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Robert olsen v2 13.11.10


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  • 1. Behavioral Finance and the Market Meltdown: What We Should Have Expected. (No Trust = No Liquidity) Robert A. Olsen, Ph.D. Financial Economist Oregon, U.S.A.
  • 2. Behavioral Finance- What?
    • Behavioral Finance is premised on the existence of a satisficing decision maker who uses a slowly evolving brain to adapt to a world that is not fully predictable.
    • It assumes an individual who is social and culturally absorbed.
    • It eschews traditional model assumptions of Newtonian determinism, Behaviorism and optimization.
  • 3. Behavioral Finance - Why?
    • Many years of research in decision science, cognitive and evolutionary psychology, network theory and neuroscience indicate that modern finance is behaviorally flawed.
    • In addition empirical “anomalies” in modern finance testing suggest that its mathematical elegance has been bought at the price of real world predictive inaccuracy.
  • 4. Behavioral Finance - Where from?
    • Behavioral Finance concepts first appeared in writings of Finance and Psychology Professors at the University of Oregon from 1951 through 1972.
    • Investigation and acceptance has accelerated in recent years as the discipline has become multidisciplinary and academically widespread.
  • 5. Behavioral Finance - Where to?
    • Some have suggested that Behavioral Finance be assimilated into modern finance. This appears unworkable because the behavioral assumptions of the two approaches are inconsistent.
    • A paradigm shift is the most likely future outcome.
  • 6. Evolution of Behavioral Finance Stage 1: ~1970 to 1990
    • Primary Disciplines Involved
      • Cognitive Psychology
      • Decision Science
      • Experimental Economics
      • Game Theory
    • Topics Studied
      • Availability, Anchoring and Adjustment,
      • Representativeness, Confidence, Hindsight Bias
      • Endowment Effect, Loss Aversion, Framing
      • Herding, Over Reaction
  • 7. Evolution of Behavioral Finance Stage 2: ~1990 to 2010
    • Primary Disciplines Involved
      • Social Psychology
      • Evolutionary Psychology
      • Network Theory
      • Adaptive Economics
      • Neuroscience
    • Topics Studied
      • Group Behavior, Home Bias, Bubbles,
      • Multi Attribute Risk Perception,
      • Dual Brain Decision Process, Intuition,
      • Naturalistic Decision Making, Adaptive
      • Decision Making, Complexity, Affect
  • 8. Traditional Finance Paradigm Primary Background Assumptions
      • Reductionist Science can conquer uncertainty (at least in a probabilistic sense).
      • Negative Feedback dominates over time leading to approximation of a stationary equilibrium.
      • The Human Mind is a “general problem solving device” like a computer
      • Emotion has a generally negative influence on the quality of decisions.
      • Humans are generally disposed to make decisions focused on a narrow interpretation of self-interest.
      • Objectivity is possible because a human decision maker may be able to “stand outside” a decision frame.
  • 9. Traditional Finance Paradigm
    • Primary Background Assumptions
      • Reductionist Science
      • Negative Feedback
      • The Human Mind
      • Emotion
      • Self-Interest
      • Objectivity
      • Behavioral Finance research indicates that all six assumptions are in error to various degrees. Assumptions 1 and 6 are wrong on general scientific grounds. Assumption 1 is refuted by quantum theory and complexity theory. Assumption 6 by neuroscience. Assumption 2 is refuted by Agent Based economic modeling. Assumptions 3, 4, 5 are refuted by social and evolutionary psychology and neuroscience.
  • 10. Markowitz Portfolio Theory
    • Primary Background Assumptions
      • Investors consider each investment alternative as being represented by a probability distribution of expected returns over some holding period.
      • Investors attempt to maximize single-period expected utility with utility curves demonstrating diminishing marginal utility of wealth.
      • Risk is based on expected variability of potential returns.
      • Investment decisions are based solely upon estimates of risk and expected return.
      • For a given level of risk, investors prefer a higher level of return. Investors are RISK AVERSE. They would prefer a certain return to an investment that is risky but offers the same expected return.
    • Behavioral Finance calls into question all 5 assumptions.
  • 11. Informationally Efficient Markets Hypothesis
    • Hypothesis:
      • The expected returns implicit in the current price of a security should fully reflect its perceived risk.
    • Rationale:
      • A large number of competing profit maximizing participants analyze each security.
      • New information comes into the market in a random fashion.
      • Competing investors attempt to adjust prices rapidly to reflect the effect of new information.
    • Sources of Inefficiency:
      • Cost of Information. Trading Costs. Limits of Arbitrage
    • Behavioral finance calls into question profit maximization, frame independent learning, and independent action.
  • 12. The U.S. Financial Crisis: A Behavioral Perspective
    • The Behavioral Perspective on Investment Risk
    • Trust as a Risk Attribute
    • Housing Decline and the Collapse of Trust
  • 13. The Behavioral Perspective on Investment Risk Research Summary:
      • Risk Perceptions are a function of personal experience and asset characteristics.
      • Risk is an internal construct and does not exist “out there” in investors’ minds. Perceptions are by necessity subjective and assumption laden.
      • Risk perceptions are generally multi attribute wherein Affect becomes the common denominator of influence.
      • Strong Affect usually causes expected returns and perceived risk to vary inversely.
      • Attributes and general weights (Likert scale) .
        • Chance of significant loss = 10
        • Trust in Investment manager = 9
        • Felt Knowledge = 7
        • Variability of return = 5
  • 14. Trust as a Risk Attribute Perceived Personal Independence Hazard Characteristics Perceived Societal Dependence Perceptions Personal Control Perceptions Trust Risk Perception
  • 15. Housing Decline and Collapse of Trust
      • The U.S. has almost no economic middleclass.
        • Top 10% wealthiest own about 75% of all private assets.
      • Attempt of offset stagnant middle class wages since 1970 have resulted in
        • Working wives increased from 20% to 60%.
        • Working hours per household have increased by 25%.
        • Debt as a % of yearly after tax income rose to 138%.
        • Savings rate fell to near 0%.
      • Real estate became primary source of loan collateral.
  • 16. Housing Decline and Collapse of Trust
      • Traditional lenders became focused on “transaction fees” as a primary source of income as opposed to traditional services (i.e., loan investment)
      • Mortgage backed Bonds marketed on seller reputation.
      • Regulatory control and oversight reduced since 1980s.
  • 17. Trust Facts
    • Trust is fragile and easily broken
    • Trust takes much time and consistency to build
    • Trust destroying events are more salient.
    • Trust destroying events seen as more informative.
    • Trust is more oral and personally based.
    • Trust is not a function of one’s level of risk aversion.
    • Women rely upon trust more than men but less trusting.
    • Trust is the financial network unmeasured GLUE.
    • When trust is questioned perceived risk is heightened.
  • 18. Behavioral Investment Implications
    • Global investing will become more difficult to implement because Trust risk increases when dealing with “outsiders”.
    • This is already apparent with “Home Bias”. Survey evidence from a sample of 8,000 individual investors indicates that neither contracts or statistical measures of risk are viable substitutes for trustworthiness.
    • Risk premiums and interest rates are lower in countries with higher levels of interpersonal trust.
  • 19. Behavioral Investment Implications
    • Complexity theory and investor distrust of complex methodologies suggests that financial predictions will not become significantly more accurate or believed in the future.
    • More emphasis should be placed on indentifying good opportunities rather than good current prices, and with matching assets to investor experience, values and horizons.
  • 20. Behavioral Investment Implications
    • The influence of Affect on investment should be given greater emphasis because it is the evolutionary inborn common denominator between cognition and emotion.
    • It will be necessary to control for the affective bias between expected return and perceived risk.
    • Because decision makers have little ability to imagine how they would feel about different potential investment outcomes greater use of experiential exercises should yield better choices and greater satisfaction.
  • 21. More Investment Implications
    • Women investors will be less confident than men with equivalent backgrounds. Trust will be given greater weight.
    • Women will focus on an adequate return and then try to reduce risk. Men will do just the opposite.
    • Risk perceptions will vary inversely with time horizon.
    • Risk perceptions will be emergent and thus vary by client and investment .
  • 22. More Investment Implications
    • Clients will exhibit “desirability bias” and perceive a greater chance of good things coming to pass.
    • Westerners will see the future as linear. Easterners will see the future as circular.
    • The possibility of extreme events will usually be underestimated.
    • Clients will prefer investments that seem consistent with their values and time horizons. They favor consistency.
  • 23. More Investment Implications
    • Clients will associate more regret with actions not taken than actions taken but gone wrong.
    • Clients will associate more regret with actions not taken than actions taken but gone wrong.
    • Clients don’t well comprehend probability. They better understand “chance” presented in “real world” stories.
  • 24. Behavioral Finance Reading List
    • Introductory
      • Ariely, Dan, (2010), Predictably Irrational, Harper.
      • Belsky, Gary,(2010), Why Smart People Make Big Money Mistakes, Simon and Schuster
      • Nofsinger, John, (2010) Behavioral Finance, Kolb.
      • Peterson,Richard, (2007), Inside The Investor’s Brain, Wiley
      • Wilkinson, Nick, (2007) Introduction to Behavioral Economics, Palgrave Macmillian.
  • 25. Behavioral Finance Reading List
    • Professional Audience
      • Fox, Justin, (2009), Myth of Rational Markets , Harper
      • Glimcher, Richard, (2010), Foundations of Neuroeconomic Analysis, Oxford University Press.
      • Hens, Thorsten, (2009), Behavioral Finance For Private Banking, Wiley Finance
      • Mitchell, Olivia, (2004) Pension Design and Structure: New Lessons From Behavioral Finance, Oxford University Press.
      • Montier, James, (2007), Behavioral Investing: A Practitioners Guide, Wiley
      • Pompian, Michael, (2006), Behavioral Finance and Wealth Management, Wiley.
      • Shefrin, Sidney, (2007), Beyond Greed and Fear, Harvard.
      • Wayneryd, Karl-Erik, (2001) Stock Market Psychology, Elgar.