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
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