Dr Weikai Li hopes to shine a light on how human irrationality affects stock market trading.*
Most people will be familiar with the economic concept that man is a rational creature who makes decisions that will maximise his wealth. Even though this concept underlies most models of human behavior, there is one minor problem: sometimes, people don’t behave rationally. Because of emotional or psychological factors, people will engage in irrational behavior.
Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional economic theory to understand why people might make irrational financial decisions.
This is a new field of study and is the focus of Dr Weikai Li, an Assistant Professor of Finance. “I feel the rational framework is too rigid to explain the real world. Behavioural finance is more realistic,” said Assistant Professor Li, 29, who joined the Lee Kong Chian School of Business last year.
Anyone hoping to take advantage of insights into irrational human behavior on the stock market should look at Dr Li’s research. He has published two papers so far: on whether investors have correctly priced the risk of climate change, and on the implication of power asymmetry between optimists and pessimists in the stock market.
On climate change, he and his co-author believe that because climate change is a new risk, investors do not have the experience in pricing it and are thus under-reacting to the risk. As a result, the paper predicts that countries most vulnerable to climate change will see their stock prices decline in future.
In his paper on power asymmetry, Dr Li look at what happens when investors disagree on the health of the economy.
Because shorting is more costly than going long, optimists have more power than pessimists. As such, when investors disagree on which direction the economy is heading, optimists can push up prices more easily because pessimists find it harder to short.
“When the market has a high disagreement, you probably don’t want to invest in that period. The market would be overvalued because of the power of the optimist,” he explained.
He also has one paper that has been accepted, though not yet published. Entitled, “Informational content of insider silence” it is an examination of the trading behaviour of corporate insiders. The premise of the paper is that even when insiders do not trade, that fact can be revealing.
“Some insiders, when they trade, use a routine approach. For example they routinely sell to diversify. So when they break their routine, that’s significant.”
Although insider trading is illegal, this particular behavior that Dr Li has observed is perfectly legal, even though it is an example of leveraging on insider information to make trading decisions. “If you have inside information, but you don’t trade, you can’t be prosecuted.”
Dr Li is excited to be working at the Lee Kong Chian School of Business. He likes the fact that the faculty is heavily involved in research, that there are plenty of people to talk to, and there is a lot of potential for collaboration. “That’s good for a young professor who wants to be productive,” he said.
This is his first job after getting his PhD from the Hong Kong University of Science and Technology last year.
Apart from research, he also teaches undergraduates. He is currently teaching a course on Financial Markets and Institutions.
Students sometimes come to him asking for stock trading tips, hoping to make a killing on the stock market. Based on his research in behavioral finance and his study of the stock market, he passes on tips on being a better trader. Many of these tips involve overcoming biases that traders unknowingly hold.
One such bias is overconfidence. “Investors think that they are better than the average investor in the market. They will trade too frequently because they think they have some advantage that other investors don’t have.”
Unfortunately, the data shows that most people do not have above average skills and thus incur high trading costs. His advice is to avoid trading too frequently. “A year is a better horizon because the trading costs is non-trivial. If you’ve made a decision based on a thorough analysis, it takes time for the stock to reflect its true value.”
Another common bias is called the disposition effect. This is a pattern where people tend to sell stocks that have gained very quickly, but hang on to losers for too long. This is a bad strategy because stocks that do well will usually do well in future, he said. Likewise, stocks that do badly will continue to underperform. “The optimal thing is to hang on to your winners and dump your loser stocks.”
Despite the many hours he has devoted to understanding stock markets and investor behaviour, he has not attempted to take advantage of his research findings himself. “As an individual investor, I don’t the capital or the infrastructure to implement these ideas.”
In fact, he avoids buying individual stocks, believing that he is outmatched by institutional investors. Institutions have the resources to investigate the truth while retail investors, lacking time and expertise, tend to trade on rumours and follow the herd.
“For retail investors, the rational thing is to follow the market and buy an index fund. Nowadays most of my portfolio is in indexed ETFs.”
He realizes that this is not a terribly exciting strategy. “It’s not so fun. But your goal is not fun, but to increase your wealth. Being boring is good for increasing wealth and for retiring with a reasonable level of wealth.”
