1 BM410: Investments Behavioral Finance Much of this material is taken from the book The Psychology of Investing by John R. Nofsinger, Prentice Hall, 2002

Objectives A.Understand behavioral finance B.Understand why we should learn behavioral finance C.Understand other alternatives to traditional finance D.Understand how behavioral finance can help us become better investors

3 A. Understand Behavioral Finance What is behavior finance? Behavioral finance is an upcoming field of financial theory that attempts to further understand securities prices and investor behavior. Why did it come about? The field of Finance is based on two rigid assumptions: 1. People make rational decisions 2. People are unbiased about their predictions of the future Are these assumptions really valid?

4 Behavioral Finance (continued) Are their specific aspects of “personal behavior” that go contrary to these rigid assumptions? Behavioral finance tries to incorporate “personal behavior” in an effort to extend finance beyond these narrow assumptions

5 Questions Any questions on behavioral finance?

6 B.Why should we learn Behavioral Finance? Why should we learn behavioral finance? 1. You can learn psychological biases that affect investment decision making 2. You can understand how these biases affect investment decisions 3. You can see how poor decisions reduce your wealth 4. You can recognize and avoid these poor decisions and become a better investor

7 Behavioral Finance (continued) Individual Biases: Illusion: Which is larger? While we all know the answer, it still looks larger

8 Behavioral Finance (continued) Individual Biases: Prediction – be sure!!! The brain does not work like a computer. Instead, it processes information through shortcuts and emotional filters to shorten the analysis time These filters and shortcuts lead to predictable errors in investing Activity Following are questions. Enter your best guess so you are 90% sure the answer lies between the two guesses. If you follow this guidance, you should get 9 of 10 answers right

9 Behavioral Finance (continued) Answer the questions so you are 90% sure the answer is between your minimum and maximum guess. 1. Average weight of adult blue whale (lbs)? 2. Year the Mona Lisa was painted? 3. Number independent countries in 2000? 4. Air distance (miles) between Paris and Sydney? 5. How many bonds in the human body? 6. How many total combatants were killed in WW1? 7. How many books are in the Library of Congress in 2000? 8. How long is the Amazon river (miles)? 9. How fast does the earth spin at the equator (mph)? 10. How many transistors are in the Pentium III computer processor

10 Behavioral Finance (continued) 1. Weight of adult blue whale 250,000 lbs 2. Year the Mona Lisa was painted? 1, Independent countries in 2000? Distance between Paris and Sydney? 10, How many bonds in the human body? Combatants killed in WW1? 8.3 million 7. Books are in the Library of Congress? 18 million 8. How long is the Amazon river (miles)? 4,000 miles 9. How fast does the earth spin? 1,044 mph 10. Transistors in the Pentium III? 9.5 million

11 Behavioral Finance (continued) How many did you get right? Since you were supposed to be 90% sure (and you could make your guess as large as you wanted), you should have only missed 1 of 10. Most will miss between 5 and 9 questions. This is an example of prediction error. We think we are more sure of our forecasts than we should be.

12 Questions Any questions on why we should learn behavioral finance?

13 C. Are there Other Alternatives? Are there other alternatives to explaining investor behavior than rational behavior and unbiased predictions? What about: Cooperation and Altruism Cooperation may be a viable strategy. People’s motives may lead to actions different than conventional rationality, i.e. selfishness, would suggest What about the people in 4 th Nephi who had “all things in common among them; therefore there were not rich and poor.” (4 Nephi 1:3)

14 Other Alternatives (continued) Bidding and the Winner’s Curse Bidding may lead to a suboptimal result when you bid your fair value Assuming everyone else has the correct value, if you win you overpaid Don’t bid your fair value

15 Other Alternatives (continued) Endowment Effect Value increases by virtue of ownership Once you own something, its value increases, at least to you Did the value really increase with your purchase?

16 Other Alternatives (continued) Status Quo Bias Individuals prefer the status quo over a new, more preferable position There is an aversion to change, even if the change is for the better Change may be good

17 Other Alternatives (continued) Loss Aversion Losses are given more weight than potential gains in any position These weights are more than utility theory would suggest What should this view on losses do to the way you form portfolios

18 Other Alternatives (continued) Mental Accounts Investors keep mental accounts rather than viewing individual assets as part of a total portfolio We try to save ourselves from ourselves We borrow 12% for a car versus taking the money from our kids college savings at 1% We know we may not pay it back if we do not borrow from a bank

19 Other Alternatives (continued) Winning by Losing We actively trade stocks instead of buying index funds which generally outperform (and we do not have the time, energy, or the money to try to beat the market) Yes, but at least we have the chance of higher returns and we are staying in the market

20 Other Alternatives (continued) Seeking solace We follow newspaper/newsletter advice and recommendations which have been shown to under- perform Yet, but at least we are investing

21 Other Alternatives (continued) Fun We trade for fun and excitement instead of gain This is OK, but make sure your fun money is no more than 5% of the value of your portfolio—that way you don’t lose too much At least we are in the market

22 Other Alternatives (continued) Percentages We move in and out of asset classes and stocks instead of keeping specific asset class percentages relatively constant (within our minimum and maximum amounts) and reducing trading costs which results in lower returns True, but it may be better than keeping your assets in a money market account

23 Other Alternatives (continued) Calendar effects Impact of tax and reporting is not consistent with theory. Behaviorists point out: Returns are a function of cash flows, which tend to be concentrated around calendar turns Institutions “window dress,” i.e., want to make their portfolios look good, so they sell unwanted and buy desired stocks for period- end reports Print media generally print recommendations around calendar turns and reporting periods

24 Other Alternatives (continued) Cash dividends Dividends are irrelevant in the absence of taxes and transactions costs. Behaviorists suppose: Dividends can be justified by “mental accounts” which increase current income at the expense of “higher self control” equity accounts Older high-net worth investors value dividends more highly and concentrate in high income securities (preferred habitat)

25 Other Alternatives (continued) Overreaction Investors assign a probability to asset returns based on past theory Appropriate reaction to a negative event is to update a prior probability to the most recent even Overreaction is when they assign too high a value

26 Other Alternatives (continued) Mean reversion Prices tend to correct themselves as investors correct for overreaction Prices tend to revert to the mean

27 Questions Any questions on behavioral finance and explaining individual behavior?

28 D. How Behavioral Finance can help us become Better Investors Strategies for overcoming psychological biases 1. Understand your biases Recognizing them is an important step in avoiding them Are you overconfident, trade too often, or just like to trade? 2. Know why you are investing Know your goals. Investing is a means to an end, not an end in itself. Review your goals often

29 Becoming Better Investors (continued) 3. Have Quantitative Investment Criteria, i.e. your Investment plan, and follow that plan Having a plan allows you to avoid investing on rumor, emotion or other biases Develop a good plan, and follow that plan closely

30 Becoming Better Investors (continued) 4. Follow the Principles of Successful Investing Following the principles discussed in class will help you to avoid many of the problems faced by other investors Remember: Know yourself, know your goals, invest low cost and tax efficiently, invest long-term, etc. It will save you thousands of dollars in the long- term

31 Becoming Better Investors (continued) 5. Control your investing environment Limit activities that magnify your psychological biases 1. Check your stocks once per week (when you do your budget), not once per hour It avoids excess trading, rumors, pride, playing, and may help you to keep your job 2. Make trades once per month on the same day of each month This avoids the problem of too-frequent trading and trading on rumors

32 Becoming Better Investors (continued) 3. Review your portfolio annually and rebalance as needed But rebalance in the most tax-effective manner Add to underweight assets with new funds from investing Make asset allocation changes using donations of appreciated assets to charity, then use those funds you would have donated to buy the underweight assets

33 Becoming Better Investors (continued) Joseph Nofsinger adds these additional suggestions: 1. Avoid stocks selling for less than $5 per share. Most investment scams are conducted in penny stocks. 2. Chatrooms and message boards are for entertainment purposes only. Overconfidence is fostered in these places. 3. Before you place a trade on a stock that doesn’t meet your criteria, remember that it is unlikely that you know more than the market. Do you?

34 Becoming Better Investors (continued) 4. Have a goal to earn the market return. Active trading is motivated by the desire to earn a higher return. And active trading usually fosters psychological biases and ultimately contributes to lower returns. 5. Review your psychological biases annually. Successful investing is more than knowing about stocks. It includes knowing yourself. John R. Nofsinger, The Psychology of Investing Prentice Hall, 2002, p

35 Review of Objectives A. Do you understand behavioral finance? B. Do you understand why we should learn behavioral finance? C. Do you understand other alternatives to traditional finance? D. Do you understand how behavioral finance can help us become better investors?