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 itsmeaning Some individuals/agents may behave irrationally oragainst predictions, but in the aggregate they becomeirrelevant. Markets Quickly incorporate all known information Represent the true value of all securities
Behavioral Finance Provides an Overlay tothe Standard Theory of Finance by Stating: Investors Are not totally rational Often act based on imperfect information There are systematic patterns or cognitive errors thatdo not go away in the aggregate, such that there is apositive probability that the ‘marginal investor’ willexhibit 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 youtake the bet? Write it down.
Loss AversionThe Disproportion of Gain and Loss Most people want to gain between 2 and2.5 times as much as they put at risk Most people will want a chance to win atleast $20,000 before they will play Simply put, people don’t like to losemoney
Loss AversionThe Nature of Risk Your risk profile will change over time–often based on market conditions Your risk pendulum can swingdramatically
Loss AversionTo Do List Devote significant attention to assessing risk Assess your risk tolerance at least once peryear possibly using a risk tolerancequestionnaire Assess your gains and losses lessfrequently
Narrow Framing Would you accept this proposition?A 50% chance to win $15,000A 50% chance to lose $10,000 Most people would say NoThey want a chance to win at least twice whatthey might lose (from Loss Aversion)
Narrow Framing Now, assume you have a net worthof $2 million. Would you accept theproposition now? Most people say YesPeople become less risk averse as theirframe 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,” nota single event Performance should always be viewedwithin the context of your total net worth(as opposed to individual investments) Look at long-term goals, not short-termresults
Disposition Effect The disposition effect refers to people’stendency to:Hang on to losers too longSell the winners too soon This allows them to enjoy the feeling ofwinning faster and defer the pain of loss
Disposition EffectTerrance Odeon study determined: Investors are 1½ times more likely to sellwinners over losers One-year after sale the losers under-performed the winners that were sold byan average of 3.5%
Disposition EffectTo Do List Consider some of the tax advantagesof selling losing investments Always measure success in terms ofprogress toward long-term goals
Anchoring Take the last three numbers of your SocialSecurity number and add 400. Now. . . Attila and the Huns invaded Europe andpenetrated deep into what is now Francewhere they were defeated and forced toreturn eastward. In what year did Attila’s defeat occur?
Anchoring Anchors affect an investor’s frameof reference Common investment anchorsInvestment indices (DJIA, S&P 500)CNNOther financial advisorsCocktail party chatterNeighbors, relatives, co-workers
Anchoring Be aware of investment anchors Use relevant benchmarks in comparingyour 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 FixedIncome34/66 Stock/Bond
Naïve Diversification Make sure you are properly diversified Don’t let investment options dictate yourasset allocation Work with your financial advisor todetermine asset classes that will maximizereturn and reduce risk
Mental Accounting You have just been given $300. Choosebetween:50% chance to win $100 and50% chance to lose $100 (A)No further bets (B) 70% chose “A”
Mental Accounting You’ve not been given anything. Choosebetween:50% chance to win $400 and50% 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 stateof wealth Instead they focus independently on theirdifferent 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 “mentalaccounts” often makes investors moreconservative than they naturally are Measure success in terms of your overallstate of wealth
Herding Investors have a tendency toward “herdbehavior” “Line” study on the effects of herd behavior Disproportionate flow of money into fourand 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 considersselling his shares and buying stock in Company B,but decides against it. He now finds he would havebeen better off by $20,000 if he had switched toCompany B Mary owns shares in Company B, but switchedto Company A. She finds she would have beenbetter off by $20,000 if she had kept her shares ofCompany B Who is more upset, John or Mary?
Regret Answer: Mary People typically regret errors of commissionmore than errors of omission.
Media Response Study of the effects of news on investmentdecisions:Two groups: one received news and one didnotThe group with no news outperformedthe group that received news
Media Response People often feel the need to react to newinformation News is often irrelevant to long-termperformance 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 toinvestment newsDon’t feel you need to react to every bitof 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 associatedwith Loss Aversion and Regret Excessive conservatism associated with NarrowFraming and Mental Accounting Loss of confidence caused by Media Response,Herding and Anchoring Optimism minimizes the roles of uncertainty andchance 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, “hotdot” products and day-to-day performance. Stickwith a long-term investment strategy Work with a financial professional. Financialprofessionals determine how these tendenciesmay be affecting the way you invest and takesteps to remedy these tendencies