Investing Lessons [Advanced]
Value Investing And Behavioral Finance
Chris Lee Susanto, Founder and CEO of Re-ThinkWealth
15 July 2017
- Value Investing is inevitably linked to Behavioural Finance
- Value Investing is a stock methodology practised by many successful investors
- Value Investing works provided you believe that the stock market is not efficient
- There are risks to Value Investing
- Psychological aspects of the human mind affects stock markets behaviour
- Greed and Fear should serve to guide us and not rule us
Why I Wrote This Article
There are different types of people in this world.
Everyone is unique and each of them has their own character.
With character, comes risk tolerance and investing method preference.
Out of the many investing methodologies, I want to share more with my readers more about value investing.
But more than that, how we can understand value investing by linking it to behavioural finance.
What Is Value Investing And Why It Works
Value Investing is a stock investing methodology that is practised by many successful investors such as Warren Buffett and Seth Klarman. You can google those two names and you will know how good they are at making money work for them for so many years.
In Value Investing, you are essentially buying a stock that is worth $1 for 50 cents. There are many reasons why you can buy a stock that is worth $1 for 50 cents.
One of the reason is that many stock investors do not understand what they are investing in.
That forces them to sell a good stock at a cheap price.
In which, the practitioners of value investing will take advantage of that by buying the stock they sold.
You should also note that value investing in fundamentally different from stocks trading.
While the latter focuses more on price movements and other technical indicators, the former focuses on analysing the business behind the stocks and buying the stocks at a cheap price.
Value investing also generally has a longer time span than other kinds of investing.
That is because it generally employs a buy and holds strategy until the value of the investment plays out.
Value investing works because simply put, the stock market is not efficient.
That means that the stock market at points in time does not accurately reflect the true value of the stock.
Someone who practices Value Investing would usually shun away from ridiculously priced stocks, even though the underlying business is good. That is because I am always reminded that even buying a really good business at an expensive price would still constitute as a bad investment.
The Risks of Value Investing
Image source: Google
Value investing is not without risks.
When buying stocks with the idea that it is selling below its intrinsic value, a lot of personal assumptions and judgements are required to come to that conclusion. There are risks that we may be wrong in our judgement.
Often times, stocks that look cheap via metrics such as price to earnings ratio or other indicators may not be really “cheap”. There are risks that the earnings of the business will continue to drop and as a result, the PE ratio of the business will increase– but the price of the stocks remain the same or drop further. That is a trap that we must look to avoid.
It is a good reminder to myself too, that stocks will not be cheap without any reason.
Foreign Exchange Risks In Value Investing Practice
Personally, most of the stocks that I invested in are US stocks.
However, I am not a US citizen and do not use US$ on a frequent basis. That exposes me to Forex risks when exchanging my US$ back to my native currencies.
There is only two occasion that matters– the time where I changed my native currencies to US$ and the time where I changed back my US$ to my native currencies. The former needed to be more than the later or at least the same– else, I will lose on the Forex exchange rate.
To mitigate the Forex risks, I feel that a lot of it has to come from personal money management of the percentages I am looking to invest in US stocks in the future. If I am planning to reduce my US holdings, I should start to convert back my US$ to my native currencies as the rate flows into my favour and vice versa.
Remember, value investing is always about the long-term game.
My Personal Story In Value Investing
Value investing has been a passion of mine for as long as I can remember.
So, in my free time, I always research on ways to make more money– but on top of that, how to make money work for us.
Then one fine day, I chance upon the word “value investing”.
I began reading more about value investing and realised that the father of value investing is Benjamin Graham and its disciple, Warren Buffet is the second richest man in the world.
I’ve always idolised Warren Buffett and Benjamin Graham for their teachings in Value Investing simply because they have a very logical way of approaching stock investing.
And I was surprised that value investing requires no particular intellect in a sense that anyone can learn it easily. The mindset is as crucial or even more crucial to our investment success rather than our knowledge of it.
You need be patient and be willing to go against the crowd.
You should also not borrow money to invest and only invest money you can afford not to use for the next 5-10 years.
Throughout my investment journey, I began to realise the exact personal investing style that suits my character.
I am a conservative person that only invests in the stocks of a good business– provided that the price is cheap in relative to the true value of the business.
This is done through value investing which is done using fundamental analysis plus patience in holding stocks for long term.
However, the long term is an abstract concept in itself.
They key about selling is truly in selling a particular stock only when it is overvalued or that our original reason for buying is not true anymore.
The key to buying stocks is the margin of safety.
Knowing that valuation of stocks in itself is an art and margin of safety allows some room for error– which means that we need to buy the stocks at a cheap enough price.
Remember, buying a good business at a high price is still a bad investment.
My passion in value investing is the only reason I started this blog as it is a place for me to reflect on my buying and selling off my stocks– as reflected in my blog articles and investment track records/results.
Rule #1 in investing which is never to lose money. It sounds simple but it is not easy. It has to come from us rethinking our previous knowledge on investing or on generating wealth and decides on whether it is true or not.
At the end of the day, we need to understand our investments before deciding to invest.
If not, it is simply speculating and we are bound to lose money– in the long run– the only time span that truly matters in investing.
What Is Behavioural Finance
Image source: Google
Behavioural finance is a study which seeks to explain why people make irrational financial decisions– especially in the stock markets.
Professor Rober Shiller is a famous professor that is very well versed on the topic of behavioural finance, in fact, recently he voiced out concerns about the overvaluation of the US stock market.
To explain better on behavioural finance, we can start off with the background being of the efficient market hypothesis– which says that the stock markets are efficient as all investors have the same information and analyse data in the same way. Therefore, nobody should be able to beat the market because the stock market is always efficient.
Now, the key here is that we need to understand that people are complex creatures.
There is a few psychology theory that is linked to behavioural finance:
1) Prospect theory is a theory of how people form decisions on uncertainty. It says that People estimate gains and losses from the reference point which is subjective and subject to manipulation.
People are more affected by small losses and less encouraged by small gains.This kind of thing allows business to exploit people. In investment, people estimate gains and losses from the price they bought the stock at and are always more affected when their stock price goes down as compared to when their stock price goes up.
2) Regret Theory is people’s fear of the pain of regret. You may make bad decisions because you overly worry about regret. We may not want to sell off our stocks even if that is the correct thing to do because we may be afraid that we would regret it.
3) Overconfidence theory found that there is a human tendency to overestimate their ability. Most of us think we are above average. This is a problem because if we are too confident of our investment idea and got complacent, we might be missing out on other key things that we do not know about.
4) Cognitive dissonance is a judgemental biased people tend to make because they don’t want to admit they are wrong. We tend to cling on to old investment belief and find evidence that supports our beliefs. We have an exaggerated impression and forget the evidence that is contrary to our thesis and only finds the one that supports our investment theory.
5) Social psychology says that people are interdependent which is also known as herd behaviour. This does not happen consciously. Our opinion of what is happening is formed as a collective sharing of information. Herd behaviour creates big swings in the stock market.
The key is here is that herd behaviour does not happen consciously, that is why we need to be extra aware of where do our beliefs about certain things come from.
How Is Behavioural Finance Linked to Value Investing
In Value Investing, we are banking on buying the stocks of businesses that are trading below its intrinsic value or also known as real value.
If the market is efficient as the efficient market hypothesis says, we should not be able to do that.
But the market is not efficient because people are complex creatures and they have emotions– namely green and fear.
Greed’s And Fear’s Influence on Investors
Greed. When the investor has made good gains on his investment, he or she refuses to sell the stocks because they are greedy for more gains.
When there is counter evidence that says that a particular stock is overvalued, they look for evidence to support their beliefs that it is not overvalued– thus, continue to hold it.
Fear. You bought the stocks and the stock fell below the anchor point– the price you bought it at. You feel scared that it will drop some more but you will not sell it because you are afraid you will regret it if it goes up after you sell it.
Again here, you look for evidence to support your belief that the stock price will rise above your buying price. But the stocks continue falling and you refuse to admit your mistakes.
I am sure it happens to all of us, because we are human, at some point in time. It is good to be aware of green and fear’s role in our investing journey. They should guide us, and not rule us.
This article can be summed up here with the biggest key lesson being that we need to learn to think independently and we should not follow the crowd.
We should understand the impact of human behaviour in the stock market and hopefully via that understanding, we would be able to invest in good value stock by being patient in focusing on the long term investment results instead of short term market fluctuations.
Using the impact of the human behaviour, more specifically on the fear of people, to use that as a buying opportunity and using the greed of people, use that to sell our overvalued stocks.
Sometimes I myself forget, that the only time frame that matters in investing is the long term– and that no one can predict the future. Therefore, do not be too happy when our stocks go up and do not be too sad when our stocks go down, the truth is we do not know what will happen tomorrow. Focus on our investment process and results will come– over time.
Disclaimer: The information provided is for general information purposes only and is not intended to be a personalized investment or financial advice.
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