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Avoiding Emotional Investing Decisions Mohd Sedek Jantan Standard Financial Adviser Sdn Bhd When Instability Occurs in the Marke

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Avoiding Emotional Investing Decisions Mohd Sedek Jantan Standard Financial Adviser Sdn Bhd When Instability Occurs in the Marke Avoiding Emotional Investing Decisions Mohd Sedek Jantan Standard Financial Adviser Sdn Bhd When instability occurs in the market, emotions are involved in investments. During turbulent economic times, one may be tempted to perform drastic actions on the investment portfolio, such as withdrawing investment to their fixed deposit. An exemplary situation is when an adviser invested RM100,000 of an individual’s money and the value is reduced to RM80,000. There may be various reactions towards this RM20,000 loss, be it selling all or some of the investments, buying more of the investments, or not performing any actions at all. These possible reactions from different individuals will provide important insights into risk profiling. Considering the volatile market condition, understanding investment risk and implementing a systematic investment plan would assist one in meeting long-term financial goals. a. Volatility, Market Information, and Noise Traders Proper research prior to investment is crucial. It is important to understand the types of risk associated with the investment. However, investors tend to be confused between the concepts of ‘risk’ and ‘volatility’. In financial terminology, ‘risk’ refers to the probability of losing an investment capital based on the expected return on any particular investment. Meanwhile, volatility measures price fluctuations in a security, portfolio, or market segment. An investor will have little or no control over any of these segments. The information regarding the changes in the company’s management team or announcement for share dividend payouts would usually result in stock price volatility. Based on the efficient market hypothesis, information is placed into security prices within a high speed that investors would not gain an opportunity to profit from the publicly available information. However, the extracted information depends on the investors’ motives to trade, either to rebalance their portfolios for risk sharing or to speculate on the market or their firm-specific information. Furthermore, different motives for a trade would result in different return dynamics. Information asymmetry causes markets to become inefficient as not all market participants have access to the information they need for their decision-making processes. As an investor’s reaction is based on the information received, the decision made based on his or her understanding would be derived by personal knowledge and experience. Unfortunately, the same amount of market information produces a different reaction, which could either be underreaction, normal reaction, or overreaction. Any of these reactions would determine investment decisions, either to sell, buy, or hold. How do investors react to Trump’s tweet s? There has been a growing number of information channels, including social media and the Internet, to the point that even the highly involved investors are unable to monitor every piece of information. With that being said, investment decisions tend to be influenced more by emotions rather than rationality. In fact, investment decisions which are influenced by emotions are difficult to manage. This is because emotional investment reaction causes short term volatility. For example, positive news usually gives happiness to the investor, while negative news gives excessive reactions. This illustrates the difference between these two types of news in terms of value. Studies on the market overreaction effect were first conducted by De Bondt and Thaler (1985), which found that significant news resulted in abnormal price movement. However, it was found by Maheshwari and Dhankar (2017) that the stock prices reverted to its fundamental value after a few periods of overreaction passed. Emotional investment derives from the distinction between the informed and uninformed investor (noise traders) shown through the market information. Meanwhile, noise traders refer to investor trading based on what they falsely believe to be special information or their misinterpretation of useful information regarding the future price or payoffs of the risky asset (Teall, 2013). One of the factors of noise trading is the need for liquidity. To be specific, investors liquidate an investment in order to reduce risk factors. They tend to buy and sell market reaction. This is an impulsive action based on irrational exuberance or emotions, such as fear or greed, without taking any major consideration to long-term returns. It was found by Hahn and Tetlock (2008) that the securities market with constantly high noise trade would exhibit significant pricing anomalies, which result in market volatility. b. Making Informed Investment Decision Investors tend to assume that they could act rationally upon volatility or when their investment values are decreasing. However, in reality, they become highly emotional upon experiencing losses to the point of selling off investment stakes of their portfolio. Therefore, frequent updates of risk profiling are essential in order to match the investment portfolio with risk appetite, as every investor’s attitudes towards risk differ from each other. Although risk profiling is an integral part of portfolio construction, it is a component which is often overlooked. However, by filling a risk profile, investment advisers would be able to identify the investor’s level of required return and risk in terms of capacity and tolerance. As a result, their investment objectives could be achieved. Risk profiling involves three types of risk measurement, namely risk capacity, the risk required, and risk tolerance. Risk capacity is a mathematical measure of the maximum level of risk which the investors could manage before it affects their financial goals. Therefore, it should be determined in the early phase of the risk profiling process, and act as a reference for the investment portfolio risk. Furthermore, risk capacity could be used during risk analysis which would determine the choice of appropriate risk responses. Moreover, it would also manage financial risk shift in the long term. This is because it is influenced by investors’ financial factors, such as promotion or job loss, new-born child, or health issue which leads to unpredictable medical bills. While risk capacity indicates the maximum level of risk which investors could manage, the risk required refers to the optimal level of risk managed by investors to achieve the desired level of investment return. Reaching the ideal investment return is essential to fulfil investment objectives. This shows the direct correlation of the required risk with investor’s required level of return. Unlike risk capacity and risk required, risk tolerance is a more subjective component. This is because risk tolerance is leaning more towards an emotional representation. Nobre and Grable (2015) defined risk tolerance as the willingness to engage in risky behaviour where possible outcomes can be negative. However, risk-taking behaviours could be divided into different domains which had no correlations between them. For example, a person who enjoys rock climbing may prefer conservative investment while retirees may prefer aggressive investment. Therefore, it could be said that the risk taken depends on the individual. Risk tolerance could also vary by gender. Grable (2017), who reviewed financial risk tolerance in psychometric angle, proposed the investment adviser to look at risk tolerance in two different methods. The first method is to look at it as one of the inputs in the client’s overall risk profile comprising of age, investment objectives, time horizon, experience, and risk capacity. The financial adviser then evaluates these factors and determines the asset allocation. The second method is making risk tolerance as the primary determinant of portfolio decisions, where risk tolerance acts as the mediator between a client’s risk profile and engagement in risky behaviour. In addition to risk profiling, investors recommend that the risk profiling questionnaires were referred to once a year when the investments are reviewed and the asset allocation is reconsidered. This is due to the possible changes which may happen to the investors’ lives over the past 12 months. c. Systematic Investing: Diversification and Dollar-Cost Averaging This section presents two concepts to be considered by investors in systematic investing, namely diversification and dollar-cost averaging. Based on classical finance theory, Tobin (1958), Sharpe (1964), Lintner (1965), and Merton (1972) stated that investor’s risk-averse trait will determine the proportion of allocation between a number of risky and riskless assets. Asset allocation refers to a strategy used by individuals to divide their investment portfolio between diverse categories to minimise investment risks. This strategy is in line with the phrase ‘do not put everything in one basket’. Moderately risk-averse investors may allocate 50% of their investment into the risky asset and another 50% into the riskless asset. Meanwhile, less risk-averse investors may allocate 100% of their investment into the risky asset. Investment instruments consist of different levels of risk which range from conservative to high risk. Moreover, investors can choose to invest in the money market, fixed income, mutual fund, and equity market. The asset allocation in the investment portfolio will reflect the investor’s need for growth, income and liquidity. Therefore, the allocation covers investment horizons, risk-free rates, and expected returns on risky assets. Figure
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