Investors' Most Common Behavorial Biases

Status Quo Bias

The investors been in a comfort zone will not be willing to do anything to change their present situation. For example, investors are willing to put their excess cash into a saving account and not willing to use them to invest in stocks and bonds as this results in a change to their present situation.

Status Quo Bias not only apply to investors, it can affect analysts as well. When there is new information in the market, the analysts need to re-evaluate their previous coverage which is tedious and takes time and effort. They will rather remain status quo which is the easy way out.

Framing

The investors did not have sufficient information, their vision is clouded and restricted. This framing will not allow the investors to have a helicopter view of the investing landscape. The investors will not be able to look for substitute products and obtain other information.

Investors tend to assess a product based on short-term investment period and did not analyse how long this situation will last and whether there are better alternatives. Investors tend to have home biasedness which is a view that local products are better than the rest of the world. For instance, a local investor will have a larger composition of Singapore shares in their portfolio. This perspective may limit their return and does not allow a better diversification with other products.

Availability Bias

Investors will be influenced by present information based on what they read and hear and not based on information such as fundamental analysis to analyse the situation. For instance, if the investors are bombarded by daily news of huge dip in stock prices, they will be frozen in their paths and not enter the market.  Warren Buffet quoted on "Be Fearful when Others are Greedy and Greedy when Others are Fearful", this is to remind investors not to follow the crowd and need to remain rational with an unbias vision.

Confirmation Bias

Investors tend to believe in what they want to believe in. For instance, when an investor is reading an analyst report, if he wants the share price to increase, he will look for information in the report which will support his belief. If he hopes that the share price will drop, he will look at the negative news to reinforce his belief.

Sunk Cost Error

When a particular stock is not performing and the investor is in the red with it, the investor may not have come to terms with this and change his focus to the next better opportunity. Investors should learn to cut loss and move on to the next opportunity . He should not be affected by the sunken cost. If the investor does not cut loss and switch to another opportunity, he can lose out on other opportunities which will more than make up for the loss.

Investors' Checklist

It is advisable for the investors to have a checklist to remain rational at all times.

• Collect information which is contradicting with your view => to help you be a contrarian
• Looking at your investment window, is your investment strategy affected by news in the market?
• Before you make a major decision, you need to ask yourself under normal circumstance what will you do?
• What is the reason to hold the stock when the price is dropping? Is it due to price or future potential earnings? Ask yourself, will you buy more of the shares now?
• Discipline is important, you need to monitor your personal balance sheet to understand what you can or cannot lose.

Seven Habits of Successful Investors

The seven habits of successful investors

Straits Times - A recent report from Allianz Global Investors on "The seven habits of successful investors" addresses concerns and problems commonly faced by retail investors. Here is an excerpt of the seven tips to guide you on your investment journey.

HABIT NO. 1: KNOW YOURSELF AND CHALLENGE YOUR INTENTIONS

Lessons learnt in behavioural finance repeatedly boil down to the one realisation: We still tend to demonstrate prehistoric behavioural patterns that cannot always be rationally explained.

For example, we often view the investment world in a frame, that is, we see what we want to see and may be excluding better alternatives as a result. We tend to follow the crowd or be driven by sentiments that push investors, particularly back and forth between fear and greed.

Aversion to losses is just as typical: We suffer more pain when we make a loss than we enjoy the same amount of gain. This can be dangerous if you leave all you have in a savings account as a result and, in doing so, forgo returns that you urgently need, or if you back off from realising losses and starting again.

"They're only losses on paper. I'll wait until share prices are back to where they were when I started and then sell," is a deceptive mindset.

HABIT NO. 2: YOUR INVESTMENT DECISIONS SHOULD BE GOVERNED BY "PURCHASING POWER PRESERVATION" RATHER THAN "SECURITY".

"Security" is often seen as synonymous with the absence of price fluctuations.

In seeking security, however, retail investors overlook the risk of losing purchasing power - which is even more unpleasant, considering that interest on savings is virtually zero currently.

If you want to preserve your capital, the minimum requirement for an investment should be "purchasing power preservation".

Let's assume you hide $100 under your pillow. Based on an inflation rate of just under 2 per cent each year, you will be able to purchase goods worth only just over $80 in 10 years' time. Or less than $70 after 20 years.

Seen this way, the biggest risk may be not taking any risk.

HABIT NO. 3: THE FUNDAMENTAL LAW OF CAPITAL INVESTMENT: GO FOR RISK PREMIUMS

Successful investors know that they cannot earn risk premiums without taking risks. The logical explanation: Investments in riskier assets should be justified with the expectation that those investments will generate higher returns over time than other investments with no risk exposure that thus offer less opportunity.

For instance, long historical time series which are available for the US equity market show that taking greater risks on equities has clearly been rewarded over the long term.

From a purchasing power perspective, equities have offered greater security than bonds.

HABIT NO. 4: INVEST, DON'T SPECULATE

Speculating is betting on price movements in the short term. Investing is putting your capital to work over the medium or longer term.

Take European equities for example: If you invested in a broadly diversified basket of European equities over the last 25 years, you earned nearly 8 per cent on average.

If you missed the 20 best days on the equity market - while waiting for better starting prices, for example - you gained less than 2 per cent.

If you missed the 40 best days, you actually incurred a loss of 2.3 per cent a year on average.

This example goes to show that the risk of missing the best days on the capital markets is extremely high.

HABIT NO. 5: MAKE A BINDING COMMITMENT

Investors have three options for making a binding commitment:

•Strategic/long-term aspects should govern allocation to the various asset classes. Decide on a strategic allocation between equities and bonds that suits your risk profile and use it to steer through turbulence in the capital markets. A good guideline for the right amount of exposure to equities in a portfolio is the rule of thumb "100 - age". So an investor who is 50 years old at present would allocate 50 per cent to equities. Building on this, individual adjustments can then be made.

•The general rule to follow is never to put all your eggs in one basket, so diversify. Historical evidence shows that what earned great returns one year quickly moved to the bottom of the pile one year later. Therefore, invest money broadly, combining equities with bonds - and maybe other segments as well. The "multi-asset" approach makes it possible.

•Invest regularly.

HABIT NO. 6: DON'T PUT OFF TILL TOMORROW WHAT YOU CAN DO TODAY

Billions of dollars are slumbering in savings and bank deposit accounts despite the fact that one of the key drivers of investment success is the compound interest effect.

For example, let's say an investor wants to have $100,000 at his disposal when he retires. If he starts very early and has 36 years to reach this goal, saving $50 each month is sufficient at an average return of 7.5 per cent. If he has only 12 years to go, he has to put aside $400 each month.

HABIT NO. 7: GO FOR ACTIVE MANAGEMENT

Anyone who opts for active management not only hopes the experts will earn him additional returns, but also exposes himself to less risk of the dead weight of one-time darlings of the equity market cluttering up his portfolio. After all, passive management maps yesterday's world.

Just think back to when the technology-media telecom bubble burst at the turn of the millennium, or the US housing crisis that had a particularly adverse impact on financial securities around 2008. It is better to counter-steer.

So investing may be easier than you think.

Don't put it off. Heed habit no. 6.

Stock Research Checklist - Inventory

In business, inventory is an important part of the process. After the manufacturing process is completed and the product is ready to market or sell to the customers, a business is left with inventory.

What is the inventory buildup?

As an investor, you need to calculate the inventory level as a percentage of sales and compare that with multiple year numbers. Suppose inventory grows faster than sales. That should raise a red flag because it means the sales growth rate is slowing. To reduce the inventory, the company needs to offer higher discounts on their products which will affect the bottom-line earnings of the company.

In the retail business, you need to pay special attention to the inventory levels compared with those of previous years. If the inventory grows faster than sales for a particular product, it means customers might have lost interest in that product. The company needs to improve the product or sell at fire sale prices to reduce the inventory.

Stock Research Checklist - Assets

Assets

Trying to identify companies that have hidden assets that are overlooked is beneficial because those stocks trade cheaper meaning you can get more reward by investing in them.

Does the Company Have Any Hidden Assets That Have Been Overlooked by Wall Street?

Sometimes, Wall Street does not recognize the value of those reserves and it misprices the securities. For those situations, you need to use the opportunity to buy the securities at discount prices. Established brand names are another form of hidden assets. Another form of hidden assets is real estate. When the land value appreciates over time, on balance sheet, those real estate investments might already been written off.

Does the Company Have a Low Percentage of Net Receivables?

The money owed to a company be customers is referred to as receivable. Net receivable means total receivables minus bad debt. If the company is in a sustainable competitive position, it should have fewer net receivables as a percentage of revenue because it can collect the receivables from the customers faster. On the other hand, if the company is in a competitive business, it can give more time to the customer to pay back the receivables in order to keep the customers happy.

If you see a high amount of net receivables as a percentage of the revenue, try to examine that company's situation carefully. If you see a sudden increase in receivables, that is a problem because the company's products may not be in great demand. The company needs to give more to dealers or distributors to pay back their invoices in order to stock their products.

Another thing you need to calculate is the rate of net-receivable growth compared to sales growth.

Does the Company Have More Pension Assets than Vested Benefits?

Certain companies provide pension and health benefits to their former employees after their service with the company. These  kinds of benefits improve the loyalty and retention of existing employees, which is great for the employees but not for the shareholders.

Nowadays tech companies and other service industries do not provide pension benefits. That is why their liabilities are less. Make sure the pension assets are higher than the vested benefits. When the company's pension assets are less than the vested benefits, the company needs to pay that difference which is a pure liability for the company.

Are Any Large Shareholders or Raiders Working to Uncover the Value of the Under Valued Asset Plays?

When you are looking at asset plays, there may be hidden assets in the company, but the market may value the business less than it is actually worth. The market might not be able to identify the hidden asset or assets that you identified. If you get into those asset plays, you might not be able to reap the benefits, because the market may take years to reflect the true value of the company.

Suppose a large shareholder or raider is working to uncover the value of the company, this can be a good thing. The shareholder or raider may engage in a legal battle or takeover war with the company. The board and management are pressured to act in order to unlock the value of the company. When that happens, as a fellow shareholder you can reap the benefits sooner and use the money to invest in other under-valued opportunities.

Stock Research Checklist - Dividend

If a business operates with stable cash flow and pays cash every quarter and the management does not have the opportunity to reinvest in the business, they can pay the dividend to the shareholders. If you are looking for income from your stock portfolio, you can select companies that pay conservative dividends and hold those stocks for the long term.

If You Are Buying the Stock for Dividend, Make Sure the Company Pays the Dividend Without Interruption and Has a History of Raising Dividends

When you are looking for good dividend companies to invest in, look for the following characteristics

• The company should be an established company and should produce stable cash flow for a long time
• The company should not have rejected or reduced its dividends at any time in its history. Businesses have to go through different economic cycles all the time-like economic expansions, slowdowns, recessions and depressions and the company should have survived in all the difficult economic cycles.
• If the company has a repeated history of repeatedly raising dividends, it is a great company to invest in for dividends.

For a higher dividend yield, dividend investors need to look for market sell-off to buy stock in dividend-paying companies.

What is the percentage of earnings paid as a dividend? Is it a small percentage of revenue?

They need to search for companies that pay out a smaller percentage of their revenue as dividends to the shareholders. This is because when the business goes through a hard time, it should have a cushion of earnings to meet the dividend payments. If not, it needs to cut the dividends to preserve cash to fight the downturn.

Payout Ratio = Dividend per share / Earnings per share as a percentage

The lower the payout ratio the better. If the payout is 80 to 90 percent, that is dangerous because there is 10 to 20 percent cushion available. When a business goes through a recessionary economic cycle, business earnings might decrease more than 20 percent. The dividends need to be cut. This is a double whammy, the stock price and dividends are hammered.

Stock Research Checklist - Management

When you are dealing with fast growing companies, pay special attention to how the business has been growing recently and what plans the management has in place to grow the business in the future.

What is the Company's Growth Recently? What Plans does Management Have to Grow the Business?

As an investor, you need to look for companies that are growing slowly and steadily. If companies use the company cash flow to fund their expansion, then that is great. If company uses moderate debt, that is also acceptable. When a business expands slowly, it can execute its plan methodically. Slow and steady companies generate great shareholder returns over the long term.

Does the Company have Related Party Transactions with the Family Members of the Senior Management or Board of Directors?

You need to research at least three or four years of annual reports to research any related party transactions. If the company is doing business with any of the company's senior management or relatives who are involved in other companies, you need to avoid this company. When relative companies act as suppliers, they are likely paid top dollar for their products or services. That will affect the profit margin of the company, and in turn, decrease the share price of the stock. If the number of pages allocated to related party transactions increase every year, be cautious and need to dig deeper.

Another point to examine is whether the company is lending any money to senior management or directors. If the answer is yes, you need to sell that stock so that you can avoid losing money.

Are you able to understand the footnotes of the Company's Financial Statements?

When you are reading the financial statements of prospective companies, be sure to read the footnotes. If you are reasonably good at reading financial statements, you should be able to understand the footnotes. If you are not able to understand them because they do not want you to, move on to another company.

Is the Management Candid in its Performance Reporting?

If management only trumpets successes or tries to hide poor results, that will give you an idea about their openness. You need to find a company where the shareholders are treated like owners. If management treat shareholders as owners, they will talk about positives and negatives openly.

Does Management Deliver What it Promises?

When you are researching companies, you need to find out if management has delivered what they have promised in previous years such as:

• Future earnings outlook
• Company profitability plan
• Setting target growth rate of the companies
• What they want to achieve in five years

Stock Research Checklist - Capital Investment

Return on Asset = Net Income / Total Asset

Total asset consist of debt and equity. This percentage gives the percentage of net income generated for the money invested which includes both debt and equity capital. As long as ROA is high, company shareholders will be greatly rewarded.

What is the Company's ROA for the last 10 years? Is it growing constantly or at least maintaining an average ROA for the last 10 years?

You need to compare the ROA with competitors in the same industry. As an investor, you need to identify which industries are offering a higher ROA.

Does the Company have consistent ROIC numbers?

Here is the formula to calculate the Return on Invested Capital

ROIC = (Net Income - Dividends) / Total Capital

Total capital includes long-term debt and common and preferred shares. The higher the ROIC, the better it is for the investors. If the ROIC is very high, it means management is doing a great job of allocating capital profitably.

Does the Company need to spend large amount of money as a capital expenditure to stay competitive?

You should examine capital expenditures over time. If a company is spending large amounts of revenue as a capital expenditure, then it is not a great business. If a company is not spending large amounts of money, it is unlikely that it can be competitive in its industry. This applies to manufacturing and auto industries.

After capital expenditures, there will be less money available for other good things to increase shareholder value, such as expanding the business, buying back shares, acquiring other businesses and paying dividends. If a company is spending large portions of its revenue for capital expenditures, it will be difficult to spend money to increase shareholder value over time.

What is the Company's Investing Strategy? Is the Company Investing in its Area of Expertise?

When a company earns income for its owners every year and increases that income, the cash is going to pile up. You need to find out what a company is doing with that cash. When a company tries to invest those earnings back into growth, you need to identify where it is sinking its investment dollars. If its strategy is growing through acquisition, you need to find out how the company management plans on acquiring companies. Is the business that management hopes to acquire related to existing business, or is it a totally different business?

You need to also examine whether or not a company invests in its area of expertise. This is important. If a company tries to buy totally different kinds of business and then tries to integrate the new companies, this is a bad move.

What percentage of revenue is spent on Research and Development?

R&D is an important task for most business because it allows the business to invent new products, upgrade existing products, increase efficiency, and decrease production costs.

R&D is very important task for technology companies. If technology companies do not invent new products all the time, competitors can kill them and take their market share. Investing a certain percentage of revenue in R&D is important for a company's growth. Spending alone does not increase the revenue of the company. You need to identify how effective the current management is at generating returns on their investments. They have to generate a good return on their investment.

Compare similar companies in the same industry and their previous new product inventions and the revenue generated from those products. If the company is not introducing new products all the time, it is in danger of losing revenue. When you are looking at a company, pay special attention to find out how effectively its previous R&D activities delivered revenue. If you find a company that does have R&D expenses and has also grown more than 15 percent for the last five years then you have found a good company and do research from there.