Robert olsen v2 13.11.10


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Robert olsen v2 13.11.10

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