Behavioral Biasesand Investment Implications

Date of first use: September 10, 2009.

Scott A. BosworthVice President

Behavioral Biasesand Investment Implications

“I can calculate the motion of heavenly bodies, but not the madness of people.”

—Sir Isaac Newton, response to the 1720 collapse of the “South Sea Bubble”

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Behavioral Biasesand Investment Implications

►What are the common biases?

►How do biases affect decision making?

►How investors can control for biases.

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Behavioral Biases

“. . . emotion overwhelms reason.”

“Financial losses are processed in the same areas of the brain that respond to mortal danger.”

Jason Zweig, Your Money and Your Brain (New York: Simon & Schuster, 2007). 3

Behavioral Biases

Overconfidence

Hindsight Bias

Familiarity Bias

Regret Avoidance

Self Attribution Bias

Extrapolation

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Market Portfolio

June 1998 13.4% 15.2%

February 2000 15.2% 16.7%

September 2001 6.3% 7.9%

Kenneth L. Fisher and Meir Statman, “Bubble Expectations,” Journal of Wealth Management 5, no. 2 (Fall 2002): 17-22.

Overconfidence

►Survey of investors, asked how the market would do and how their own portfolio would do over the ensuing 12 months.

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Hindsight Bias

“How could I have been so stupid?”

►Past events seem easy to predict.

►The future, therefore, seems easy to predict.

►Hindsight is not 20/20.

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Familiarity Bias (invest in what you know)

►Provides a false sense of security by giving the impression of control.

►Examples:– Concentrating wealth in a few well-known companies with which you

are familiar.– Holding a “legacy” stock.

The market does not reward investors with risk premiums for “loyalty” or “familiarity.”

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“I won’t make that mistake again.”

►Counterfactual thoughts lead to regret.

► “If only I had not made the decision to buy X.”

You did buy X, so not buying it in the past is counterfactual.

Regret Avoidance

8Diversification neither assures a profit nor guarantees against loss in a declining market.

Self Attribution Bias

“Look how smart I am.”OR

“No one could have seen that coming.”

Credit: Attribute success to self-possessed skills or inherent abilities.

Blame: Attribute failures to externalities that we could not know or control.

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Extrapolation

Historical returns are based on old news.

Future returns are unknown . . .

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►A report of recent events.

►Previously unknown information.

►Something having a specified influence or effect.

“News”

Source: Merriam-Webster online dictionary. 11

Magazine publication dates: Fortune, March 3, 1997 (America’s Most Admired Companies); Money, August 1997 (Don’t Just Sit There… Sell Stocks Now); Money, May 1999 (Tech Stocks, Everyone’s Getting Rich!); Time, September 9, 1974 (Economy: The Big Headache); Time, October 15, 1990 (High Anxiety); Time, November 2, 1987 (The Crash).

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Steve ForbesPublisher, Forbes Magazine

“You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”

Excerpt from presentation at The Anderson School, University of California, Los Angeles, April 15, 2003. 13

Investor BehaviorIn 2008 the S&P 500 Index returned -37.72%In 2008 the average equity investor earned -41.63%

From Jan 1989 through Dec 2008 (20 Years):► Average equity investor earned annual return of 1.87%► Underperformed the S&P 500 Index by 6.48%► Underperformed inflation by 1.02%

Takeaways:► Investors buy high and sell low.► Returns are more dependent on investor behavior than fund performance.► Buy-and-hold investors typically earn higher returns over time than those who

time the market.

Dalbar, Inc., “Quantitative Analysis of Investor Behavior 2009,” (www.dalbar.com). DALBAR develops standards for, and provides research, ratings, and rankings of intangible factors to the mutual fund, broker/dealer, discount brokerage, life insurance, and banking industries. They include investor behavior, customer satisfaction, service quality, communications, Internet services, and financial-professional ratings.

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The S&P data are provided by Standard & Poor’s Index Services Group.

The Appeal of Market Timing

► What if you only invested in the stock market in months when it outperformed T-Bills?

► From 1990 through 2008, a $1 MM investment in the following would have returned:

► Wealth from timing would be 34 times that of a buy-and-hold strategy.

US T-Bills (buy and hold) $2.12 MMUS stock market (buy and hold) $3.94 MMUS stock market only when equity premium is positive $136.21 MM

US stock market measured by CRSP 1-10 Index. Third calculation based on highest asset class return each year from previous slide. CRSP is a research center at the Graduate School of Business (founded in 1898) of the University of Chicago. CRSP is a non-profit center which also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26, 500 stocks – active and inactive – listed on the NYSE, Alternext (formerly known as the Alternext (formerly AMEX)), NASDAQ and ARCA exchanges. OTC bulletin board stocks are not included.. US T-Bill data provided by Ibbotson Associates. .

15Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government’s full faith and credit and are exempt from state and local taxes. Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation.

Perspective on Markets

“October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

—Mark Twain

“The market can stay irrational longer than you can stay solvent.”

— Quotation attributed to John Maynard Keynes

16Dan Wheeler is the founder of the Dimensional Fund Advisors Financial Advisors Services.

Perspective from Academia

“As I have often argued: Even the Almighty cannot determine a single correct value for the market as a whole.”

—Burton Malkiel, “How Much Higher Can the Market Go?” Wall Street Journal, September 22, 1999.

“There’s something in people, you might even call it a little bit of gambling instinct . . . I tell people [investing] should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

—Paul Samuelson, 1970 Nobel Laureate in Economics, in “The Ultimate Guide to Indexing,” Bloomberg, September 1999.

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Risk and Return

►Free markets must compensate investors for bearing risk.

►The market is “forward looking.” Expectations of risk are priced into the market currently.

►Risk is higher (and prices lower) during recessions.

►Expected returns for risky assets should be higher during recessions.

Expected return is the percentage increase in value a person may anticipate from an investment based on the level of risk associated with the investment, calculated as the mean value of the probability distribution of possible returns.

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Dalbar, Inc., “Quantitative Analysis of Investor Behavior 2009,” (www.dalbar.com). DALBAR develops standards for, and provides research, ratings, and rankings of intangible factors to the mutual fund, broker/dealer, discount brokerage, life insurance, and banking industries. They include investor behavior, customer satisfaction, service quality, communications, Internet services, and financial-professional ratings.

Disciplined Approach

What You Can’t Control– Pick winning stocks

– Pick superior managers

– Time the markets

– Financial press

What You Can Control– Reduce expenses

– Diversify portfolio

– Minimize taxes

– Discipline

19Diversification neither assures a profit nor guarantees against loss in a declining market.

Nick Murray

“At the end of our investing lifetime, it won’t matter what your funds did, it’ll matter what you did. And what you did will be a pure function of the quality of the advice you got—from one caring, competent [advisor], and not from any number of magazines.”

“Murray on Marketing,” Investment Advisor Magazine, October 1994. 20Diversification neither assures a profit nor guarantees against loss in a declining market.

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