Investment Strategy by Behavioral Finance

Topics: Stock market, Investment, Stock Pages: 9 (3061 words) Published: June 9, 2013
Design an Investment Strategy
using Behavioral Finance Concepts

Introduction
Traditional economic and finance literature assumes that investors approach risk and return rationally. However, in real life, the emotions drive investors to make many fundamental missteps during investment. After study Behavioral Finance this year, I understand how people actually make decisions and ways in which they tend to deviate from full rationality. Understanding of these biases can help me to avoid some common pitfalls and position my portfolios to best fit my personality. In long term, I believe it will enhance the performance and reduce the risk of my investment. Behavior Biases affect my Investment Decision

Before planning for the long-term investment strategy, I should review which behavior bias affecting my investment decisions in the past so that I can avoid them in future. In below sections, I will explain what mistakes I have committed and how behavior biases affected me. Home Bias and Ambiguity Aversion

1. There are so many stocks in the market. Just like other investors, when I choose the stock from the pool, I always go with the stock name that I am familiar with. For example, when I wanted to buy the shares which is a tele-communication company, the first stock name which appeared in my mind is China Mobile Limited (941). It was because I was currently using the service provided by it. I did not consider other companies in the same industry and compare their financial information thoroughly before I bought China Mobile. 2. For the shares I bought now, all of them are traded in Hong Kong Stock Market. I do not invest in any stocks which traded in foreign stock market, even though it is every convenient to trade foreign stocks through trading in Internet. 3. My company, HSBC, provides share options to us every year. I execute the share options every year. Now the value of the HSBC shares which I hold equals around 20% of my total portfolio. I ignored the double hit to my financial security that the problems in the company would cause. All these investing decisions which I made before are typically influenced by Home Bias. When an investor feels that he fully understands the benefits and risks involved in investing in foreign assets, he is more willing to invest in foreign securities. In contrast, when an investor feels less competent, he is more likely to avoid foreign assets. Investors always prefer the familiar to the unfamiliar and are also afraid of ambiguity. Snake Bite effect and Loss Aversion

In 2000, when I earned a few thousand dollars in the first summer intern job, my parents told me to utilize the money to do something meaningful instead of spending it for leisure. Eventually I decided to invest in stock market. At that time, I did not have any direction which stocks I should choose. I tried to read the newspaper and some magazines to see any hints. During that time, most of the people talked about Stocks with IT background. Much news mentioned the stock price of those Dot.Com company rose to historical high. Eventually I chose to buy the stock of Sunevision (8008), which was a company provide Internet service. This decision was purely based on the recommendation from the media without doing any fundamental analysis In the first two months, the stock price increased to historical high. I still hoped that it would continue to increase. I did not have any plan to sell it to gain the profit. At the end, the Dot.Com bubble burst, the stock price dropped more than 80%, even lower than my purchase price. Up to now, I still refused or think of to invest into any company with IT background because the previous experience frightened me. It was the Snake Bite effect. This effect can also be explained by a behavioral bias called Loss Aversion. People generally feel a stronger impulse to avoid losses than to acquire gains. People weigh all potential gains and losses in relation to...
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