Malcolm Gladwell, author of global best sellers Blink and Outliers, has said that "as we grow older and more experienced, we overrate the accuracy of our judgments." This is so true when people make investment decisions.

Although the key to any investment is to buy on dips, this is not easy for investors, especially in a highly uncertain environment. It is not uncommon that enthusiasm outstrips knowledge. However, emotions should not override realistic market assessment.

One of the lessons of the financial tsunami is that no matter how good an individual stock was, systemic risk was the dominant determinant. The contagion effect of the financial tsunami showed that a succession of financial difficulties can lead to a rapid diffusion of adverse and widespread psychological effects in global stock markets.

The financial tsunami has provided some other important lessons for investors.

First, it showed that a high sensitivity to the global economic and political atmosphere is a prerequisite for investors - a kind of macro-awareness to bring to micro-investment management.

Second, both the earlier Asian financial crisis and financial tsunami last year demonstrated that losses in one capital market can lead to sales, including sell-offs and bargains, in another, due in part to a high level of arbitraging, an increasing economic interdependence and flow-on psychological effect. Clearly, understanding investment psychology is a necessity for investors.

Behavioral finance - a field pioneered by psychology professors Dr Daniel haneman and Amos Tversky, Hebrew University, in the 1970s - integrates principles of classical economics and finance with psychology and the sciences of decision-making (under conditions of uncertainty).

Researchers in the field have found that irrational behavior in finance is commonplace. Today, there is a growing school of economists who are studying a wide range of behavioral traits in personal investment with technical labels, such as "anchoring", "failure of invariance", "over-confidence" and "memory bias".

Consider these three investment phenomena: 1. Investors tend to feel the possibility of recouping a loss is more important than the possibility of greater gain.

2. Herd instinct shows people may have a strong impulse to ape the investments of others.

3. Studies have revealed that money flows into above-average-performance mutual funds more rapidly than money flows from below-average-performance mutual funds in the US.

Behavioral finance theory challenges the conventional assumption that investors and consumers are always acting to maximize their payoffs and "utilities" in a rational way. If that is true, they ask, why leave a tip in a restaurant where you will eat only once, never to return? Where's the payoff?

How practical is behavioral finance? Richard Thaler of the University of Chicago, one of Kahneman's and Tversky's disciples, has practiced principles of behavioral finance through an investment company called Fuller & Thaler.

One of their investment strategies is to capitalize on the market's over-reaction to negative information regarding a company's future prospects by using principles of behavioral finance. The fund managers combine the applications of human decision-making models to find these mispriced stocks with traditional fundamental analysis.

Of course, the effectiveness of applying the principles of behavioral finance is not yet 100 percent assured. For example, the market psychology can be very different between Hong Kong and US stock markets due to varying cultural, macroeconomic factors and market liquidity. Although more empirical studies and investment performance of behavioral finance funds are needed to prove the full scope and power of behavioral finance in investing, it is to be noted that investment psychology can clearly help alert investors to the consequences of their possibly biased investment behaviors.

Ringo Chan is programme director at University of Hong Kong SPACE. The views expressed are entirely his own.

(HK Edition 02/04/2010 page4)