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Behavioral Finance
Outlines Standard Theory of Finance Overview of Behavioral Finance The importance of Behavioral Finance Survey of beha...
Standard Theory of Finance Investors Are rational beings Consider all information and accurately assess itsmeaning Som...
Behavioral Finance Provides an Overlay tothe Standard Theory of Finance by Stating: Investors Are not totally rational ...
Behavioral Characteristics Loss aversion Narrow framing Anchoring Mental accounting Diversification Disposition effe...
Loss Aversion Flip a coin. Heads? You lose $10,000. Tails? You win! How much would you have to win before youtake the ...
Loss AversionThe Disproportion of Gain and Loss Most people want to gain between 2 and2.5 times as much as they put at ri...
Loss AversionThe Nature of Risk Your risk profile will change over time–often based on market conditions Your risk pendu...
Loss AversionTo Do List Devote significant attention to assessing risk Assess your risk tolerance at least once peryear ...
Narrow Framing Would you accept this proposition?A 50% chance to win $15,000A 50% chance to lose $10,000 Most people w...
Narrow Framing Now, assume you have a net worthof $2 million. Would you accept theproposition now? Most people say YesP...
Narrow Framing Now assume you’ll flip the coin 100 times.Would you accept the gamble now? Again, most people say YesLos...
Narrow Framing Investing is a series of “propositions,” nota single event Performance should always be viewedwithin the ...
Disposition Effect The disposition effect refers to people’stendency to:Hang on to losers too longSell the winners too ...
Disposition EffectTerrance Odeon study determined: Investors are 1½ times more likely to sellwinners over losers One-yea...
Disposition EffectTo Do List Consider some of the tax advantagesof selling losing investments Always measure success in ...
Anchoring Take the last three numbers of your SocialSecurity number and add 400. Now. . . Attila and the Huns invaded E...
Anchoring Anchor Mean Answer 400-599400-599 626626 600-799600-799 660660 800-999800-999 789789 1000-11991000-1199 865...
Anchoring Anchors affect an investor’s frameof reference Common investment anchorsInvestment indices (DJIA, S&P 500)CN...
Anchoring Be aware of investment anchors Use relevant benchmarks in comparingyour investment portfolio Be cognizant of ...
Naïve DiversificationAllocation of various retirement plans: TIAA-CREF: One Stock Fund, One Fixed Income50/50 Stock/Bond...
Naïve Diversification Make sure you are properly diversified Don’t let investment options dictate yourasset allocation ...
Mental Accounting You have just been given $300. Choosebetween:50% chance to win $100 and50% chance to lose $100 (A)No ...
Mental Accounting You’ve not been given anything. Choosebetween:50% chance to win $400 and50% chance to win $200 (A)A s...
Mental Accounting People often do not focus on their overall stateof wealth Instead they focus independently on theirdif...
Mental AccountingTo Do List Understand that keeping separate “mentalaccounts” often makes investors moreconservative than...
Herding Investors have a tendency toward “herdbehavior” “Line” study on the effects of herd behavior Disproportionate f...
RegretThe Story of John and Mary John owns shares of Company A. He considersselling his shares and buying stock in Compan...
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 didnotThe grou...
Media Response People often feel the need to react to newinformation News is often irrelevant to long-termperformance an...
Media Response Advice:Stick with a long-term investment strategyTurn your televisions off when it comes toinvestment ne...
Optimism People believe it is likely that: Good things will happen to them Bad things will happen to others They belie...
Summing Up The Issues Physiological and emotional pain associatedwith Loss Aversion and Regret Excessive conservatism as...
What you should do… Recognize that behavioral issues affect us all–you are not alone Don’t focus on the short-term marke...
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Behavioral finance (2008)

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Behavioral finance (2008)

  1. 1. Behavioral Finance
  2. 2. Outlines Standard Theory of Finance Overview of Behavioral Finance The importance of Behavioral Finance Survey of behavioral characteristics
  3. 3. 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
  4. 4. 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
  5. 5. Behavioral Characteristics Loss aversion Narrow framing Anchoring Mental accounting Diversification Disposition effect Herding Regret Media response Optimism
  6. 6. 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.
  7. 7. 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
  8. 8. Loss AversionThe Nature of Risk Your risk profile will change over time–often based on market conditions Your risk pendulum can swingdramatically
  9. 9. 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
  10. 10. Narrow Framing Would you accept this proposition?A 50% chance to win $15,000A 50% chance to lose $10,000 Most people would say NoThey want a chance to win at least twice whatthey might lose (from Loss Aversion)
  11. 11. Narrow Framing Now, assume you have a net worthof $2 million. Would you accept theproposition now? Most people say YesPeople become less risk averse as theirframe of reference broadens
  12. 12. Narrow Framing Now assume you’ll flip the coin 100 times.Would you accept the gamble now? Again, most people say YesLoss aversion is diminished by aggregation
  13. 13. 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
  14. 14. Disposition Effect The disposition effect refers to people’stendency to:Hang on to losers too longSell the winners too soon This allows them to enjoy the feeling ofwinning faster and defer the pain of loss
  15. 15. 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%
  16. 16. Disposition EffectTo Do List Consider some of the tax advantagesof selling losing investments Always measure success in terms ofprogress toward long-term goals
  17. 17. 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?
  18. 18. Anchoring Anchor Mean Answer 400-599400-599 626626 600-799600-799 660660 800-999800-999 789789 1000-11991000-1199 865865 1200-13991200-1399 988988Answer: 451 ADResults:The artificial dateaffects the estimate!
  19. 19. Anchoring Anchors affect an investor’s frameof reference Common investment anchorsInvestment indices (DJIA, S&P 500)CNNOther financial advisorsCocktail party chatterNeighbors, relatives, co-workers
  20. 20. Anchoring Be aware of investment anchors Use relevant benchmarks in comparingyour investment portfolio Be cognizant of long-term goals, not short-term fluctuations
  21. 21. Naïve DiversificationAllocation of various retirement plans: TIAA-CREF: One Stock Fund, One Fixed Income50/50 Stock/Bond TWA Pilots: Five Stock, One Fixed Income75/25 Stock/Bond University of California: One Stock, Four FixedIncome34/66 Stock/Bond
  22. 22. 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
  23. 23. 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”
  24. 24. 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”
  25. 25. 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
  26. 26. 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
  27. 27. 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
  28. 28. 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?
  29. 29. Regret Answer: Mary People typically regret errors of commissionmore than errors of omission.
  30. 30. Media Response Study of the effects of news on investmentdecisions:Two groups: one received news and one didnotThe group with no news outperformedthe group that received news
  31. 31. 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
  32. 32. Media Response Advice:Stick with a long-term investment strategyTurn your televisions off when it comes toinvestment newsDon’t feel you need to react to every bitof information you hear
  33. 33. 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
  34. 34. 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
  35. 35. 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

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