Wealth Planner:
Why many investors act irrationally when dealing with risk

          Everyone loves a bargain, correct? Each time the Midnight Sale is on at Central or Emporium, the stores are jam packed with bargain hunters. Yet the opposite tends to happen with stocks. When they are cheap or “On Sale”, nobody wants them. Investors tend to act irrationally when confronted with financial market risks.

           This irrational behaviour can be partly explained by human psychology and how people balance their greed and fear emotions. Fear takes hold when markets head south, while greed kicks in during bull markets. But common sense dictates that the opposite should be true. Human being human, it has often been said that we are our own worst enemies. To most people, losses hurt more and the memories of these stay in our minds longer than the gains. In addition, many investors tend to have short memories and tend to look at things from a short-term perspective. Chart 1 below proves my point.

Chart 1

เปรียบเทียบผลตอบแทนของตลาดหุ้นทั่วโลก

           During the past 3 years from 2005 to 2007, global equity markets posted double digits gain from 21% in the US to 130% gain for Emerging Markets. But when the correct came during the first two weeks of January, everyone acted as if the whole world just ended. In fact, most markets only declined by less than 10%.

           As a rule, in times of crisis, it is best to stay calm and avoid panic responses. Since we can’t influence the outcome of the markets why lose sleep over something that’s out of our controls. Past experience of market turbulence shows that acting in the heat of the moment usually results in a poor investment outcome. In essence, all investors are trying to get their money to work harder. But unfortunately, their emotions usually get in the way at some point i.e. become too greedy and increase their equity exposure at the worst possible moment, when prices are already high, or sell everything in the middle of a downturn. Another big mistakes investors often make is lack of diversification and too much trading. As an investor, you are not in the business of intra-day-trading, therefore, one should invest for the long term. One strategy that may work is to set up a core-satellite portfolio, where the “core” portfolio would comprise long-term holdings and “satellite” portfolio can be more speculative. In this way, you can enjoy the best of both worlds as in having more aggressive strategies along side defensive core investments.

A question of style

Broadly speaking, investors fall into three main groups: -

Active investors: are constantly seeking out opportunities to exploit. They believe that not all investors have access to information and that they can beat the market by being contrarians and pursue an active investment style.

Passive investors: believe that investments with or against the trend will cancel each other out in the long term because markets are efficient and every possible piece of news and information are quickly incorporated into the market price. Therefore, active investors are unlikely to beat the market in the long run. Accordingly, passive investors prefer to buy index funds that replicate the entire market.

Combined approach: certain investors combine the two approaches together by setting up a “core-satellite” portfolio.

What ever your approach, the right answer depends on each individual’s needs and risk preferences. But according to the performance table of Thai equity funds during the past 3 to 5 years, it would seem that passive investors still have the edge over active investors whereby nearly 80% of actively managed funds fail to out perform the SET-50 Index.