CHAPTER ELEVEN Practical Investment Management Robert A. Strong BEHAVIORAL FINANCE

South-Western / Thomson Learning ©  Introduction  Established Behaviors  Representativeness Heuristic  Loss Aversion  Fear of Regret  Myopic Loss Aversion  Herding  Anchoring  Illusion of Control  Prospect Theory Outline

South-Western / Thomson Learning ©  Established Behaviors … continued  Mental Accounting  Asset Segregation  Hindsight Bias  Overconfidence  Framing  Availability Heuristic  Illusion of Truth  Biased Expectations  Reference Dependence Outline

South-Western / Thomson Learning ©  Mistaken Statistics  The Special Nature of Round Numbers  Extrapolation  Percentages vs. Numbers  Sample Size  Apparent Order  Regression to the Mean Outline

South-Western / Thomson Learning © Introduction  There are three sub fields to modern financial research.  Theoretical finance is the study of logical relationships among assets.  Empirical finance deals with the study of data in order to infer relationships.  Behavioral finance integrates psychology into the investment process.

South-Western / Thomson Learning © “Financial economists have been aware for a long time that in laboratory settings, humans often make systematic mistakes and choices that cannot be explained by traditional models of choice under uncertainty.” – Paul Pfleiderer Introduction

South-Western / Thomson Learning © Behavioral finance research focuses on  how investors make decisions to buy and sell securities, and  how they choose between alternatives. Introduction

South-Western / Thomson Learning © Established Behaviors Representativeness Heuristic  The representativeness heuristic takes one characteristic of a company and extends it to other aspects of the firm.  In particular, many investors believe a well- run company represents a good investment.

South-Western / Thomson Learning © Representativeness Heuristic Insert Table 11-1 here.

South-Western / Thomson Learning © Representativeness Heuristic Insert Figure 11-1 here.

South-Western / Thomson Learning © Loss Aversion  Investors do not like losses and often engage in mental gymnastics to reduce their psychological impact.  Their tendency to sell a winning stock rather than a losing stock is called the disposition effect in some of the behavioral finance literature. Established Behaviors

South-Western / Thomson Learning © Fear of Regret  Investors do not like to make mistakes.  Rather than being unable to decide among attractive alternatives, their focus is on the negative: What if they pick the wrong stock? Established Behaviors

South-Western / Thomson Learning © Myopic Loss Aversion  Investors have a tendency to assign too much importance to routine daily fluctuations in the market.  Abandoning a long-term investment program because of normal market behavior is sub optimal behavior. Established Behaviors

South-Western / Thomson Learning © Herding  Herding refers to the lemming-like behavior of investors and analysts looking around, seeing what each other is doing, and heading in that direction.  There may not have been safety in numbers, but there probably was some comfort in them. Established Behaviors

South-Western / Thomson Learning © Anchoring  Our decisions can be influenced by extraneous information contained in the problem statement.  For example, investors tend to remember the price they paid for a stock, and this information influences their subsequent decisions about what to do with it. Established Behaviors

South-Western / Thomson Learning © Illusion of Control Established Behaviors  We like to pretend that we can influence the resulting score by varying the force with which we throw a dice.  Similarly, investors like to look at charts, although charts are theoretically not helpful in predicting the future prospects for a stock.

South-Western / Thomson Learning © Prospect Theory  Risk averse investors get increasing utility from higher levels of wealth, but at a decreasing rate.  Research shows that while risk aversion may accurately describe investor behavior with gains, investors often show risk seeking behavior when they face a loss. Established Behaviors

South-Western / Thomson Learning © Prospect Theory Insert Figure 11-2 here.

South-Western / Thomson Learning © Prospect Theory Insert Figure 11-3 here.

South-Western / Thomson Learning © Prospect Theory Insert Table 11-2 here.

South-Western / Thomson Learning © Mental Accounting  Mental accounting refers to our tendency to “put things in boxes” and track them individually.  For example, investors tend to differentiate between dividend and capital dollars, and between realized and unrealized gains. Established Behaviors

South-Western / Thomson Learning © Asset Segregation  Asset segregation refers to our tendency to look at investment decisions individually rather than as part of a group.  The portfolio may be up handsomely for the reporting period, but the investor will still be concerned about the individual holdings that did not perform well. Established Behaviors

South-Western / Thomson Learning © Asset Segregation Insert Table 11-3 here.

South-Western / Thomson Learning © Hindsight Bias  Hindsight bias refers to our tendency to remember positive outcomes and repress negative outcomes.  Investors remember when their pet trading strategy turned up roses, but do not dwell on the numerous times the strategy failed. Established Behaviors

South-Western / Thomson Learning © Overconfidence  Overconfidence refers to our tendency to believe that certain things are more likely than they really are.  For example, most investors think they are above-average stock pickers. Established Behaviors

South-Western / Thomson Learning © Framing  The concept of framing involves attempts to overlay a situation with an implied sense of gain or loss.  It is easier to pay $3,400 for something that you expected to cost $3,300 than it is to pay $100 for something you expected to be free. Established Behaviors

South-Western / Thomson Learning © Availability Heuristic  The availability heuristic is the contention that things that are easier to remember are thought to be more common. Established Behaviors

South-Western / Thomson Learning © Illusion of Truth  People tend to believe things that are easier to understand more readily than things that are more complicated.  Most investors prefer a low PE ratio, since they prefer to buy low-priced stocks with high earnings. Established Behaviors

South-Western / Thomson Learning © Biased Expectations  Our prior experience causes us to anticipate certain relationships or characteristics that may not apply outside our frame of reference. Established Behaviors

South-Western / Thomson Learning © Reference Dependence  Suppose you demand $75,000 in salary for the next year. Your boss offers you $60,000 and if things go to arbitration, $50,000.  People currently earning $60,000 tend to accept the offer, while people currently earning $75,000 tend to take the gamble and go to arbitration. Established Behaviors

South-Western / Thomson Learning © Mistaken Statistics  There are some other tendencies that may have a behavioral influence on asset values.  These involve “innumeracy” or a misunderstanding of the likeliness of an event or series of events.

South-Western / Thomson Learning © The Special Nature of Round Numbers Mistaken Statistics  Given a giant lottery wheel with numbers from one to one thousand, many of us would find a random outcome like 287 to be more reasonable than the “unusual” outcome of 1,000.  Similarly, investors tend to make disproportionate use of round numbers when placing stop or limit orders.

South-Western / Thomson Learning © Extrapolation  We have a tendency to assume that the past will repeat itself and to give too much weight to recent experience.  A belief that recent occurrences influence the next outcome in a sequence of independent events is known as the gambler’s fallacy. Mistaken Statistics

South-Western / Thomson Learning © Percentages vs. Numbers  Suppose the incidence of a particular disease rose from 10 in a million to 13 in a million.  We would likely find that to many people, 3 more cases is not a cause for concern, although a 30% increase is. Mistaken Statistics

South-Western / Thomson Learning © Sample Size  There are many instances where people draw incorrect inferences from statistical data.  The probability of a given person winning the lottery twice is very remote. However, the probability of someone winning twice is actually reasonably good. Mistaken Statistics

South-Western / Thomson Learning © Sample Size Insert Table 11-4 here.

South-Western / Thomson Learning © Apparent Order  A single occurrence of an unlikely event becomes much more likely as the sample size increases.  However, many people will find a run of six consecutive numbers in a daily state lottery extremely unlikely. Mistaken Statistics

South-Western / Thomson Learning © Regression to the Mean  The regression to the mean concept states that given a series of random, independent data observations, an unusual occurrence tends to be followed by a more ordinary event.  Hence, chasing last year’s winning mutual fund is likely to be a losing strategy, although many investors do precisely this. Mistaken Statistics

South-Western / Thomson Learning ©  Introduction  Established Behaviors  Representativeness Heuristic  Loss Aversion  Fear of Regret  Myopic Loss Aversion  Herding  Anchoring  Illusion of Control  Prospect Theory Review

South-Western / Thomson Learning ©  Established Behaviors … continued  Mental Accounting  Asset Segregation  Hindsight Bias  Overconfidence  Framing  Availability Heuristic  Illusion of Truth  Biased Expectations  Reference Dependence Review

South-Western / Thomson Learning ©  Mistaken Statistics  The Special Nature of Round Numbers  Extrapolation  Percentages vs. Numbers  Sample Size  Apparent Order  Regression to the Mean Review