Why we invest poorly
Family businesses know investments need to be diversified, but many are too risk-averse to bet considerably on equities.
For them, the odds of beating the stock market are probably as good as beating the house in the casino, and bestsellers such as the classic “A Random Walk Down Wall Street” show they might be right.
However, with extremely low savings and time deposit rates not enough of a hedge against inflation, family businesses may have no choice but to prudently invest in stocks, else their hard-won earnings continue to lose value even if they are placed under the mattress or locked in the family vault.
A deeper study of probability and statistics will help, but recent psychology findings can provide insights into our investment behavior.
The above scenario describes loss aversion, where we grieve over a loss much more than we rejoice over a gain. For example, stock A can be a great win but it’s risky (say, you made a windfall and are interested in stock A). With stock A, you have a 50 percent chance of gaining a million pesos, but also a 50 percent chance of losing half a million. The expected return is half a million minus a quarter million, leaving you with still a cool quarter million.
Put this way, you would go for this investment, right?
Not so fast. Behavioral psychology predicts you will instead put your windfall into stock B, where you have a 50 percent chance of gaining a quarter million, with the other 50 percent chance losing nothing (but gaining nothing, either). The expected return here is half of a quarter million, which is nothing to sneeze at.
But family businesses that tend to be conservative (a trait inherited from frugal founders, perhaps) would go for stock B, even if mathematically, they should choose stock A.
Gambler’s mentality
Ironically, the same mentality that would pick stock B would try to avoid any loss, even if it means taking irrational risks.
Say you already have stock C, which is steadily losing money. You tell yourself to invest for the long run, and you don’t want to sell your stock the moment it dips. You have a 50 percent chance of gaining half a million pesos if you hold on, but you also have a 50 percent chance of losing P2 million unless you sell.
Would you still hold on to stock C? The expected loss would be a quarter million minus one million, which is negative P750,000. Negative means you lose.
You also have stock D, which is sadly also losing money. You try to hold on, but the stock is performing so badly that you know there is no upside. You have practically a 100 percent chance of losing a quarter million. Of course you would download stock D immediately.
I am sure you will agree with selling stock D. After all, there is no hope. But the expected loss is a quarter million that, while not a pittance, is a lot less than you would experience by clinging to stock C.
But psychology says investors are far from rational, especially when faced with the chance, however measly, of gaining anything. This is the gambler’s mentality: You are convinced that you just need to hold on, because who knows, in the next throw of the dice, your luck will change—maybe, but in real life, this is unlikely to happen.
Confirmation bias
Investors pride themselves of getting the best information, poring over Bloomberg terminals and Bangko Sentral ng Pilipinas (BSP) interest rates as if they were the oracle of Delphi. But info overload does not mean quality of analysis because, like it or not, most of us are victims of confirmation bias.
Say, we like a particular stock E. Maybe it’s a blue chip, maybe it’s our first stock, maybe it reminds us of our favorite product, maybe it has never failed us before. Then we start hearing rumors the company is in trouble, but we refuse to believe it.
In short, we tend to retain only the messages that confirm what we already think or feel to be true, and we ignore other data, often to our peril.
In the 2008 financial crisis, even ratings agencies could not believe venerable institutions like Lehman Brothers were in trouble, or that Freddie Mac or Fannie Mae were in dire straits.
Back to stock E. You bought it at P100 per share and is now trading at P105. You are up, but you will not sell because you are so certain the stock is worth a lot more than that. So you hold on, until the bottom drops out, and in one fell swoop, the price plummets to P90, then P80, as you wait in shock and hold on to it because you do not want to sell at a loss.
Confirmation bias and risk aversion—a toxic combination.
Queena N. Lee-Chua is on the Board of Directors of Ateneo de Manila University’s Family Business Development Center. Get her book “Successful Family Businesses” at the University Press (e-mail: [email protected]). E-mail the author at [email protected].
