Behavioral Finance

Outlines

Standard Theory of Finance Overview of Behavioral Finance The importance of Behavioral Finance Survey of behavioral characteristics

Standard Theory of Finance Investors

Are rational beings Consider all information and accurately assess its

meaning Some individuals/agents may behave irrationally or

against predictions, but in the aggregate they become irrelevant.

Markets Quickly incorporate all known information Represent the true value of all securities

Behavioral Finance Provides an Overlay to the Standard Theory of Finance by Stating:

Investors Are not totally rational Often act based on imperfect information There are systematic patterns or cognitive errors that

do not go away in the aggregate, such that there is a positive probability that the ‘marginal investor’ will exhibit a cognitive bias.

Markets May be difficult to beat in the long term In the short term, there are anomalies and excesses

Behavioral Characteristics

Loss aversion Narrow framing Anchoring Mental accounting Diversification

Disposition effect Herding Regret Media response Optimism

Loss Aversion

Flip a coin. Heads? You lose $10,000.

Tails? You win!

How much would you have to win before you take the bet?

Write it down.

Loss AversionThe Disproportion of Gain and Loss

Most people want to gain between 2 and 2.5 times as much as they put at risk

Most people will want a chance to win at least $20,000 before they will play

Simply put, people don’t like to lose money

Loss AversionThe Nature of Risk

Your risk profile will change over time– often based on market conditions

Your risk pendulum can swing dramatically

Loss AversionTo Do List

Devote significant attention to assessing risk Assess your risk tolerance at least once per

year possibly using a risk tolerance questionnaire

Assess your gains and losses less frequently

Narrow Framing

Would you accept this proposition?A 50% chance to win $15,000A 50% chance to lose $10,000

Most people would say No They want a chance to win at least twice what

they might lose (from Loss Aversion)

Narrow Framing

Now, assume you have a net worth of $2 million. Would you accept the proposition now?

Most people say Yes People become less risk averse as their

frame of reference broadens

Narrow Framing

Now assume you’ll flip the coin 100 times. Would you accept the gamble now?

Again, most people say YesLoss aversion is diminished by aggregation

Narrow Framing

Investing is a series of “propositions,” not a single event

Performance should always be viewed within the context of your total net worth (as opposed to individual investments)

Look at long-term goals, not short-term results

Disposition Effect

The disposition effect refers to people’s tendency to:Hang on to losers too longSell the winners too soon

This allows them to enjoy the feeling of winning faster and defer the pain of loss

Disposition Effect

Terrance Odeon study determined: Investors are 1½ times more likely to sell

winners over losers One-year after sale the losers under-

performed the winners that were sold by an average of 3.5%

Disposition EffectTo Do List

Consider some of the tax advantagesof selling losing investments

Always measure success in terms of progress toward long-term goals

Anchoring Take the last three numbers of your Social

Security number and add 400. Now. . . Attila and the Huns invaded Europe and

penetrated deep into what is now France where they were defeated and forced to return eastward.

In what year did Attila’s defeat occur?

Anchoring

Anchor Mean Answer 400-599400-599 626626 600-799600-799 660660 800-999800-999 789789 1000-11991000-1199 865865 1200-13991200-1399 988988

Answer: 451 ADResults:

The artificial date affects the estimate!

Anchoring Anchors affect an investor’s frame

of reference Common investment anchors

Investment indices (DJIA, S&P 500)CNNOther financial advisorsCocktail party chatterNeighbors, relatives, co-workers

Anchoring

Be aware of investment anchors Use relevant benchmarks in comparing

your investment portfolio Be cognizant of long-term goals, not short-

term fluctuations

Naïve DiversificationAllocation of various retirement plans:

TIAA-CREF: One Stock Fund, One Fixed Income50/50 Stock/Bond

TWA Pilots: Five Stock, One Fixed Income75/25 Stock/Bond

University of California: One Stock, Four Fixed Income34/66 Stock/Bond

Naïve Diversification

Make sure you are properly diversified Don’t let investment options dictate your

asset allocation Work with your financial advisor to

determine asset classes that will maximize return and reduce risk

Mental Accounting You have just been given $300. Choose

between: 50% chance to win $100 and

50% chance to lose $100 (A)No further bets (B)

70% chose “A”

Mental Accounting You’ve not been given anything. Choose

between: 50% chance to win $400 and

50% chance to win $200 (A)A sure gain of $300 (B)

Now only 43% choose “A.” Why? The “House Money Effect”

Mental Accounting

People often do not focus on their overall state of wealth

Instead they focus independently on their different accounts Retirement (401(k), IRA, etc.) Children’s education Taxable investment accounts Dividends Company stock or stock options

Mental AccountingTo Do List

Understand that keeping separate “mental accounts” often makes investors more conservative than they naturally are

Measure success in terms of your overall state of wealth

Herding

Investors have a tendency toward “herd behavior”

“Line” study on the effects of herd behavior Disproportionate flow of money into four and

five-star rated mutual funds Ratings have a lack of predictive value

RegretThe Story of John and Mary

John owns shares of Company A. He considers selling his shares and buying stock in Company B, but decides against it. He now finds he would have been better off by $20,000 if he had switched to Company B

Mary owns shares in Company B, but switched to Company A. She finds she would have been better off by $20,000 if she had kept her shares of Company B

Who is more upset, John or Mary?

Regret

Answer: Mary

People typically regret errors of commission more than errors of omission.

Media Response

Study of the effects of news on investment decisions:Two groups: one received news and one did

notThe group with no news outperformed

the group that received news

Media Response

People often feel the need to react to new information

News is often irrelevant to long-term performance and is often misinterpreted

Information overload can cause stress

Media Response

Advice: Stick with a long-term investment strategyTurn your televisions off when it comes to

investment newsDon’t feel you need to react to every bit

of information you hear

Optimism People believe it is likely that:

Good things will happen to them Bad things will happen to others

They believe others are more likely to: Become an alcoholic Have a heart attack Develop cancer

They believe others are less likely to: Become rich Become famous

Summing Up The Issues

Physiological and emotional pain associated with Loss Aversion and Regret

Excessive conservatism associated with Narrow Framing and Mental Accounting

Loss of confidence caused by Media Response, Herding and Anchoring

Optimism minimizes the roles of uncertainty and chance in investing

What you should do… Recognize that behavioral issues affect us all–

you are not alone Don’t focus on the short-term market trends, “hot

dot” products and day-to-day performance. Stick with a long-term investment strategy

Work with a financial professional. Financial professionals determine how these tendencies may be affecting the way you invest and take steps to remedy these tendencies