USING BEHAVIORAL FINANCE TO UNDERSTAND AND ACT ON MAJOR MARKET ANOMALIES

Presented by Charles K. Bobrinskoy May 21, 2014

BEN GRAHAM AND WARREN BUFFETT ON “MR MARKET”

“Mister Market, sad to say, has incurable

emotional problems.

At times he feels euphoric and can see only

the favorable factors affecting the business.

At other times he is depressed and can see

nothing but trouble. On these occasions he

will name a very low price, since he is

terrified that you will unload your interest on

him.

Under these conditions, the more manic-

depressive his behavior, the better for you.”

1

THE “ANOMALIES” THAT ENDURE

• Stocks Beat Bonds

• Value Investing Beats Growth

• Small Caps Beat Large Caps

• Momentum Exists

BEHAVIORAL FINANCE

HELPS EXPLAIN THEM ALL

2

THE BEST BOOKS ON BEHAVIORAL FINANCE

•  Predictably Irrational: The Hidden Forces That Shape Our Decisions By Dan Ariely

•  Thinking, Fast and Slow by Daniel Kahneman

•  The Signal and the Noise: Why So Many Predictions Fail — but Some Don't By Nate Silver

3

PROSPECT THEORY

• Evaluation is relative to neutral reference point usually the status quo. Outcomes are judged, not on an absolute basis, but relative to what I have now.

• Loss Aversion: losses loom larger than gains. This asymmetry has an evolutionary history. Organisms that treat threats as more urgent have a better chance to survive.

4

ARIEL BEHAVIORAL FINANCE BIASES

5

1. PLANNING FALLACY

The tendency to produce forecasts that are

unrealistically close to best case

2. ANCHORING ON PRIOR

ESTIMATES

The tendency to adjust prior estimates

insufficiently when presented with new

information

3. OVERCONFIDENCE

The tendency to overestimate what one

knows and underestimate the uncertainties

of the future

4. ENDOWMENT EFFECT

The tendency to overvalue that which one

owns versus that which one doesn’t own

5. CONFIRMATION BIAS

The tendency to seek data that is

compatible with beliefs currently held

6. RELIANCE ON INTUITION

OVER DATA

The tendency to think one’s gut instinct

is superior to data/ and to overestimate

the significance of very small samples

7. VIVIDNESS/RECENCY EFFECT

The tendency to measure frequency by

one’s ability to think of examples;

which in turn produces a tendency to

overweight recent examples

PLANNING FALLACY

• Tendency to produce forecasts that are unrealistically close to best case

• Example:

– Start up tech company projections assume success, ignore new competition.

– 10 year DCF model for bank earnings include no recessions.

• Fix:

– Probability weighted scenario analysis

– Debt ratings

6

ANCHORING EFFECT

• Tendency to adjust prior estimates insufficiently when presented with new data

• Example:

– Target prices moving up slowly despite dramatic earnings beat.

– Stock price momentum

• Fix:

– No penalty for revisions

– Change of view encouraged

7

ENDOWMENT EFFECT

• Tendency to overvalue that which we own versus that which we don’t own

• Example:

– Overvalue the stock which you own, not comparing it to the stock which you don’t

• Fix:

– Watch list which compares valuation and quality of that which we own versus that which we don’t

– Devil’s advocate

8

CONFIRMATION BIAS

9

• The tendency to seek data that is compatible with beliefs currently held

• Example:

– Passing around article that agrees with you but dismissing a contrary article as “one person’s opinion.”

– Watching Fox News if you are a Republican and MSNBC if you are a Democrat.

• Fix:

– Be aware of it!

– Read bearish reports. Watch MSNBC.

– Use scientific method. Try to refute the theory.

AVAILABILITY HEURISTIC

• Tendency to measure frequency by one’s ability to think of examples

• Example:

– Overestimating chance of company started by college kid in dorm room succeeding (Dell, Microsoft, Facebook)

• Fix:

– Look at the data, but it’s hard.

– “We are all captives of our experiences.”

10

RELIANCE ON INTUITION OVER DATA

• Tendency to think one’s gut instinct is superior to data

• Controversial within investment community

– “Blink” versus “Moneyball”

• Fix:

– Look at the data.

– Remind teammates of law of small numbers. “Is that a sample size of one?”

11

POOR STATISTICAL INTUITION

• 1.4% of women under age 40 have breast cancer.

• 75% of women with breast cancer test positive.

• 10% of women who do not have breast cancer test positive.

A woman under 40 tests positive. What is the probability that she actually has breast cancer?

12

BAYES LAW

13

THE “ANOMALIES” THAT ENDURE

14

EQUITIES BEAT BONDS

Explanation: Loss Aversion, Planning Fallacy

VALUE INVESTING BEATS GROWTH

Explanation: Planning Fallacy, Optimism Bias, Availability Heuristic

SMALL CAPS BEAT LARGE CAPS

Explanation: Endowment Effect, Loss Aversion

STOCK PRICE MOMENTUM EXISTS

Explanation: Anchoring, Loss Aversion

TOP 3 TAKEAWAYS FOR YOUR PRACTICE

15

USE THIS PPT TO:

• Discuss these topics with your investors

(host an educational workshop etc.)

• Ask fund managers how they are actively

seeking to exploit these biases in their

investment choices (develop a list of

questions to ask managers or your

wholesalers)

• Assess how you are actively exploiting

these biases in the investment decisions

you make for your clients

Past performance does not guarantee future results. Investing in equity stocks is risky and subject to the volatility of the markets. Investing in small cap and mid-cap stocks is more risky and more volatile than investing in large cap stocks.

Bonds are fixed income securities in that at the time of the purchase of a bond, the amount of income and the timing of the payments are known. Risks of bonds include credit risk and interest rate risk, both of which may affect a bond’s investment value by resulting in lower bond prices or an eventual decrease in income. Treasury bonds are issued by the government of the United States. Payment of principal and interest is guaranteed by the full faith and credit of the U.S. government, and interest earned is exempt from state and local taxes.

A growth investment strategy seeks stocks that are deemed to have superior growth potential. Growth stocks offer an established track record and are perceived to be less risky than value stocks. A value investment strategy seeks undervalued stocks that show a strong potential for growth. The intrinsic value of the stocks in which a value strategy invests may be based on incorrect assumptions or estimations, may be affected by declining fundamentals or external forces, and may never be recognized by the broader market.

16