Psychology and Investments Andrei Simonov Behavioral Finance 14/01/2019

Intro:Behavioral finance as discipline Violations in expected utility theory Kahmnemann-Tversky Bounded rationality Classical Finance is based on the notion of Homo Chicagoan Rational Do keep track of all available investment opportunities and correctly assess probabilities of all and every event Can process tons of information instantly and costlessly We will focus on the second part. Behavioral Finance 14/01/2019

Outline Investors’ perception of their knowledge, overconfidence and overoptimism Trading behavor Investors’ perception of stochastic processes of asset prices Investors’ perception of value Risk-return trade-off Behavioral Finance 14/01/2019

Word of caution: BF is relatively new area. As such, some of the definitions are vague. Sometimes the same term refer to completely different phenomena. Behavioral Finance 14/01/2019

Overconfidence and Optimism (1) Rule of thumbs: ”I am 99% sure” should be translated as ”I am 70-90% sure” Empirical Results: people do overestimate the precision of their knowledge Alpert & Raiffa 82 Stael von Holstein 1972 –inv. bankers Cooper et. al. 88 - enterpreneurs Behavioral Finance 14/01/2019

Cooper et. al: Entrepreneurs’ perceived chances for success Behavioral Finance 14/01/2019

Overconfidence and Optimism (3) People overestimate their ability to deal with task. The more important the task is the greater is the optimism (Frank 35) 82% of students are in top 30% of their class (Svenson) 81% of 2994 new business owners are sure that their firm has 70% or better chances of survival. Only 39% thought that the business like theirs has similar chances (Cooper). BAD GOOD Behavioral Finance 14/01/2019

Overconfidence and Individual Investors: Barber & Odean (1) Individual Investors Behavior: H1: Overconfident investors’ buy transactions should underperform H2: Overconfident investors’ sell transactions should overperform Transaction cost for ”round-trip” 6% buys should overperform sells by 6% Result of Barber&Odean 4mo: rBUY-rSELL -2.5% 1 yr: rBUY-rSELL -5.1% 2 yr: rBUY-rSELL -8.6% Behavioral Finance 14/01/2019

Overconfidence and Individual Investors: Barber & Odean (2) Turnover: The more investors trade the more they reduce their return. Partitioning investors into quintiles: Quitile that trades unfrequently underperform bu-and-hold strategy for 0.25% annually. Active traders underperformed 7.04% Gender: ”Boys will be boys” ”Overall, men claim more ability than do women, but this difference emerges most strongly on masculine tasks” Deaux &Farris, 1977 Barber&Odean: Men traded 45% more actively. The difference between returns of men and women is 0.94% Behavioral Finance 14/01/2019

Overconfidence and Individual Investors: De Bondt (1998) (3) AAII members: Overestimate precision of their knowledge (conf. Intervals) Underestimate covariance structure of returns Overoptimistic, especially for stocks they selected Behavioral Finance 14/01/2019

Overconfidence and Individual Investors (4): Illusion of Control Goetzmann & Peles 1997 AAII members(=informed investors) survey On average investors overestimate the performance of ”their” mutual funds by 3.4% If investors have control over choosing the fund, their estimate exceed the real number by 8.6% (vs. 2.4% for defined contributions plans) Illusion of control matters. Internet and online access provides that kind of illusion Barber and Odean: ”Fast dies first” Investors who switch to online trading underperform more than before Metrick (NBER2000) Thades done through online channel are unambiguously less profitable Behavioral Finance 14/01/2019

Overconfidence: what to do? New year resolution list (Kaneman & Riepe): Always analyse ”worst case scenario”, avoid focus on upside Keep the list of past recommendation you made that did not work (Caesar, you are just a man...) Serious stuff: Create sub-account in which investor trades (=gambles) as he/she wish. Typical client invests 5-7% of his portfolio himself with dismal results. Give ’em more control. ”Clients are wanting more details, more paper and more technology” (Hurley 2000) Education matters Behavioral Finance 14/01/2019

Perception of price movements Extrapolation bias: what was going up yesterday will go up tomorrow. Technical analysis Investors may apply law of large numbers to small sequences. Example: fair coin tossing. THTHTHHHHHH -> P(T) = ?, P(H) = ?. Which of the 2 sequences is more likely to occur in a fair coin tossing experiment? HHHHHHTTTTTTHHHHHH HHTHTHHTHTTHTHHTTH Behavioral Finance 14/01/2019

Confirmation Bias August 1987 saw a historically high valuation of dividends, beating out even that of 1929. The result was a 1,000 points crash (Prechter,1997) True, low DivY was followed by low returns in the following year 33 times in 1872-1999. But: Low DivY – high Ret =31 years High DivY – low Ret =31 years High DivY – high Ret =33 years Behavioral Finance 14/01/2019

Confirmation Bias(2) Cure: Statistical analysis. 1year return: no relation annualized 10yr returns: strong positive correlation Ref. Due: Fisher&Statman, JPM 2000 Behavioral Finance 14/01/2019

Investor Sentiment, Bubbles and Crashes Case & Shiller(88): Expectations about future house value appreciation is an increasing function of previous period’ appreciation. Affects the decision to purchase the new house. Frankel & Froot: Long-term $ is overvalued w.r.t. Y, but short term it will go up. Effect of ”magical” thresholds (100Y=1$) $/€ is another good example. Shiller (88): Investors sold in 87 because they believed that the market is going to decline further. Behavioral Finance 14/01/2019

Investor sentiment and funds flow Goetzmann, Massa(99,Y2K): ”behavioral factors can explain 45% in cross-sectional variation in mutual funds returns” Mf flow is by itself responsible for significant % of the resent market run. Those inflows are heavily affected by the opinion of ”experts” and behavioral factors. Behavioral Finance 14/01/2019

Example of Investor’ sentiment: Rose.com 63 companies that change the name from Widget to Widget.com/.net within Jan-Mar 98 80% announcement effect Renaming the company attracts investors with bullish sentiment towards internet stock. ”Rule of thumbs thinking”: change of name = change in strategy. Reacting to non-information Behavioral Finance 14/01/2019

How those decisions are done? Investors are overconfident and overoptimistic. Investors process information based on intuition and set of rules, “bounded rationality”, “satisficing” behavior. Information processing & memory limitations. Lo&Repin NBER8508: Professinal traders make decisions based on intuition. They cannot rationally explain their decisions 10 min. past... What affects investors sentiment? Generally, emotional state of investors. January effect, September Effect Weather: Hirshleifer & Shumway (2001) Good day sunshine positively correlated with daily stock return. No effect of rain and snow… Behavioral Finance 14/01/2019

How investors then select firms? Availability bias: ”Familiarity breeds investment” Huberman: people invest in the company they know. Baby bells stories Moskowitz & Coval (2001): Mutual funds managers prefer to invest in companies that are close to the HQ. Simonov-Giannetti: Same effect exists in Sweden Bondaruk: Effect is economically significant for small investors. 1.5%-3.5% Behavioral Finance 14/01/2019

How investors then select firms? (2) In search of excellence or mediocrity? Behavioral Finance 14/01/2019

They are bad, but returns are good... Behavioral Finance 14/01/2019

Is this example unique? No Moody’s Bankrupt Bond Index shows that bankrupt bonds are superior investments that are normally abandoned by investors at the moment of bankruptcy Behavioral Finance 14/01/2019

Another example: Value vs Another example: Value vs. Growth Past growth negatively correlated with future growth... Behavioral Finance 14/01/2019

Value vs. Growth(2) Forecasters’ errors are strongest for growth companies (extrapolation bias) Behavioral Finance 14/01/2019

And Returns confirm the story... Behavioral Finance 14/01/2019

Investors’ belief about risk & return I would rather have in my stock portfolio just a few companies that I know well than many companies that I know little about [89% agreed ] If you do not do your homework the investment success is unlikely [70%] Investing in stocks is like buying lottery tickets. Luck is everything. [0%] Because most investors do not like risk, risky stocks sell at lower market prices [7%] The risk of the stock depends on whether price is correlated with the market [18%] Behavioral Finance 14/01/2019

Framing Benartzi & Thaler (96): When shown series of 30 one-year return, people allocate 40% to stocks and 60% to bonds. When shown just cummulative 30 yr. return, the allocation was 90:10... Effect of framing for current market entrants. Opportunity example: covered calls Framing: one should use the broader possible frame. Role of education. Behavioral Finance 14/01/2019

Is it all behavioral? No. Information availability plays important role. Neglected firms effect May choose a portfolio very close to the benchmark against which they are evaluated (for example: S&P500 index). Herding: may select stocks that other managers select to avoid “falling behind” and “looking bad”. Window-dressing: add to the portfolio stocks that have done well in the recent past and sell stocks that have recently done poorly. Behavioral Finance 14/01/2019

Summary Investor behavior does have an impact on the behavior of financial markets. How much? Not clear! Both “social” and “psychological” must be taken into account in explaining the behavior of agents in financial markets. Market “anomalies” may be widespread. Behavioral Finance: does not replace but complements traditional models in Finance. Finally, noise risk is just another risk factor... Biases are not necesserily problems. They might provide you opportunities as well. But exploiting those opportunities means to face some other risks (RDS case) Behavioral Finance 14/01/2019