. This is in addition to the almost total collapse of the “victim’s” family and social support, as his gambling addiction totally destroys all aspects of his life.
From an investing perspective, I would like to introduce what is called the “Gambler’s Fallacy”. Essentially, by definition this refers to a person’s view that since a random event has occurred with a certain regularity or in a certain perceived pattern, this would immediately indicate that this pattern or trend is unlikely to continue in the future. This is incorrect because random events are considered independent events in probability theory and have no correlation or causative effects on another random event. Yet, people tend to associate both events together and make deductions or conclusions based on the frequency or probability of occurrence of the second event. This works both ways in investing to the investor’s disadvantage – when the price of a stock (note: NOT its value) is going up in consecutive sessions, an investor has the urge and tendency to sell because he believes the trend will not continue. Conversely, if the stock price has gone down a few consecutive trading days, an investor may also tend to hold on longer than he should as he believes the trend will “break”. This is akin to flipping a coin 20 times and getting “heads” every single time, thus you expect that on the 21st flip, it would have to come out “tails” because it was heads for 20 times already! Of course, one can clearly see the flaw in logic in this example as each coin toss result is independent of all other coin tosses.
When a person observes the price of a counter and does not focus on the value of a company, he will be subject to Gambler’s Fallacy all the time. By studiously going through a company’s newsflow, fundamentals and financials, one can make a more informed decision of the actions he should take with regards to an investment which are not prejudicial to his own interests. Instead of relying on price actions to guide his decisions, one can make more astute decisions by treating stocks as part ownership of businesses and making a business decision instead. One will then cease to be classified as a “gambler” (i.e. speculator) and become an investor.
Interestingly, I had noted the gamblers’ mentality when I recently assisted a friend to purchase some 4-D and Toto tickets (the Singapore version of lottery tickets). Most of them consist of blue collar workers and retirees who stake anything from a few dollars to a few hundred dollars buying numbers in a certain sequence and hope for a windfall gain. Others (usually strapping young men) also engage in legal soccer betting through Singapore Pools by studying the odds on a big LCD monitor and then placing their bets at the counter. Most of these folk, I am sure, are totally clueless about the exact probability of winning the top prize (or any prize, for that matter!). It has been said that a reward quantum should be based on magnitude of reward, as well as probability of achieving that reward. To give an example, if the probability that I will win $100 in 50%, that means the reward quantum is $50 (50% of $100). In a lottery, the probability can go down to as low as one in ten million (yes, it’s 10,000,000 with eight zeroes!), and the top prize is probably about $1,000,000. So this means the reward quantum is about $0.10 (1 million divided by 10 million) – not a very attractive proposition and certainly nothing to salivate at! But the problem here is people’s expectation of that great big reward which keeps them punting and returning to try their luck, irregardless of how many times they fail to hit the jackpot.
I once asked this friend of mine why he spent so much (tens of dollars at a time, twice a week) on punting. He said he was “investing” in lottery and he wanted to make a windfall gain. My natural reaction that was to ask if he had kept track of every single transaction in an Excel spreadsheet and tracked his “ROI”. He looked blank for a while but then confidently asserted that he must have “made money” over the long-haul, because he remembers hitting the top 3 prizes (for 4-D) a few times, so he should have recouped all his capital and more. The problem with this line of thinking is that your “winners” will pervade your thoughts more than the countless number of times you had “lost” money (i.e. not won the lottery). This is also why traders and investors tend to remember their winners rather than their losers, and so kid themselves into thinking they made a pile of money while not accounting for their realized (and unrealised) losses! The right way to go about this is to document every single trade (yes, including fees) over time and to compile it over an extended period (3-5 years minimum) to see if one consistently can generate a decent return on investment. I am currently doing so myself to remain objective and to remind myself that I have “losers” as well as “winners”.
The same thing happens at casinos, which I feel compelled to comment on now that the IR in Singapore is almost close to completion. Casinos play on many behavioural aspects of human beings and thus act as a “trap”; in fact there is little entertainment value (go play a computer game) and is hardly suitable for money-making (try investing in an ETF instead), yet there are hardcore casino players (called “high-rollers”) who spend millions and burn their money away till some are bankrupt. Take the most notorious case of a certain Chia Teck Leng, a former APB Finance Manager who swindled about S$117 million (over 4 years) from several banks – the money was not for altruistic reasons like helping African children to buy more food, in fact it was to feed his insatiable addiction to casino gambling!
So to end off, one should always be wary of gambler’s fallacy, as well as the dangers of problem gambling. A little punting here and there on soccer betting is probably harmless, but if one gets obsessed with winning and starts to stake higher and higher amounts then it will spiral into a huge problem, and will end up a disaster in the making.
From an investing perspective, I would like to introduce what is called the “Gambler’s Fallacy”. Essentially, by definition this refers to a person’s view that since a random event has occurred with a certain regularity or in a certain perceived pattern, this would immediately indicate that this pattern or trend is unlikely to continue in the future. This is incorrect because random events are considered independent events in probability theory and have no correlation or causative effects on another random event. Yet, people tend to associate both events together and make deductions or conclusions based on the frequency or probability of occurrence of the second event. This works both ways in investing to the investor’s disadvantage – when the price of a stock (note: NOT its value) is going up in consecutive sessions, an investor has the urge and tendency to sell because he believes the trend will not continue. Conversely, if the stock price has gone down a few consecutive trading days, an investor may also tend to hold on longer than he should as he believes the trend will “break”. This is akin to flipping a coin 20 times and getting “heads” every single time, thus you expect that on the 21st flip, it would have to come out “tails” because it was heads for 20 times already! Of course, one can clearly see the flaw in logic in this example as each coin toss result is independent of all other coin tosses.
When a person observes the price of a counter and does not focus on the value of a company, he will be subject to Gambler’s Fallacy all the time. By studiously going through a company’s newsflow, fundamentals and financials, one can make a more informed decision of the actions he should take with regards to an investment which are not prejudicial to his own interests. Instead of relying on price actions to guide his decisions, one can make more astute decisions by treating stocks as part ownership of businesses and making a business decision instead. One will then cease to be classified as a “gambler” (i.e. speculator) and become an investor.
Interestingly, I had noted the gamblers’ mentality when I recently assisted a friend to purchase some 4-D and Toto tickets (the Singapore version of lottery tickets). Most of them consist of blue collar workers and retirees who stake anything from a few dollars to a few hundred dollars buying numbers in a certain sequence and hope for a windfall gain. Others (usually strapping young men) also engage in legal soccer betting through Singapore Pools by studying the odds on a big LCD monitor and then placing their bets at the counter. Most of these folk, I am sure, are totally clueless about the exact probability of winning the top prize (or any prize, for that matter!). It has been said that a reward quantum should be based on magnitude of reward, as well as probability of achieving that reward. To give an example, if the probability that I will win $100 in 50%, that means the reward quantum is $50 (50% of $100). In a lottery, the probability can go down to as low as one in ten million (yes, it’s 10,000,000 with eight zeroes!), and the top prize is probably about $1,000,000. So this means the reward quantum is about $0.10 (1 million divided by 10 million) – not a very attractive proposition and certainly nothing to salivate at! But the problem here is people’s expectation of that great big reward which keeps them punting and returning to try their luck, irregardless of how many times they fail to hit the jackpot.
I once asked this friend of mine why he spent so much (tens of dollars at a time, twice a week) on punting. He said he was “investing” in lottery and he wanted to make a windfall gain. My natural reaction that was to ask if he had kept track of every single transaction in an Excel spreadsheet and tracked his “ROI”. He looked blank for a while but then confidently asserted that he must have “made money” over the long-haul, because he remembers hitting the top 3 prizes (for 4-D) a few times, so he should have recouped all his capital and more. The problem with this line of thinking is that your “winners” will pervade your thoughts more than the countless number of times you had “lost” money (i.e. not won the lottery). This is also why traders and investors tend to remember their winners rather than their losers, and so kid themselves into thinking they made a pile of money while not accounting for their realized (and unrealised) losses! The right way to go about this is to document every single trade (yes, including fees) over time and to compile it over an extended period (3-5 years minimum) to see if one consistently can generate a decent return on investment. I am currently doing so myself to remain objective and to remind myself that I have “losers” as well as “winners”.
The same thing happens at casinos, which I feel compelled to comment on now that the IR in Singapore is almost close to completion. Casinos play on many behavioural aspects of human beings and thus act as a “trap”; in fact there is little entertainment value (go play a computer game) and is hardly suitable for money-making (try investing in an ETF instead), yet there are hardcore casino players (called “high-rollers”) who spend millions and burn their money away till some are bankrupt. Take the most notorious case of a certain Chia Teck Leng, a former APB Finance Manager who swindled about S$117 million (over 4 years) from several banks – the money was not for altruistic reasons like helping African children to buy more food, in fact it was to feed his insatiable addiction to casino gambling!
So to end off, one should always be wary of gambler’s fallacy, as well as the dangers of problem gambling. A little punting here and there on soccer betting is probably harmless, but if one gets obsessed with winning and starts to stake higher and higher amounts then it will spiral into a huge problem, and will end up a disaster in the making.
Friday, July 10, 2009
Why do birds suddenly appear, every time there is fear ?
Those who are into music (oldies to be exact) may recognize the title as a spoof of a song sung by The Carpenters called “Close To You”. As I was humming this tune innocently, the twist in the lyrics just came to me and I could not help penning it down as a posting; just please forgive the corny change in the original lyric which still manages to somehow rhyme ! For those who are curious, the original lyric is “Why do birds suddenly appear, every time you are near”.
The title actually refers to my observation that stock markets in general tend to rebound sharply and suddenly after a prolonged period of fear, trepidation and uncertainty. After some thought and some additional reading from investment and market psychology books, I have come to realize that this effect is actually rooted in expectancy and anticipation. Both are contributory factors which determine the tenor of the market and whether there is irrational exuberance or misplaced fear. I shall touch on the former first, move on to the latter then attempt to gel the two together to make a coherent argument as to why the mixture of the two has such a dramatic impact on the stock market.
Expectancy refers to expectations of certain events and their likelihood of occurrence will determine the magnitude of the psychological reaction. A good example would be expectations of a 50% jump in profits for Company A, based on Company A’s track record of good growth and also prudent and steady Management. Expectations would be high for the Company to grow its profits by more than the long-term average of 10-20% due to external factors as well, such as a booming economy, favourable economic policies or strong interest in that industry. This is an example of expectations being pushed high as a result of a myriad of factors. The result is that if the Company reports a 30-35% increase in earnings, the result is a drastic sell-down in the Company’s shares as expectations were not met. This is also known as the “expectation gap”. The magnitude of a psychological reaction to an expectation gap depends on the strength of belief in the outcome, as well as the depth of difference between the perceived outcome and the actual result. The converse is also true for expectations of poor performance, but the reader should note that the resultant positive reaction is largely more muted than one composed of negative surprise. This is due to the previously mentioned over-reaction bias inherent in all humans, who tend to over-accentuate the negative and discount the positive.
For anticipation, this usually relates to market participants anticipating some positive news such as M&A deals, contract wins or other related corporate news which is unrelated to periodic results announcements (which are mandatory). Though one may argue that they are one and the same, anticipation from an unplanned event may actually have an even greater impact on market psychology than a positive expectation from an earnings surprise. This is in part due to the fact that earnings are a quarterly event and their timing can be reasonably ascertained; hence the only unknown is the magnitude of the drop or rise in earnings. Whereas in the case of corporate events or contract wins, though there is usually some anticipation built in, the news may still come as a complete surprise. This usually provokes a much bigger reaction as the unexpectedness of the news catches everyone by surprise and like lemmings, everyone rushes to jump on the bandwagon. The flip side of such anticipation is that without the associated newsflow to support such anticipation, the initial reaction will gradually fizzle out and cause a deflation in market sentiment and lead to a share price collapse. This is why I often state that one should purchase companies when expectations are low rather than high, because prices will be bidded down much more when expectations are low and there is greater margin of safety as long as you know and are confident that the underlying business remains sound. If one purchases based on high anticipation or high expectation, one can expect to be disappointed if things do not turn out as planned.
The mixture of expectation theory and anticipation of certain corporate events creates a heady and unpredictable mix of uncertainty which causes companies to be mis-priced. It is precisely these emotions which Mr. Market exhibits which result in companies trading at sometimes ridiculous valuations, and the job of the astute investor is to pounce on juicy opportunities when they present themselves, and to steadfastly ignore companies which have too much expectations priced in. A recent example is Midas Holdings, which has made a total of 4 contract win announcements over a period of 3 weeks. Impressive though this may seem, I suspect this news was largely priced in because analysts and investors had already been anticipating these events some time before their occurrence. Thus, the high valuations accorded to Midas by these analysts have already incorporated their bullish predictions; thus a margin of safety cannot be present with such inflated expectations. Don’t get me wrong though – I am in no way implying that the Company is a bad one, but there is always a price to pay for earnings and cash flows, and to me the risk-reward ratio does not seem favourable in the long run should one purchase at lofty valuations.
Benjamin Graham, widely recognized as the Father of value investing, says: “Today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus, what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss”.
The title actually refers to my observation that stock markets in general tend to rebound sharply and suddenly after a prolonged period of fear, trepidation and uncertainty. After some thought and some additional reading from investment and market psychology books, I have come to realize that this effect is actually rooted in expectancy and anticipation. Both are contributory factors which determine the tenor of the market and whether there is irrational exuberance or misplaced fear. I shall touch on the former first, move on to the latter then attempt to gel the two together to make a coherent argument as to why the mixture of the two has such a dramatic impact on the stock market.
Expectancy refers to expectations of certain events and their likelihood of occurrence will determine the magnitude of the psychological reaction. A good example would be expectations of a 50% jump in profits for Company A, based on Company A’s track record of good growth and also prudent and steady Management. Expectations would be high for the Company to grow its profits by more than the long-term average of 10-20% due to external factors as well, such as a booming economy, favourable economic policies or strong interest in that industry. This is an example of expectations being pushed high as a result of a myriad of factors. The result is that if the Company reports a 30-35% increase in earnings, the result is a drastic sell-down in the Company’s shares as expectations were not met. This is also known as the “expectation gap”. The magnitude of a psychological reaction to an expectation gap depends on the strength of belief in the outcome, as well as the depth of difference between the perceived outcome and the actual result. The converse is also true for expectations of poor performance, but the reader should note that the resultant positive reaction is largely more muted than one composed of negative surprise. This is due to the previously mentioned over-reaction bias inherent in all humans, who tend to over-accentuate the negative and discount the positive.
For anticipation, this usually relates to market participants anticipating some positive news such as M&A deals, contract wins or other related corporate news which is unrelated to periodic results announcements (which are mandatory). Though one may argue that they are one and the same, anticipation from an unplanned event may actually have an even greater impact on market psychology than a positive expectation from an earnings surprise. This is in part due to the fact that earnings are a quarterly event and their timing can be reasonably ascertained; hence the only unknown is the magnitude of the drop or rise in earnings. Whereas in the case of corporate events or contract wins, though there is usually some anticipation built in, the news may still come as a complete surprise. This usually provokes a much bigger reaction as the unexpectedness of the news catches everyone by surprise and like lemmings, everyone rushes to jump on the bandwagon. The flip side of such anticipation is that without the associated newsflow to support such anticipation, the initial reaction will gradually fizzle out and cause a deflation in market sentiment and lead to a share price collapse. This is why I often state that one should purchase companies when expectations are low rather than high, because prices will be bidded down much more when expectations are low and there is greater margin of safety as long as you know and are confident that the underlying business remains sound. If one purchases based on high anticipation or high expectation, one can expect to be disappointed if things do not turn out as planned.
The mixture of expectation theory and anticipation of certain corporate events creates a heady and unpredictable mix of uncertainty which causes companies to be mis-priced. It is precisely these emotions which Mr. Market exhibits which result in companies trading at sometimes ridiculous valuations, and the job of the astute investor is to pounce on juicy opportunities when they present themselves, and to steadfastly ignore companies which have too much expectations priced in. A recent example is Midas Holdings, which has made a total of 4 contract win announcements over a period of 3 weeks. Impressive though this may seem, I suspect this news was largely priced in because analysts and investors had already been anticipating these events some time before their occurrence. Thus, the high valuations accorded to Midas by these analysts have already incorporated their bullish predictions; thus a margin of safety cannot be present with such inflated expectations. Don’t get me wrong though – I am in no way implying that the Company is a bad one, but there is always a price to pay for earnings and cash flows, and to me the risk-reward ratio does not seem favourable in the long run should one purchase at lofty valuations.
Benjamin Graham, widely recognized as the Father of value investing, says: “Today’s investor is so concerned with anticipating the future that he is already paying handsomely for it in advance. Thus, what he has projected with so much study and care may actually happen and still not bring him any profit. If it should fail to materialize to the degree expected he may in fact be faced with a serious temporary and perhaps even permanent loss”.
Monday, January 12, 2009
Behavioural Finance Part 4 - Hindsight Bias
Initially, I had decided to discuss hindsight bias much later in this series as I had already lined up other "issues" in mind to feature before coming to this one. However, the recent market crash and subsequent bear market have caused a proliferation of hindsight bias theories to emerge, and I felt that it was time to address this very pervasive yet little mentioned topic in order to clear up misconceptions and make us all better investors.
Hindsight bias occurs when one believes (falsely) that one could or should have done something in the past with adequate knowledge only with the benefit of knowing the past (hence, 'hindsight'). I shall give one or two examples here and discuss why this condition is so pervasive and how it affects a majority of investors (including me as well, no one is immune !). As they say, hindsight is always 20/20 while foresight is legally blind, so for those who think the future is clear just by observing the past, they had better take note that this may not always be the case !
One clear example of hindsight bias is how often economists and "expert forecasters" look back and say that they knew something was going to happen, AFTER it happened ! The most recent case of course was the sub-prime debacle which has dragged global stock markets lower and caused the first synchronized global recession since World War II. Looking back, most economists and analysts now proclaim that they "saw it coming" even though I clearly remember that at the time in early and mid-2008, NO ONE saw the collapse of Lehman Brothers and the subsequent drastic fallout from the sub-prime crisis infecting credit markets and causing the credit freeze. Hindsight bias makes things in the past look as though they were "obvious" even though almost no one could have predicted the severe turn of events accurately, and certainly no brokerage firm or analyst correctly predicted the performance of the stock markets as at end-2008, with most having a bullish forecast of on average +10% ! This goes to show that the future can be notoriously difficult to predict and that most people have an inflated opinion of their forecasting abilities solely because of hindsight bias makng them over-confident (another behavioural finance trait, incidentally).
Another pertinent example of hindsight bias which I often get on my blog as well is the constant reminder that I "should have sold at the high and bought back at the low". This is the ultimate form of hindsight bias and concerns looking at past price movements (on a chart) to determine what one SHOULD or WOULD have done. It's a little like saying to accident victims (after the accident) that they should not have gone to so-and-so place so that they could have prevented the accident from occuring. The logic of this flawed argument is obvious - how could one possibly have anticipated something happening in the future and thus have done something to prevent it ? I find this statement usually very laughable, as people are implying that one can time the markets successfully and always buy low and sell high. In reality, it is very difficult to do this consistently (ask anyone who is honest), and some who had done this using valuation metrics (discussed in my previous post) would have also gotten it fairly wrong. An example is those who sold during the early bull market in the early 90's would have stayed sidelined for another 5-6 years as the bull market roared onwards till 2000. So my advice to those who always say one should have sold and bought back lower - how would you know how "low" it goes ? Assuming onoe had purchased a good company at a very good and low price some years back, there is always the chance the bear market may not revisit those amazing lows again. This will only be clear, of course, on hindsight ! In the meantime, the market-timing speculator will miss out on all the dividend payouts while he is not vested, thus reducing his potential gain even further.
As illustrated in the 2 examples above, hindsight bias is a very frequent phenomenon and is pervasive with regards to people who think they can can predict events or forecast the future. With respect to the stock market, nothing is clear and foresight should always be based on an analysis of the best available facts and figures. If one thinks that market timing is a viable strategy (i.e. sell when "high" and buy back when "lower"), then I have to caution that this is and always will be a product of hindsight bias, as one can only tell the highs and lows when one sees a historical chart of share prices.
How can hindsight bias be eliminated in an investor ? Very simple, I believe we should not expect an exceptional return on our investments, but instead be content with a decent rate of return (about 6-8% including dividends) over time. Those who expect an exceptional return will always think of selling at the highs and buying at the lows, and will always lament not doing something they should have done (a form of cognitive dissonance when it comes to actual purchasing). An act of commission is always more destructive than an act of omission, and in the stock market, one is not forgiven for not knowing what he is doing, and this often results in a permanent loss of capital.
At the same time, we should also be humble and accept that the future is often murky, and that we (as rational human beings) are trying out best under the difficult circumstances to maximize our returns and to grow our wealth. Thus, no use kicking yourself over the past and what one should have done as regret is a useless emotion. Instead, one should learn from his mistakes and face the future confidently, as lives must be lived forwards and not backward.
Initially, I had decided to discuss hindsight bias much later in this series as I had already lined up other "issues" in mind to feature before coming to this one. However, the recent market crash and subsequent bear market have caused a proliferation of hindsight bias theories to emerge, and I felt that it was time to address this very pervasive yet little mentioned topic in order to clear up misconceptions and make us all better investors.
Hindsight bias occurs when one believes (falsely) that one could or should have done something in the past with adequate knowledge only with the benefit of knowing the past (hence, 'hindsight'). I shall give one or two examples here and discuss why this condition is so pervasive and how it affects a majority of investors (including me as well, no one is immune !). As they say, hindsight is always 20/20 while foresight is legally blind, so for those who think the future is clear just by observing the past, they had better take note that this may not always be the case !
One clear example of hindsight bias is how often economists and "expert forecasters" look back and say that they knew something was going to happen, AFTER it happened ! The most recent case of course was the sub-prime debacle which has dragged global stock markets lower and caused the first synchronized global recession since World War II. Looking back, most economists and analysts now proclaim that they "saw it coming" even though I clearly remember that at the time in early and mid-2008, NO ONE saw the collapse of Lehman Brothers and the subsequent drastic fallout from the sub-prime crisis infecting credit markets and causing the credit freeze. Hindsight bias makes things in the past look as though they were "obvious" even though almost no one could have predicted the severe turn of events accurately, and certainly no brokerage firm or analyst correctly predicted the performance of the stock markets as at end-2008, with most having a bullish forecast of on average +10% ! This goes to show that the future can be notoriously difficult to predict and that most people have an inflated opinion of their forecasting abilities solely because of hindsight bias makng them over-confident (another behavioural finance trait, incidentally).
Another pertinent example of hindsight bias which I often get on my blog as well is the constant reminder that I "should have sold at the high and bought back at the low". This is the ultimate form of hindsight bias and concerns looking at past price movements (on a chart) to determine what one SHOULD or WOULD have done. It's a little like saying to accident victims (after the accident) that they should not have gone to so-and-so place so that they could have prevented the accident from occuring. The logic of this flawed argument is obvious - how could one possibly have anticipated something happening in the future and thus have done something to prevent it ? I find this statement usually very laughable, as people are implying that one can time the markets successfully and always buy low and sell high. In reality, it is very difficult to do this consistently (ask anyone who is honest), and some who had done this using valuation metrics (discussed in my previous post) would have also gotten it fairly wrong. An example is those who sold during the early bull market in the early 90's would have stayed sidelined for another 5-6 years as the bull market roared onwards till 2000. So my advice to those who always say one should have sold and bought back lower - how would you know how "low" it goes ? Assuming onoe had purchased a good company at a very good and low price some years back, there is always the chance the bear market may not revisit those amazing lows again. This will only be clear, of course, on hindsight ! In the meantime, the market-timing speculator will miss out on all the dividend payouts while he is not vested, thus reducing his potential gain even further.
As illustrated in the 2 examples above, hindsight bias is a very frequent phenomenon and is pervasive with regards to people who think they can can predict events or forecast the future. With respect to the stock market, nothing is clear and foresight should always be based on an analysis of the best available facts and figures. If one thinks that market timing is a viable strategy (i.e. sell when "high" and buy back when "lower"), then I have to caution that this is and always will be a product of hindsight bias, as one can only tell the highs and lows when one sees a historical chart of share prices.
How can hindsight bias be eliminated in an investor ? Very simple, I believe we should not expect an exceptional return on our investments, but instead be content with a decent rate of return (about 6-8% including dividends) over time. Those who expect an exceptional return will always think of selling at the highs and buying at the lows, and will always lament not doing something they should have done (a form of cognitive dissonance when it comes to actual purchasing). An act of commission is always more destructive than an act of omission, and in the stock market, one is not forgiven for not knowing what he is doing, and this often results in a permanent loss of capital.
At the same time, we should also be humble and accept that the future is often murky, and that we (as rational human beings) are trying out best under the difficult circumstances to maximize our returns and to grow our wealth. Thus, no use kicking yourself over the past and what one should have done as regret is a useless emotion. Instead, one should learn from his mistakes and face the future confidently, as lives must be lived forwards and not backward.
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.
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.
Saturday, February 09, 2008
Behavioural Finance Part 2 - Over-Confidence
Part 1 of the behavioural finance series talked about the effects of mental accounting and how it can distort our perception of money and influence our decision-making process. The second part of this series touches on a very common problem among human beings, that of over-confidence. Over-confidence is an insidious condition which can rob a person of normal rationality and cause him to take risks larger than what he is supposed to be comfortable with. Thus, this figures high on the list of behaviours to watch out for when investing in the stock market.
According to the book "The Essential Buffett" by Robert G. Hagstrom, an overwhelming majority of people (when interviewed) claimed that they were good drivers, which leaves one to wonder where all the bad ones are ! Also, according to him, doctors state that they can diagnose pneumonia 90% of the time while the actual percentage is closer to only 50%. These examples show that human beings have the tendency to over-estimate their abilities and to feel that they are superior to other human beings. The truth is, of course, that only a minority of people are actually very good and consistent when it comes to stock market performance; and these are the people who understand about temperament and emotions and learn to master them instead of letting their emotions take control.
Confidence itself is a good thing when it comes to investing, as it implies that one is certain and confident of his investment strategy and that he can execute it competently enough to ensure consistent profits for his investments. Over-confidence is excessive confidence in one's ability and can lead to one making silly and stupid mistakes as a result of an inflated ego. But just how does over-confidence manifest itself during investing ? Some examples would include someone "getting it right" a few times in a row when it comes to picking "winners", thus he feels that he has found a secret formula or that he can do no wrong. Therefore, he recklessly picks his next few investments and plonks large amounts of money into them, only to lose massive amounts of cash in the process.
Another example of over-confidence may be someone who thinks he has stumbled on a secret "system" to beat the market every single time, and thus far it has worked very well and generated consistent profits. One instance of this behaviour was highlighted in a New Paper article showing how an Singaporean under-grad studying in Australia had managed to make a small sum from "contra" trades, only to lose an amount close to S$700,000 over three months after over-confidence took control of his senses. There have been forumers on various share forums in Singapore who also displayed excessive optimism on their own stock picking abilities, only to fall prey to the moods of Mr. Market which their "perfect" system could not detect swiftly enough.
Personally, I have also been guilty of being over-confident at times, as this is a perfectly human trait and we are not infallible. At such times, I have to constantly remind myself not to gloss over the facts of the case and to remain focused; because even though I have had some success in picking good companies, it does not mean that I will ALWAYS be successful in picking good companies. Being mindful of one's fallibility makes one more humble and also allows one to admit mistakes made, in order to learn and improve on one's investment acumen.
Part 1 of the behavioural finance series talked about the effects of mental accounting and how it can distort our perception of money and influence our decision-making process. The second part of this series touches on a very common problem among human beings, that of over-confidence. Over-confidence is an insidious condition which can rob a person of normal rationality and cause him to take risks larger than what he is supposed to be comfortable with. Thus, this figures high on the list of behaviours to watch out for when investing in the stock market.
According to the book "The Essential Buffett" by Robert G. Hagstrom, an overwhelming majority of people (when interviewed) claimed that they were good drivers, which leaves one to wonder where all the bad ones are ! Also, according to him, doctors state that they can diagnose pneumonia 90% of the time while the actual percentage is closer to only 50%. These examples show that human beings have the tendency to over-estimate their abilities and to feel that they are superior to other human beings. The truth is, of course, that only a minority of people are actually very good and consistent when it comes to stock market performance; and these are the people who understand about temperament and emotions and learn to master them instead of letting their emotions take control.
Confidence itself is a good thing when it comes to investing, as it implies that one is certain and confident of his investment strategy and that he can execute it competently enough to ensure consistent profits for his investments. Over-confidence is excessive confidence in one's ability and can lead to one making silly and stupid mistakes as a result of an inflated ego. But just how does over-confidence manifest itself during investing ? Some examples would include someone "getting it right" a few times in a row when it comes to picking "winners", thus he feels that he has found a secret formula or that he can do no wrong. Therefore, he recklessly picks his next few investments and plonks large amounts of money into them, only to lose massive amounts of cash in the process.
Another example of over-confidence may be someone who thinks he has stumbled on a secret "system" to beat the market every single time, and thus far it has worked very well and generated consistent profits. One instance of this behaviour was highlighted in a New Paper article showing how an Singaporean under-grad studying in Australia had managed to make a small sum from "contra" trades, only to lose an amount close to S$700,000 over three months after over-confidence took control of his senses. There have been forumers on various share forums in Singapore who also displayed excessive optimism on their own stock picking abilities, only to fall prey to the moods of Mr. Market which their "perfect" system could not detect swiftly enough.
Personally, I have also been guilty of being over-confident at times, as this is a perfectly human trait and we are not infallible. At such times, I have to constantly remind myself not to gloss over the facts of the case and to remain focused; because even though I have had some success in picking good companies, it does not mean that I will ALWAYS be successful in picking good companies. Being mindful of one's fallibility makes one more humble and also allows one to admit mistakes made, in order to learn and improve on one's investment acumen.
Sunday, December 30, 2007
Behavioural Finance Part 1 - Mental Accounting
This may sound ambitious, but I am starting a new series on behavioural finance as I feel it is very relevant to value investing and investing in general. I will be updating my investing sins and research series at the same time, so readers, kindly be patient. Most people actually lose money in the markets through their own mental faults, rather than a result of not being able to analyze a company objectively. Humans are natually emotional creatures (we are not robots !) and we tend to over-emphasize the emotional aspects of money in an unconscious manner. When dealing with the stock market, this can be counter-productive and extremely disruptive to wealth building. Charlie Munger (Warren Buffett's partner in Berkshire Hathaway) understood the basics of behavioural finance long before the experts took it up as a serious topic. Now, there is a whole field of study relating to it and experts acknowledge that a lot of research needs to be be done in order to ascertain the effects of behavioural finance on investing. Examples of topics I will be covering under this category are over-confidence, over-reaction bias, loss aversion and mental accounting.
The topic I would like to touch on today is mental accounting. Mental accounting is the process by which we tends to mentally segregate our money into various "buckets" for spending and utilizing. This can create problems because after all, money is money right ? Why should we separate money into distinct categories ? This is due to the fact that human beings like to compartmentalize money, and we do it unconsciously in everyday life. For example, we tend to mentally set aside $100 for meals every month, $80 for transport and say $200 for entertainment and leisure activities. Thus, it will not pain me if I spend $150 on a good concert because I had already mentally accounted for it. Assuming I am effective at budgeting, this will not be a problem; problems arise only if the mental accounting map had set aside $1,000 instead of $200 !
The above was a simple example of mental accounting, but the more pervasive effects can be found in stock markets and casinos. To illustrate, imagine a person winning $1,000 in a casino on his first few rolls, due to sheer luck. This $1,000 is then perceived as "bonus" money which can be spent frivolously as the gambler will not be fazed if he lost all of it as he did not have this extra $1,000 to begin with. In the end, the house always wins in a casino and he may very well lose the $1,000 he initially made, and probably his pants too if he is not careful ! The point here is that the extra $1,000 is still money, though it came from a windfall; but our minds automatically segregate it as "additional" money which can spent freely and with abandon. The wise thing to do would be to stop playing and keep the extra $1,000. (Better still, invest in and get a 5-10% yield !).
I have seen mental accounting very often in stock market behaviour, and have been victim to it myself (though I recognize it better now and take steps to tell my brain NOT to mental account). I often hear from friends who have gains in the stock market that these gains can very well be left to evaporate as "they were gains in the first place". Put another way, my friends feel that it is OK to lose money in a lousy company as the losses were originally made up of profits in the first place. This example is akin to the casino example I gave above, in that we tend to feel that profits can be lost without a blink rather than our own initial capital. If we put it in a rational perspective, and using value investing principles, every single cent of gain should be preserved as capital preservation is a cornerstone of value investing. This means that all gains should be retained and compounded to produce even better returns, instead of using those gains to "gamble" just because we have mentally accounted for it.
To conclude, mental accounting is a very subtle and insidious way of losing money which many people do not realize. It is time to ask yourself if you are guilty of this aspect of behavioural finance, and whether you can actively choose to prevent it from occurring again. In this way, we can all be better investors !
This may sound ambitious, but I am starting a new series on behavioural finance as I feel it is very relevant to value investing and investing in general. I will be updating my investing sins and research series at the same time, so readers, kindly be patient. Most people actually lose money in the markets through their own mental faults, rather than a result of not being able to analyze a company objectively. Humans are natually emotional creatures (we are not robots !) and we tend to over-emphasize the emotional aspects of money in an unconscious manner. When dealing with the stock market, this can be counter-productive and extremely disruptive to wealth building. Charlie Munger (Warren Buffett's partner in Berkshire Hathaway) understood the basics of behavioural finance long before the experts took it up as a serious topic. Now, there is a whole field of study relating to it and experts acknowledge that a lot of research needs to be be done in order to ascertain the effects of behavioural finance on investing. Examples of topics I will be covering under this category are over-confidence, over-reaction bias, loss aversion and mental accounting.
The topic I would like to touch on today is mental accounting. Mental accounting is the process by which we tends to mentally segregate our money into various "buckets" for spending and utilizing. This can create problems because after all, money is money right ? Why should we separate money into distinct categories ? This is due to the fact that human beings like to compartmentalize money, and we do it unconsciously in everyday life. For example, we tend to mentally set aside $100 for meals every month, $80 for transport and say $200 for entertainment and leisure activities. Thus, it will not pain me if I spend $150 on a good concert because I had already mentally accounted for it. Assuming I am effective at budgeting, this will not be a problem; problems arise only if the mental accounting map had set aside $1,000 instead of $200 !
The above was a simple example of mental accounting, but the more pervasive effects can be found in stock markets and casinos. To illustrate, imagine a person winning $1,000 in a casino on his first few rolls, due to sheer luck. This $1,000 is then perceived as "bonus" money which can be spent frivolously as the gambler will not be fazed if he lost all of it as he did not have this extra $1,000 to begin with. In the end, the house always wins in a casino and he may very well lose the $1,000 he initially made, and probably his pants too if he is not careful ! The point here is that the extra $1,000 is still money, though it came from a windfall; but our minds automatically segregate it as "additional" money which can spent freely and with abandon. The wise thing to do would be to stop playing and keep the extra $1,000. (Better still, invest in and get a 5-10% yield !).
I have seen mental accounting very often in stock market behaviour, and have been victim to it myself (though I recognize it better now and take steps to tell my brain NOT to mental account). I often hear from friends who have gains in the stock market that these gains can very well be left to evaporate as "they were gains in the first place". Put another way, my friends feel that it is OK to lose money in a lousy company as the losses were originally made up of profits in the first place. This example is akin to the casino example I gave above, in that we tend to feel that profits can be lost without a blink rather than our own initial capital. If we put it in a rational perspective, and using value investing principles, every single cent of gain should be preserved as capital preservation is a cornerstone of value investing. This means that all gains should be retained and compounded to produce even better returns, instead of using those gains to "gamble" just because we have mentally accounted for it.
To conclude, mental accounting is a very subtle and insidious way of losing money which many people do not realize. It is time to ask yourself if you are guilty of this aspect of behavioural finance, and whether you can actively choose to prevent it from occurring again. In this way, we can all be better investors !
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