Behavioral finance

I read about this interesting article in The Edge few issues ago. The key points are summarized here.

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Research shows that investors aren't always rational. Psychological studies have repeatedly demonstrated that the pain investors feel when they are losing money from investment is nearly 3 times greater than the joy of earning money. Small correction often become full scale crash, made by panicked investor who try to avoid losing money in short term rather than focus on long term potential. Behavioral finance try to study how emotion and mental error can cause stock to be overvalued or undervalued. It is trying to identify the common mental mistakes.

Mental shortcut
Brain helps investor quickly generate an estimate rather than fully digesting all info before producing an exact answer. This cause investor to over or under react to new company news. Study shown, longer the investor study the company, harder for them to quickly analyse the new data properly and adjust the view.

1. Representativeness
Assume things that have similar traits are likely to be identical. If a company repeatedly delivered poor result, investor assume it would keep doing so, ignore the fact that the company is showing sign of turn around.

2. Anchoring
Select an initial reference point and slowly adjust the correct answer as it receive additional information. A sudden surge of company earning would be viewed as temporary, investor remained anchored to the previous view of company profitability.
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I certainly agree with the argument that investor feel more painful in losing money than earning it. I felt this way countless of time, when market going through correction. Some investors just gave up and realise the lost.

Here is the personal experience I can think of which related to the above two points. I started buying Uni Food when I began investing. For the pre-ipo years, it have been showing consistent and good profit growth. We think that it is likely to going on. However, SARS came, bird flu came, high raw material and pig shortage, the industry condition has changed and the company is slow to react. Eventually, I cashed out this at more than 50% of losses.

I felt the two points discussed here are closely related. Usually, the investment mistake could be related to both of them at the same time. You take the old result as representation and you have anchored to that view. When news released, you are slow to react, because you firmly believe in the view you have subscribed to. However, that piece of news might already signal that all are not getting well already.