Behavioral Finance

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 its meaning  Some individuals/agents may behave irrationally or against predictions, but in the aggregate they become irrelevant. Markets  Quickly incorporate all known information  Represent the true value of all securities

Behavioral Finance Provides an Overlay to the Standard Theory of Finance by Stating: Investors  Are not totally rational  Often act based on imperfect information  There are systematic patterns or cognitive errors that do not go away in the aggregate, such that there is a positive probability that the ‘marginal investor’ will exhibit 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 you take the bet? Write it down.

Loss Aversion The Disproportion of Gain and Loss Most people want to gain between 2 and 2.5 times as much as they put at risk Most people will want a chance to win at least $20,000 before they will play Simply put, people don’t like to lose money

Loss Aversion The Nature of Risk Your risk profile will change over time– often based on market conditions Your risk pendulum can swing dramatically

Loss Aversion To Do List Devote significant attention to assessing risk Assess your risk tolerance at least once per year possibly using a risk tolerance questionnaire Assess your gains and losses less frequently

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 what they might lose (from Loss Aversion)

Narrow Framing Now, assume you have a net worth of $2 million. Would you accept the proposition now? Most people say Yes  People become less risk averse as their frame of reference broadens

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

Narrow Framing Investing is a series of “propositions,” not a single event Performance should always be viewed within the context of your total net worth (as opposed to individual investments) Look at long-term goals, not short-term results

Disposition Effect The disposition effect refers to people’s tendency to:  Hang on to losers too long  Sell the winners too soon This allows them to enjoy the feeling of winning faster and defer the pain of loss

Disposition Effect Terrance Odeon study determined: Investors are 1½ times more likely to sell winners over losers One-year after sale the losers under- performed the winners that were sold by an average of 3.5%

Disposition Effect To Do List Consider some of the tax advantages of selling losing investments Always measure success in terms of progress toward long-term goals

Anchoring Take the last three numbers of your Social Security number and add 400. Now... Attila and the Huns invaded Europe and penetrated deep into what is now France where they were defeated and forced to return eastward. In what year did Attila’s defeat occur?

Anchoring Anchor Mean Answer Answer: 451 AD Results: The artificial date affects the estimate!

Anchoring Anchors affect an investor’s frame of reference Common investment anchors  Investment indices (DJIA, S&P 500)  CNN  Other financial advisors  Cocktail party chatter  Neighbors, relatives, co-workers

Anchoring Be aware of investment anchors Use relevant benchmarks in comparing your investment portfolio Be cognizant of long-term goals, not short- term fluctuations

Naïve Diversification Allocation 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 Fixed Income  34/66 Stock/Bond

Naïve Diversification Make sure you are properly diversified Don’t let investment options dictate your asset allocation Work with your financial advisor to determine asset classes that will maximize return and reduce risk

Mental Accounting You have just been given $300. Choose between:  50% chance to win $100 and 50% chance to lose $100 (A)  No further bets(B) 70% chose “A”

Mental Accounting You’ve not been given anything. Choose between:  50% chance to win $400 and 50% 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 state of wealth Instead they focus independently on their different accounts  Retirement (401(k), IRA, etc.)  Children’s education  Taxable investment accounts  Dividends  Company stock or stock options

Mental Accounting To Do List Understand that keeping separate “mental accounts” often makes investors more conservative than they naturally are Measure success in terms of your overall state of wealth

Herding Investors have a tendency toward “herd behavior” “Line” study on the effects of herd behavior Disproportionate flow of money into four and five-star rated mutual funds Ratings have a lack of predictive value

Regret The Story of John and Mary John owns shares of Company A. He considers selling his shares and buying stock in Company B, but decides against it. He now finds he would have been better off by $20,000 if he had switched to Company B Mary owns shares in Company B, but switched to Company A. She finds she would have been better off by $20,000 if she had kept her shares of Company B Who is more upset, John or Mary?

Regret Answer: Mary People typically regret errors of commission more than errors of omission.

Media Response Study of the effects of news on investment decisions:  Two groups: one received news and one did not  The group with no news outperformed the group that received news

Media Response People often feel the need to react to new information News is often irrelevant to long-term performance and is often misinterpreted Information overload can cause stress

Media Response Advice:  Stick with a long-term investment strategy  Turn your televisions off when it comes to investment news  Don’t feel you need to react to every bit of 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 associated with Loss Aversion and Regret Excessive conservatism associated with Narrow Framing and Mental Accounting Loss of confidence caused by Media Response, Herding and Anchoring Optimism minimizes the roles of uncertainty and chance 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, “hot dot” products and day-to-day performance. Stick with a long-term investment strategy Work with a financial professional. Financial professionals determine how these tendencies may be affecting the way you invest and take steps to remedy these tendencies