Behavioral Economics of Investing & Portfolio Management Lasse Fuss April 8, 2015

Why This Presentation? 19% think they belong to the richest 1% 82% say they are in the top 30% of safe drivers 80% of students think they will finish in the top half of their class

A Definition “repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty”

BE in Action Imagine you are going on a road trip to Kansas City. On the way to Kansas City you are speeding at 80 mph. On the return trip, traffic is disastrous and your speed is 40 mph. What is your average speed for the entire trip?

BE in Action 60 miles per hour Imagine you are going on a road trip to Kansas City. On the way to Kansas City you are speeding at 80 mph. On the return trip, traffic is disastrous and your speed is 40 mph. What is your average speed for the entire trip? 60 miles per hour

BE in Action 53.3 miles per hour Imagine you are going on a road trip to Kansas City. On the way to Kansas City you are speeding at 80 mph. On the return trip, traffic is disastrous and your speed is 40 mph. What is your average speed for the entire trip? 53.3 miles per hour

BE in Action A test of a disease presents a rate of 5% false positives. The disease strikes 1/1000 of the population. The city of Kirksville decided to test people at random, no matter if they are suspected of actually having the disease. You take the test and are told your test is positive. What is the probability that you have the disease?

BE in Action Most doctors: 95% A test of a disease presents a rate of 5% false positives. The disease strikes 1/1000 of the population. The city of Kirksville decided to test people at random, no matter if they are suspected of actually having the disease. You take the test and are told your test is positive. What is the probability that you have the disease? Most doctors: 95%

BE in Action A test of a disease presents a rate of 5% false positives. The disease strikes 1/1000 of the population. The city of Kirksville decided to test people at random, no matter if they are suspected of actually having the disease. You take the test and are told your test is positive. What is the probability that you have the disease? In fact: ~2%

BE Explained These mistakes are human Part of an efficient mechanism Heuristics = mental shortcuts Fixed action patterns But they may backfire → Biases! sometimes common sense after the fact

Important Concepts Endowment Effect Disposition Effect Confirmation Bias System 1 & 2 Law of Small Numbers Narrative Fallacy Anchoring Basic Statistics

Fortune 500 use BE

Emotional Cycle of Investing

Endowment Effect

Endowment Effect Loss averse by nature Overvalue what we own expect others to do the same . This is because humans are by nature (and evolutionary causes) loss averse. Thus, we avoid giving up what we own and assign a higher value to our possessions the portfolio management team needs to stick to the original valuation and investment thesis and, if necessary, reevaluate the stocks independently from the pitching group to minimize

Endowment Effect Loss averse by nature Overvalue what we own expect others to do the same BSIF Impact: Portfolio Management Do not get attached to stocks Stick to original investment thesis Reevaluate stocks independently = . This is because humans are by nature (and evolutionary causes) loss averse. Thus, we avoid giving up what we own and assign a higher value to our possessions the portfolio management team needs to stick to the original valuation and investment thesis and, if necessary, reevaluate the stocks independently from the pitching group to minimize

2. Disposition Effect Reluctant to realize losses Irrational belief Future performance is related to purchasing price Denial and postponing “I am in for the long haul” reluctance to realize losses. Various studies have shown that investors prefer selling stocks at a gain than realizing a loss. If an investment thesis turns out to be false or there is a change in fundamentals, the rational action is to sell the stock. However, investors are irrational since the future performance of equity is unrelated to its purchasing price objectively evaluating each holding’s in the portfolio and to determine whether the investment thesis still holds true. Investors should not be afraid to sell at a loss when the investment environment has changed

2. Disposition Effect Reluctant to realize losses Irrational belief Future performance is related to purchasing price Denial and postponing “I am in for the long haul” BSIF Impact: Portfolio Management objective analyze investment thesis not be afraid to sell at a loss reluctance to realize losses. Various studies have shown that investors prefer selling stocks at a gain than realizing a loss. If an investment thesis turns out to be false or there is a change in fundamentals, the rational action is to sell the stock. However, investors are irrational since the future performance of equity is unrelated to its purchasing price objectively evaluating each holding’s in the portfolio and to determine whether the investment thesis still holds true. Investors should not be afraid to sell at a loss when the investment environment has changed

3. Confirmation Bias

3. Confirmation Bias Subconscious process BSIF Impact: Sector Groups Biased search for and interpretation of information BSIF Impact: Sector Groups Once group decides on one stock Preconception: stock is good → confirmation Interest in stock: focus more on positives Discount negative information setting higher hurdles to become the group’s final pick and actively seeking out negative information as part

3. Confirmation Bias Subconscious process BSIF Impact: Sector Groups Biased search for and interpretation of information BSIF Impact: Sector Groups Once group decides on one stock Preconception: stock is good → confirmation Recommendation Set higher hurdles within group Actively seek out negative information early on Interest in stock: focus more on positives Discount negative information setting higher hurdles to become the group’s final pick and actively seeking out negative information as part

4. System 1 & 2 "Reflective System" and the "Automatic System"

4. System 1 & 2 Attentive and analytical thinking requires energy Brain tries decrease effort Good BUT causes numerous biases Outcome Bias Halo Effect BSIF Impact: All Decisions Attentive and analytical thinking requires effort and is often avoided by the brain. It would be nice to say “Turn on System 2 while working on your investment thesis or pitching and voting on a stock.” However, especially late in the evening this is unlikely the case.

5. Narrative Fallacy Stories: make sense of reality easy to remember vivid and convincing Stories: simplify the world selected aspects only Fallacy: looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen Since our world is complex, people construct narratives to make sense of reality. Stories provide a frame of reference to remember concepts which leads us to prefer narrative to data. Statistics are difficult to visualize whereas stories are vivid. However, a story often simplifies the real world and focuses on selected aspects. Analyzing data objectively without building a story around it is a difficult task. “narrative fallacy” which describes people looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen Even though this story may be extremely appealing to our brain, it is not ideal for a careful evaluation of a stock. Thus, when listening to stories, student analysts have to be careful when weighing its conclusions.

5. Narrative Fallacy Stories: make sense of reality easy to remember vivid and convincing Stories: simplify the world selected aspects only BSIF Impact: Stock Pitches do not oversimplify using stories be careful when weighing stories’ conclusions Fallacy: looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen Since our world is complex, people construct narratives to make sense of reality. Stories provide a frame of reference to remember concepts which leads us to prefer narrative to data. Statistics are difficult to visualize whereas stories are vivid. However, a story often simplifies the real world and focuses on selected aspects. Analyzing data objectively without building a story around it is a difficult task. “narrative fallacy” which describes people looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen Even though this story may be extremely appealing to our brain, it is not ideal for a careful evaluation of a stock. Thus, when listening to stories, student analysts have to be careful when weighing its conclusions.

6. Anchoring Subconscious process to use reference points Stocks: past prices, estimates, valuations Buffet has fallen prone to anchoring BSIF Impact: Stock Pitches watch out for anchors and ignore them look forward and not get lost in the past “stock is X% off its 52-week high” a stock is X percent off its 52-week high and therefore undervalued.” the unconscious process to judge a value relative to a reference point which can be past prices, estimates, or valuations

7. Some Basic Statistics told you to misunderstand, or do not want to understand probability, maybe because randomness devalues our idea of a logical and meaningful world. Thus, when making investment decision, we have to accept that events can be random, that earnings surprises can be luck, and that losses in a stock can be simply bad luck. probability is not linear: A 2% move is 4-10 times more significant than a 1% move. A 7% move can be several billion times more relevant than a 1% move One statistical tool we face numerous times in our daily life is the arithmetic mean. Everyone quotes averages, and numerous decisions are based on the average. What we fail to consider is that many distributions are not bell-shaped but skewed. For these distributions, knowing the mean is worthless or even counterproductive since our mind jumps to faulty conclusions about the actual distribution. Thus, before interpreting an important statistics, it is crucial to examine the underlying distribution, for example by creating a histogram. use more statistics and

7. Some Basic Statistics We assume distributions to be bell- shaped Examine underlying distributions We assume probability to be linear A 2% move is 4-10 times more significant than a 1% move. A 7% move can be several billion times more relevant than a 1% move maybe because randomness devalues our idea of a logical and meaningful world. . Our world is complex and our brain tries to make sense out of it. By finding patterns and building causal relationships, we better understand our surrounding and make sense out of occurances. Since many events are indeed causally related, we apply this concept to too many aspects in our life including investment decisions. Our brain simply does not handle randomess well, and luck is unacceptable. Few accept that some companies’ success can be based on luck, statistically speaking they are simply an outlier. told you to Thus, when making investment decision, we have to accept that events can be random, that earnings surprises can be luck, and that losses in a stock can be simply bad luck. probability is not linear: A 2% move is 4-10 times more significant than a 1% move. A 7% move can be several billion times more relevant than a 1% move One statistical tool we face numerous times in our daily life is the arithmetic mean. Everyone quotes averages, and numerous decisions are based on the average. What we fail to consider is that many distributions are not bell-shaped but skewed. For these distributions, knowing the mean is worthless or even counterproductive since our mind jumps to faulty conclusions about the actual distribution. Thus, before interpreting an important statistics, it is crucial to examine the underlying distribution, for example by creating a histogram. use more statistics and

8. Law of Small Numbers Extrapolate data, oil prices - analysts are claiming oil prices have always recovered in the past, but how many times have they actually fallen by such a great extent → carefull

8. Law of Small Numbers Believe small sample are indicative of popl.

8. Law of Small Numbers Gambler’s Fallacy Hot Hand Fallacy when the probability of the outcome is known people try to predict the next draw from a sequence, expecting the small sequence to match the known probability Hot Hand Fallacy when the probability of an outcome is uncertain and someone uses a small sequence to predict the probability of an outcome

8. Law of Small Numbers Gambler’s Fallacy Hot Hand Fallacy when the probability of the outcome is known people try to predict the next draw from a sequence, expecting the small sequence to match the known probability Hot Hand Fallacy when the probability of an outcome is uncertain and someone uses a small sequence to predict the probability of an outcome BSIF Impact: Analysis be careful to accept extrapolations question p-claim based on small sample of past outcomes

Recommendations Gary Klein’s “premortem” “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” Completed by each member in pitch groups Section: Investment Risk Since mental fallacies are abundant, it is crucial to addresses what investors and portfolio managers can do to avoid falling prone to these biases. An excellent way to combat overconfidence, confirmation bias, and a one sided stock pitch that misses important negative aspects is Gary Klein’s “premortem.” Klein suggests when organizations have almost come to an important decision, members of the decision making committee should present a short speech or argument with the following premise: “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” (as cited in Thinking, Fast and Slow).Such an exercise avoids focusing only on one side of the argument and also overcomes groupthink. In the student-led investment fund, each pitch group should undergo this process and also include their findings in the stock pitch in a section labeled investment risks. This will stimulate critical thinking and hopefully improves the stock selection. Similarly, other behavioral scientists suggest to actively seek out contrary opinions by trying to rebut rather than confirm hypothesis and assigning someone to be a bearish analyst. It is also crucial not to anchor on historical information or stock prices; all that matters is the future. This also includes updating initial estimates of intrinsic value and remaining true to buy and sell targets.

Recommendations Seek out contrary opinions Be a bearish analyst Be objective Don’t be emotional Remain true to buy/sell targets Careful with probability & cause effect Use System 2 (easier said than done) Since mental fallacies are abundant, it is crucial to addresses what investors and portfolio managers can do to avoid falling prone to these biases. An excellent way to combat overconfidence, confirmation bias, and a one sided stock pitch that misses important negative aspects is Gary Klein’s “premortem.” Klein suggests when organizations have almost come to an important decision, members of the decision making committee should present a short speech or argument with the following premise: “Imagine that we are a year into the future. We implemented the plan as it now exists. The outcome was a disaster. Please take 5 to 10 minutes to write a brief history of that disaster” (as cited in Thinking, Fast and Slow).Such an exercise avoids focusing only on one side of the argument and also overcomes groupthink. In the student-led investment fund, each pitch group should undergo this process and also include their findings in the stock pitch in a section labeled investment risks. This will stimulate critical thinking and hopefully improves the stock selection. Similarly, other behavioral scientists suggest to actively seek out contrary opinions by trying to rebut rather than confirm hypothesis and assigning someone to be a bearish analyst. It is also crucial not to anchor on historical information or stock prices; all that matters is the future. This also includes updating initial estimates of intrinsic value and remaining true to buy and sell targets.