Behavioral Finance

Pauline ShumSchulich School of Business

York University

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Agenda

1. What is behavioral finance?

2. Behavioral biases and their implications for investment beliefs and decision making

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1. What is behavioral finance?

Relatively new school of thought Gradually recognized as a legitimate field in

finance in the 1990s

A marriage of psychology and finance It says psychology plays a role in

financial decision making Is it a surprise that we are human?

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1. What is behavioral finance?

Cognitive errors and biases affect investment beliefs, and hence financial choices

Poses a challenge to the traditional idea that markets are always efficient

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1. What is behavioral finance?

Why should we care?

To better understand our own investment behavior, and that of others set the right incentives for clients, pension plan design

To better understand asset management companies and active strategies that base their investment philosophy on behavioral finance

Even retail banking is talking to customers about it (e.g., CIBC Imperial Service: Investor Psychology 101)

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2. Behavioral biases

Summary of well-known cognitive errors and biases, and their impact on investment beliefs and decision making

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Overconfidence

Better than average: “I’m a better than average driver.”

Illusion of control “I won’t have a car accident.”

Overconfidence

As applied to investments, overconfidence may lead to excessive trading

“Trading is hazardous to your wealth” by Barber and Odean (2000)

Find that portfolio turnover is a good predictor of poor performance: Investors who traded the most had the lowest returns net of transaction costs

Mostly confined to one particular gender…8

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Why don’t they learn?

Why don’t overconfident investors learn from their mistakes?

Self-attribution bias Attribute successes to their own ability Blame failures on bad luck

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Loss aversion

GainLoss

Pleasure

Pain

+10%

-10% Small pleasure

Big pain

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Narrow framing

Loss aversion may be a consequence of narrow framing

Narrow frame of evaluation Limited set of metrics in evaluating investments Myopic behavior even though investment is long-

term Obsessive about price changes in a particular

stock Can lead to over-estimation of risk

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Narrow framing/loss aversion

Consequence:

Tendency to sell winners too soon, and hang on to losers for too long E.g., Nortel “If I haven’t realized the loss, then it isn’t yet a

loss.”

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Myopic loss aversion

Example: Currency hedging Influenced by recent events or stick with

long-term view? Combination of loss aversion and

representativeness

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Representativeness

Making decisions based on recent history, or a small sample size

Believe that it is representative of the future, or the full sample

Representativeness

May lead to “excessive extrapolation” Erroneously think that recent performance is representative of longer term prospects

Results: Investors chase past winners Overreacts to glamour stocks (e.g., Technology

bubble) Overreacts to bad news which may be temporary

(thus creating “value opportunities”) Creates short-term momentum, but long-term reversal

in returns

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Representativeness Let’s look at performance of portfolio managers

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Quartile 1998-2001 2002-2005 1998-2001 2002-2005

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Based on a sample of 220 U.S. equity managers (Wood, 2006)

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Representativeness

Another example of excessive extrapolation: Sample size

Erroneously think that a small sample size is representative of the population E.g. opinion of a car vs. investing in the car

company

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Regret Avoidance

Leads to procrastination and inertia Status quo bias Good intentions but poor follow-through

Results in delayed saving and investment choices Defined Contribution Plans: A significant

number of accounts are kept in their default allocation for a long time

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Ambiguity aversion

Sticking with the familiar Results in under-diversification Home bias, local bias Bias is more substantial if take into

account human capital

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Impact on committee decision making

Lack of diversity in membership could pose a problem

Common knowledge syndrome: less willing to share unique or different information for the sake of social cohesion

It takes 16 similarly-minded committee members to generate the diversity of 4 different-minded members

Final Note Some empirical findings are more respected in

the profession than others More controversial studies: Stock market returns

affected by number of hours of sunshine, seasonal changes …etc.

More and more asset management companies are using the “behavioral finance” buzz word (mostly value strategies)

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Final Note

Can the two schools of thought co-exist? How I like to think about it: Short-term: markets can be inefficient due to investor

behaviour Long term, markets are efficient (on average)

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