I finally know what distinguishes man from the beast : financial worries.
Jules Renard, 1864-1910. French Novelist and playwright
There is one principle which a man must follow if he wishes to succeed, and that is to understand human nature.
Henry Ford, 1863-1947, Founder of Ford Motor Co.
If you look at the performance of various stock markets around the world it can be best described as a roller-coaster ride. The following is the chart for our KLCI as from December 2012. Notice how volatile is the price in the chart. It is of common belief that stock prices movements are as a result of changes in economic fundamentals such as interest rates, GDP growth, consumer confidence and corporate earnings. The movement of the market index like our FBMKLCI is a result from the individual actions of thousands of buyers and sellers at the end of each trading day. Hence it can also be deduce that the movement of the individual chart movement of interest rate, GDP growth, consumer confidence or corporate earnings should mimic the movement of FBMKLCI. But what can be seen from below is that none of the individual charts movement mimics that of FBMKLCI.
Thus it can be deduced that changes in economic fundamentals does not fully explain the movement of stock prices. This is because stock prices vary too greatly. Instead the other part that causes changes in stock prices is due to human emotions. I shall present to you below a write-up on how human emotions or ‘animal spirit’ affects our decisions on investment.
By the end of this article you should learn the following.
- What is mental accounting and prospect theory and how they affect our decision making in investing and daily lives.
- How bubbles and crash are formed?
- How greed and fear contributed to the wild swings in stock and real estate prices?
- Why stock prices tend to revert to the mean?
- How to capitalize on human emotions?
What is Behavioral Economics? Unfortunately it is one of the newer fields in the study of economics that has been literally left in the freezer. It has been taught in colleges and universities for more than 40 years but has not attracted much public attention. Behavioral Economics or sometimes called Behavioral Finance is the multi-disciplinary study of psychology and economics. Or put it simply, it is the study on how our rational and irrational decision making influences the way we invest, spend, borrow or save money. In other words it is a study of how our inborn animal instinct affects our financial decisions. Thus, by understanding how our animal instinct affecting our decision process, it tends to help us avoid many of our irrational decision making such as the following.
- Why people tend to buy at the highest and sell at the lowest in stock market and real estate investments?
- Why people are more willing to charge a $1000 dinner on credit card than spending $500 cash on a dinner.
- Why we tend to spend all the money given to us by way of gift, inheritance, a profit from the stock market or a win in the lottery?
- Why are financial prices so volatile?
- Why are we unwilling to spend $1000 to overhaul the old car given to us by a relative?
It is also unfortunate that a lot of people believed that the economic events such as a rise or fall in the GDP, inflation rate, stock and real estate market are due to technical factors or past government decisions affecting the economy through its macro and micro-economic policies.
According to traditional economics theory that goes back to the days of Adam Smith where free market performs the best if it is left on its own, without intervention from the government. In a free market people will rationally use all available opportunities to produce goods and trade with each other. This will thus result in full employment because workers are willing to work for less than what they can demand for. Hence by this definition it also means that the economy will always achieve stability because people looking for a job will always be employed because they are willing to sacrifice for a lower wage.
However it is insufficient to solve modern day economic crisis like during the Great Depression where the height of the crisis the unemployment rate reached a high of 25%. It may helped solved the problem on why the balance 75% of the population is employed because they are willing to work for less than they can demand for. Similarly, it cannot explain why unemployment is high in the current Global Economic Crisis. The following info-graph from the World Economic Forum shows the youth unemployment throughout the world.
How Animal Spirits influence our decisions?
Hence it can be deduced that although free market capitalism may help to explain why people are employed but it may not be able to provide answers on why economies go into expansion and contraction. This is because other than making rational economic decisions people are also influenced by non-economic decision which is guided by their ‘animal spirits’. This non-economic decision is influenced by changes in our thinking process such as confidence, envy, temptation, compulsiveness, fear, greed, peer pressure, addictions and illusions. Understanding how these psychological traits in influencing how people make decisions will enable us to find answers to the earlier questions above. The fact is that now more people are making decisions that are not rational, self-interest or consistent in order to get more return from their limited resource allocation such as money.
An example is well illustrated by our recent rise of 20 cents in the RON 95 petrol. People may think that they are acting rationally by queuing up in petrol stations to fill up their tanks. They reckoned that by filling up their tanks at the old price which saves some money and hence a rational thing to do. However they failed to realized that not only what they saved is pittance but also a waste of time queuing. The savings resulted from filling up their tanks are much lesser (less than $10) after deducting the fuel spent on waiting and travelling from their home to the gas stations. Before we delve further into the field of Behavioral Economics, I reckon it is best to explore how and where it began.
The origin of Behavioral Economics
Although there are many claimed they are the pioneers of Behavioral Economics but the most likely location for the beginning is at the Hebrew University in Jerusalem. In the late 1960s, two Israeli psychologists Amos Tversky and Daniel Kahneman are devising a method to motivate fighter pilots in training. The flight instructors who are taking a class in Hebrew University taught by the above psychologists found that when a pilot is praised for a good flight he tended to do worse on his next flight and similarly when a pilot is criticized for a bad flight he tend to perform better in his next flight. This led them to argue against the conventional wisdom that rewards is a better tool than punishment in motivating fighter pilots. How can this be?
One explanation offered by the psychologists is through the mathematical concept called ‘Statistical Regression’ or ‘Reverting to the Mean’. It can be best described with the following chart.
From the chart above you can see that the samples which are represented by the ‘O’ scattered around the Mean or Moving Average (Regression Line). As shown over time the ‘O’ will tend to revert back to the Mean which is represented by the Regression Line.
Similarly any flight performed by the pilot whether good or bad which can be represented by the ‘O’ in this case. Over time it tend to revert back to the mean which is also the pilot’s long rang average. Not understanding this, the instructors concluded that criticisms tend to improve the pilots performance and praise tend to degrade the pilots performance. Even in the sport of tennis, it is found that when a player had a bad forehand it will be followed by a better forehand and vice versa. The more he hit the closer will be his performance reverting to his average.
How Behavioral Economics affects our decision making?
The two pillars upon which Behavioral Economics are based on are the concept of Mental Accounting and the Prospect Theory. We shall begin with the concept on Mental Accounting first. What is Mental Accounting?
Mental accounting refers to a situation where we treat money differently depending on where it came from. To illustrate this concept we shall see how mental accounting affects a gambler. A gambler tends to gamble more when using casino chips than with cash. This is because less pain is inflicted on him as a result of his loss using casino chips than it does with cash. This is because he tends to place different value on the chips than cash.
Another example will be the different value people placed on earned income and gift income. We tend to spend the $50 given by our parents with less thought than the $50 that we earned from our job. This can help explain why people treat our Government’s BR1M as gift money and hence they will spend it without any thought. Similarly when those Felda smallholders received windfall payments from the listing of Felda Global Ventures spent their money as gift money. As a result many of them spend it on cars, motorbikes, houses and other non-income recurring investments instead of replanting their rubber trees which will provide sustainable future incomes.
Probably the best example to illustrate how mental accounting caused havoc in our personal finance is the use of credit card. If you happen to visit an electrical shop and wanted to buy an oven that cost $200. Even if you have $400 in your pocket you will hesitate to pay by cash because it will instantly reduce your cash holding and hence buying power by half. Instead you don’t have problem charging it to your credit card because you tend to treat the money differently. By charging it to the credit card you not only don’t feel any loss of buying power but also the money spent seem cheapened or devalued because we don’t feel we are spending our dollars.
The Prospect Theory deals with the way we arrive at a decision based on gains and losses of money and how it affects our attitude toward risk. Instead of assigning different value to money as in mental accounting we now assign different value to the loss and gain of money. Thus by understanding how people view losses and gains differently, it can help us figure out why people make bad decisions on investing and spending. The prospect theory can be divided into two concepts which are also known as the ‘loss aversion and sunk cost fallacy.’
Loss aversion refers to our feelings towards a loss. To illustrate the concept of loss aversion and how it affects our decision on investing we present you the following test done by Tversky and Kahneman.
You are given $1000 and asked to choose between two options. Option 1 is you are guaranteed $500 and option 2 you are to flip a coin. If it’s head then you will receive an additional $1000 and if it’s tail then you will get nothing more.
Again you are given $2000 and asked to choose between two options. Option 1 you are guaranteed to lose $500 and option 2 you are to flip a coin. If it’s head you will lose $1000 and if it’s tail then you will lose nothing.
Which option will you choose in Scenario 1 and 2? The result suggests that most people will choose Option 1 in Scenario 1 and Option 2 in Scenario 2. This is because when you choose the above it shows that you are only willing to take more risk when losses are avoided hence ‘loss aversion’.
How does loss aversion affect us in Investing?
Understanding the concept of loss aversion can be very useful in helping us to improve our decision in investing. For those who are very sensitive to losses it implants a loss-phobia in them. During market downturns they are the ones who will panic sell and tend to get out of the market too soon. Watching their stocks going down with the market is something that is too much to bear and hence what other way than selling to stop the pain. However by reacting too spontaneously, the investor might not be able to differentiate whether the market reaction is a profit taking or crash. If the market reaction is due to profit taking then the investor have made a wrong decision. Additionally he will be subjected to another round of pain by watching his stocks rising again.
Another effect of loss aversion is making us holding on to our bad investments for far too long. I am sure during your investing career you had come upon stocks that are underperforming or so-called dogs. Due to your attitude towards loss aversion you tend to hold on to them forever believing it will make a comeback one day. The problem is that most of the time it doesn’t.
So what we can deduce from the above is that investors tend to sell winners too quickly and kept losers too long. This is because according to the loss aversion concept, it is less painful to sell winners and keep losses. This led them to do the opposite the sound investment strategy of ‘letting your profits run and cutting your losses’. This situation is also known as the ‘disposition effect’ in economics.
Sunk Cost Fallacy
Sunk cost is a cost that has already been incurred and cannot be recovered like paying the deposit for a home or car. An example to illustrate how sunk cost affects our decision making is the research paper by Hal. R. Arkes and Cathering Blumer of Ohio University titled ‘The Psychology of Sunk Cost’ in 1985.
In this experiment three groups of people are paying different prices for their theatre tickets for the 1983 season. The first group paid full price for the tickets of $15. The second group paid $13 or a $2 discount while the last group paid $8 or a $7 discount. What they found at the end of the experiment is that those people who pay full price for their tickets attend more performances than those who received discounts. Hence this shows that the more people spend on their tickets the greater will be their sunk costs and hence willing to attend the performances more frequently.
In the world of stock investment, sunk cost fallacy can help explain why investors tend to throw good money after bad money. Take for example from above the more money we throw into the stock market the greater will be the sunk costs. Say for example if you bought Stock A at $5 about 3 months ago but since has been going down and now trading at $2. Being a rational investor you should be cutting losses but due to the sunk cost committed you tend to buy more to average down your cost. When you average down by buying more when the price goes down you tend to throw good money after bad. Averaging down is not a good strategy because you are buying a weak stock with bad fundamentals whose price tends to slide further down overtime.
Similarly in real estate investments, people tend to hold on to bad investments because large amount of sunk costs have committed such as paying a hefty deposit or installments for the past few years. Liquidating bad investments not only proved that we made a wrong decision but also the pain inflicted with taking a loss. Hence we tend to hang on to them as long as we can.
By now you should understand how the above psychological traps influence our decision in buying and selling of stocks and real estate. At the micro level all these buying and selling or churning of stocks or real estate will influence the daily price movements. Thus by understanding how greed and fear move prices in the micro level, we can use it to our advantage. We now turn our attention to the macro level where collective actions of many individuals affect the market price of both stocks and real estates. This brings us to the following questions.
Why Stock Prices so volatile?
To begin with let us look at the definition of how an asset is being priced. The value of any asset can be expressed as ‘the present value of expected future cash flows discounted at a rate commensurate with the perceived risk of the asset’. For stocks the expected future cash flow comes from the expected dividend stream derived from the stocks. Or it can be expressed with the following formula which is also known as Gordon formula or Gordon Stock-dividend-capital appreciation model.
Price = Da (1 + g)ª / (1+k)ª
Da = expected dividend in period a
G = expected growth rate in dividend
K = investor’s required rate of return
It is not our intention to decipher the above formula in this article but a guideline to show you stock prices are partly determined by investor’s expectations. Below I present 3 different concepts on how ‘animal spirits’ within us influences stock market prices.
A rational investor will always let his profits run in a bull market while cut his losses during a bear market. When every investor reacted to the same manner where they all buy when the market is rising and sell when the market is declining eventually it will have a tremendous effect on the final price. This is because when everyone reacts in the same manner it will create a feedback effect into the changes in the prices in one direction. In other words buying begets buying and selling begets selling.
What happens next is that when buying begets buying it will help create a bubble where it will burst because the buying will be exhausted eventually. Similarly when selling begets selling the market will crash because there is not enough demand to absorb the selling. This phenomenon is also known as ‘price-to-price feedback’.
The other source of feedback that affects the prices of both the stock and real estate market is the price-to-earnings-to-price feedback. As you see when the market is going up people will consume more because they reckons that their gains (although paper gains) have make them richer and thus less tendency to save. The effect of increased consumption that is resulted from an increased in asset price is known as the ‘wealth effect on consumption.’
When the stock market increase in value it gives an indication that the economy is doing well and thus encourage companies to expand their plants by hiring more people and buy more machineries. Not only the companies are seeing the encouraging signs, the confidence in individuals will be boosted. As a result of the so-called increased in ‘Consumer Confidence’, people tend to spend more because of their positive expectation on the economy in the future. This in turn will boost corporate earnings and thus will encourage their stock prices to go up.
This increased in consumer confidence will again feedback into the economy and will further encourage more people to spend and thus further boost confidence. But a lot of people cannot rationalize whether this boom is everlasting. They cannot rationalize that the increased earnings in companies which were brought about by their increased consumption might be a temporary manifestation of the rise in the stock prices. Eventually a bubble will be formed and will burst because this fallacy cannot go on forever because eventually the law of diminishing returns will apply to consumption.
The Price-to-leverage feedback refers to how the effects of leverage can cause a rise in the asset prices. How much leverage is often determined by the so-called Collateral Ratio. The collateral ratio is the amount of money banks lend to people as a percentage of the value of assets that are pledged. Naturally during a rising market the collateral ratio will rise because the value of the assets whether stocks or real estate rises. Again this price-to-leverage feedback will eventually feeds back into the economy. This is because people can now buy more shares as a result of the increased margin value of their shares. Similarly, in the real estate market people can now buy their second home for speculation because banks are now willing to lend more based on the increased value of their properties. Hence this leverage feedback loop will further push the home prices upwards. Again this speculative frenzy will have to come to an end which nobody knows exactly when. But those that are going to be wiped out are definitely the greedy ones and the late comers.
How about the Real Estate?
Real estate prices can also be as volatile as stock prices as shown in the past. The current upward trend in real estate prices rest on the premise of land, population and economic growth story. Real estate has always been a good choice for investment not only for shelter but also for capital gain. Coupled with the belief that limited land supplies and population growth, it further convinces the people that real estate prices can only go up.
To explain why property prices in the vicinity of Kuala Lumpur especially in the Golden Triangle can maintain at a very level is partly due to the ‘Green Belt effect.’ The land area within the vicinity of Kuala Lumpur is very limited and there is no effort to increase the land supply by extending the city limit to surrounding areas. Thus it will create a shortage of land within its vicinity which results not only in the steep rise in the price of land but also rentals. Since the price of land is so expensive and limited supply coupled with an increasing population, the only way to develop is upwards and hence contributed to the recent mushrooming of condominiums around the KLCC area. Hence with the mindset that land is a scarce resource and there is always a demand, it has somehow made the idea of ‘real estate as a good investment’ cast in stone.
The feedback loops such as price-to-price, price-to-GDP-price and price-to-leverage-price as we have seen in stock prices also operates in the real estate market. When real estate prices start to go up, bankers are more willing to lend and thus people are borrowing more money to buy more expensive or even second or third home for speculation purposes. As word gets around that money can be easily made from real estate. Thus the price-to-price feedback will eventually leads to the price-to-leverage feedback which will propel home prices higher and higher. Finally this endless loop of feedbacks will propel the real estate market to bubble level which eventually will burst.
In wrapping up, I reckon by now you should realized that it is the human emotion or animal spirits within us that is partly responsible for driving up the prices of all asset classes. It is our fear and greed that really drives us to make irrational decisions in either investments or anything regarding our daily lives.
Thus by understanding the weakness of others we can capitalize on it by making more rational decisions. For example one of the strategies that hedge funds employed is the Global Macro strategy. For global macro strategy to work, hedge fund managers first have to look at the big picture or larger trends in the global market space. Once a trend or an imbalance in an economy is detected the funds will then position itself into that particular country. Knowing that over-reaction in stock prices offers tremendous opportunity to make money. They then make bets opposite the direction of the market. This is because they know that market extremes tend to revert back to the mean or their long term average. Thus the hedge fund managers will then bet on either long/short positions.
Similarly for folks like us, we can make better decisions after knowing how mental accounting and prospect theory affects our decision making. The next time before you charge it on your credit card think about the 18% interest rates the bank charges on your card. If you have money given to you either as inheritance or gift, treat is as if it is ‘earned money’. Try training yourself to wait for a while before spending the money or put it into fixed deposits. Then it should prevent you from spending it like grandma‘s money. In making stock market decisions try not to relate it to previous losses as it will affect your decision due to your loss aversion mindset.
Policy makers who are sharp and cunning can also make use of the sunk cost fallacy to their own advantage. To avoid future objections from NGOs or the public in controversial projects, they first try to spend as much money as they could so that the sunk cost fallacy will protect them. By the time the public wakes up to challenge or demonstrate against the project, millions of dollars have already been spent. Thus no one in the right mind is going to prevent the project from going on. One such project is the Lynas Advanced Materials Plant (LAMP) in Malaysia. Now that the plant is ready and the license has already been issued, there isn’t much the public can do about it other than signing anti-Lynas petitions and demonstrations.
On the other hand Policy makers can incorporate animal spirits into their macro and micro-economic policies which can help them cushion the effects of a financial meltdown. By designing policies that will dampen euphoria during extreme bullish market conditions or instill confidence during market crashes will not only help ease the impact of a financial crisis but also make our economy more sustainable.