Behavioral Finance

9,313 views
8,995 views

Published on

0 Comments
3 Likes
Statistics
Notes
  • Be the first to comment

No Downloads
Views
Total views
9,313
On SlideShare
0
From Embeds
0
Number of Embeds
12
Actions
Shares
0
Downloads
385
Comments
0
Likes
3
Embeds 0
No embeds

No notes for slide

Behavioral Finance

  1. 1. Behavioral Finance at JP Morgan <ul><li>Managerial Finance Presentation </li></ul><ul><li>Presented by </li></ul><ul><li>Hussein Elgarhy </li></ul><ul><li>& </li></ul><ul><li>Fouad Ellaithy </li></ul><ul><li>Supervised by </li></ul><ul><li>Prof. Dr. Mustafa Eldewany </li></ul><ul><li>April, 2010 </li></ul>
  2. 2. Agenda <ul><li>Behavioral Finance * </li></ul><ul><ul><li>Why/What is BF </li></ul></ul><ul><ul><li>BF Characteristics </li></ul></ul><ul><ul><ul><li>Over Confidence / Loss aversion </li></ul></ul></ul><ul><ul><li>Prospect Theory </li></ul></ul><ul><ul><li>The Weighting Function </li></ul></ul><ul><li>JP Morgan ** </li></ul><ul><ul><li>BF At JP Morgan </li></ul></ul><ul><ul><ul><li>Over Confidence / Loss aversion </li></ul></ul></ul><ul><ul><li>BF Implementation </li></ul></ul><ul><ul><li>JPM Branded BF Fund </li></ul></ul><ul><ul><li>Top JPM BF Funds Updated Status </li></ul></ul><ul><li>* Behavioral Finance: BF </li></ul><ul><li>** JP Morgan: JPM </li></ul>Slide 1 © Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
  3. 3. Why Behavioral Finance? <ul><li>If we always behaved rationally… </li></ul><ul><ul><li>Nobody would ever sell stocks in a panic at the first sign of trouble </li></ul></ul><ul><ul><li>Nobody would ever buy stocks (or other investments) based on hunches, hot tips or media hype </li></ul></ul><ul><ul><li>Nobody would ever keep money in the bank instead of using it to pay off high-interest credit card balances </li></ul></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
  4. 4. Behavioral Finance <ul><li>Behavioral Finance provides an ‘overlay’ to the Standard Theory. Theory It provides a framework to understand ‘non-rational’ investor and market behaviors… </li></ul><ul><li>Investors </li></ul><ul><ul><li>Are not totally rational </li></ul></ul><ul><ul><li>Often act based on imperfect information </li></ul></ul><ul><ul><li>Make “non-rational” decisions in predictable ways </li></ul></ul><ul><li>Markets </li></ul><ul><ul><li>May be difficult to beat in the long term </li></ul></ul><ul><ul><li>In the short term, there are anomalies and excesses </li></ul></ul><ul><li>The two aspects of behavioral finance are: </li></ul><ul><ul><li>The behavior of investors </li></ul></ul><ul><ul><li>The behavior of markets </li></ul></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
  5. 5. Our Brains affect on Financial Decisions © Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. <ul><li>Fear Vs Greed </li></ul><ul><li>Dough Vs Gain </li></ul>
  6. 6. Behavioral Finance Cont’ <ul><li>Behavioral Finance is a reflection to extremes we see in Efficient Market Theory or in Mathematical Finance. </li></ul><ul><li>It is not just Behavioral Psychology applied to finance but also includes more broad social aspects which are not related to anything fundamental. </li></ul>Stocks Market Price Stocks Dividends 1880 1900 1920 2000
  7. 7. Behavioral Characteristics <ul><li>Loss aversion </li></ul><ul><li>Media response </li></ul><ul><li>Disposition effect </li></ul><ul><li>Herding </li></ul><ul><li>Narrow framing </li></ul><ul><li>Optimism </li></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. <ul><li>Mental accounting </li></ul><ul><li>Overconfidence </li></ul><ul><li>Regret </li></ul><ul><li>Anchoring </li></ul><ul><li>Hindsight bias </li></ul><ul><li>Recency </li></ul>
  8. 8. Behavioral Characteristics “ JP Morgan focus “ <ul><li>Loss aversion </li></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. <ul><li>Overconfidence </li></ul>
  9. 9. Over Confidence <ul><li>What is the weight of Status of Liberty -in Tons- ? </li></ul><ul><li>Population of Turkey -2008- ? </li></ul><ul><li>Size of Sahara Desert -Sq meter- ? </li></ul>
  10. 10. Over Confidence <ul><li>What is the weight of Status of Liberty -in Tons- ? </li></ul><ul><ul><li>252 Tons </li></ul></ul>
  11. 11. Over Confidence <ul><li>What is the weight of Status of Liberty -in Tons- ? </li></ul><ul><ul><li>252 Tons </li></ul></ul><ul><li>Population of Turkey -2008- ? </li></ul><ul><ul><li>73,914,260 </li></ul></ul>
  12. 12. Over Confidence <ul><li>What is the weight of Status of Liberty -in Tons- ? </li></ul><ul><ul><li>252 Tons </li></ul></ul><ul><li>Population of Turkey -2008- ? </li></ul><ul><ul><li>73,914,260 </li></ul></ul><ul><li>Size of Sahara Desert -Sq meter- ? </li></ul><ul><ul><li>3.5 Million Sq meter </li></ul></ul>
  13. 13. Prospect Theory In year 1979 Daniel Kahneman & Amos Tversky published there article about Prospect Theory as a psychologically realistic alternative to Expected Utility Theory. There is a discontinuity in slope which means we value losses more than we value gains given an equal probability for both. In contrary to EUF, here we are always at the reference point exaggerate in our minds the importance of deviations from where we are. This is not rational! So losses tend to dominate so you don’t want to take the bet. Expected Utility Function Value Function
  14. 14. The Weighting Function <ul><li>Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory: </li></ul><ul><li>Given these two prospects </li></ul><ul><li>Which one you choose ? </li></ul>Probability Gain 25% $3000 20% $4000
  15. 15. The Weighting Function Cont’ <ul><li>Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory: </li></ul><ul><li>Given these two prospects </li></ul><ul><li>Which one you choose ? </li></ul><ul><li>Most people would choose the 20% & $4000 </li></ul>Probability Gain 25% $3000 20% $4000
  16. 16. <ul><li>What if you have </li></ul><ul><li>Which one you choose ? </li></ul>The Weighting Function Cont’ Probability Gain 100% $3000 80% $4000
  17. 17. <ul><li>What if you have </li></ul><ul><li>Which one you choose ? </li></ul><ul><li>Most people would choose the 100% & $3000 because we prefer certainty. This contradict with the EUF theory. </li></ul>The Weighting Function Cont’ Probability Gain 100% $3000 80% $4000
  18. 18. The Weighting Function Cont’ <ul><li>Kahneman & Tversky said we weight probabilities in our minds in a distortion way. They stated that we emotionally minimize the differences between probabilities if they are close. </li></ul>
  19. 19. JP Morgan <ul><ul><li>J.P. Morgan Chase & Co. is one of the oldest financial services firms in the world. It has operations in 60 countries. It is a leader in financial services with assets of $2 trillion. </li></ul></ul><ul><ul><li>J.P Morgan manages clients’ assets through three key business units: </li></ul></ul><ul><ul><li>Private Bank </li></ul></ul><ul><ul><ul><li>High net worth individual (26 counties) </li></ul></ul></ul><ul><ul><li>Private Client Services (PCS) </li></ul></ul><ul><ul><ul><li>Client with < $ 25M in Assets </li></ul></ul></ul><ul><ul><li>Asset Management </li></ul></ul><ul><ul><ul><li>Developing financial products for retail and institutional investors </li></ul></ul></ul><ul><ul><li>JPM was the seventh largest asset management company in the world in 2005 </li></ul></ul>
  20. 20. Behavioral Finance at JP Morgan <ul><ul><li>They emphasis on two behavioral Biases: </li></ul></ul><ul><ul><li>Over confidence </li></ul></ul><ul><ul><ul><li>JPM funds systematically overweight value stocks, means that our investment behavior is changed. We are forced to focus on out of fashion stocks that we wouldn’t naturally have bothered with and that means that we cannot fall into the same overconfidence trap. </li></ul></ul></ul><ul><ul><li>Loss Aversion </li></ul></ul><ul><ul><ul><li>Our approach requires a systematic tilt to momentum, forcing us to run our winners and cut our losers. It also forces our investors to re-evaluate stocks which have done well for a long time but are now starting to disappoint </li></ul></ul></ul>
  21. 21. <ul><li>The implementation of the BF investment philosophy had three parts: </li></ul><ul><ul><li>Stock selection </li></ul></ul><ul><ul><ul><li>A quantitative stock selection model is used to rank stocks based on behavioral characteristics </li></ul></ul></ul><ul><ul><li>Portfolio construction </li></ul></ul><ul><ul><ul><li>Portfolio construction involved maximizing exposure to stocks with value and momentum, while controlling other risk exposures, such as overall risk, sector exposures </li></ul></ul></ul><ul><ul><li>Execution. </li></ul></ul><ul><ul><ul><li>In our portfolios, stocks are systematically combined in such a way as to produce a barbell portfolio which is cheaper than the market and has better momentum than the market - a kind of “super-stock.” </li></ul></ul></ul>Behavioral Finance Implementation
  22. 22. JPM Branded BF Fund <ul><li>Intrepid Funds </li></ul><ul><ul><li>Intrepid America </li></ul></ul><ul><ul><li>Intrepid Growth </li></ul></ul><ul><ul><li>Intrepid Value </li></ul></ul><ul><ul><li>Intrepid Multi Cap </li></ul></ul><ul><ul><li>They Capitalize on the emotions that often cause people to make poor investment decisions </li></ul></ul><ul><ul><li>Their performance had been impressive </li></ul></ul><ul><ul><ul><li>Example: Intrepid Value was ranked first of 400 funds since its release in 2003 </li></ul></ul></ul>
  23. 23. Top JPM BF Funds Updated Status
  24. 24. QUESTIONS
  25. 25. <ul><li>Back up </li></ul>
  26. 26. Loss Aversion: Pop Quiz <ul><li>A friend wants to make a bet with you. If accept the bet you will have a 50% chance of losing $10,000 and a 50% chance of winning $_______. </li></ul><ul><li>How much would you want to have a chance of winning before you would take the bet? </li></ul><ul><li>Please right down your number </li></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
  27. 27. Loss Aversion: The Disproportion of Gain & Loss <ul><li>Most people want to gain between 2 and 2.5 times as much as they put at risk. So most people will want a chance to win $20,000 before they will play. </li></ul><ul><li>Practical Example: </li></ul><ul><ul><li>Between 1926 and 2000 </li></ul></ul><ul><ul><ul><li>Stocks returned 8% (real) </li></ul></ul></ul><ul><ul><ul><li>Bonds returned 2% (real) </li></ul></ul></ul><ul><ul><li>The answer is loss aversion: The less frequently you evaluate stocks, the less risky they appear. People tend to evaluate stocks as if they had a short time horizon. </li></ul></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. <ul><ul><li>Question: Why would anyone </li></ul></ul><ul><ul><li>invest in bonds? </li></ul></ul>
  28. 28. <ul><ul><li>Anticipation of gain (greed) is more satisfying than the actual gain </li></ul></ul><ul><ul><li>Pain of loss has a larger emotional impact than the pleasure of gain </li></ul></ul><ul><ul><li>Investors lose confidence in markets due to the media response, herding, and anchoring effects </li></ul></ul><ul><ul><li>Excessive conservatism and aversion to risk is exacerbated by narrow framing, mental accounting and short time horizons </li></ul></ul><ul><ul><li>Investor overconfidence, optimism and minimization of uncertainties create inflated egos </li></ul></ul><ul><ul><li>Investors often repeat predictable, destructive behaviors and don’t learn from past mistakes </li></ul></ul><ul><ul><li>Bottom line: These behaviors and reacting to ‘recency’ events leads to lower overall returns over the long-term. </li></ul></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. Behavioral Finance: Key points
  29. 29. <ul><ul><li>Recognize that behavioral issues affect us all—including financial advisors, institutional money managers, and individual investors </li></ul></ul><ul><ul><li>Do a self-assessment to determine what behaviors you’ve exhibited and how it may impact the advice you provide clients or the advice your clients have clients—or received from other advisors </li></ul></ul><ul><ul><li>Challenge the financial advisors you work with—see with see if their advice and recommendations are influenced by latent behavioral biases </li></ul></ul>© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010. Conclusion

×