Ashish Mali Josh Cavers Ian Herle Lindsey Polishuk Behavioral Finance Ashish Mali Josh Cavers Ian Herle Lindsey Polishuk

Standard and Behavioral Finance Biases Rational Choice QUIZ AGENDA Standard and Behavioral Finance Biases Rational Choice QUIZ

Standard Finance Investors are rational Markets are efficient Investors should design their portfolios according to the rules of Mean-Variance portfolio theory Expected returns are a function of risk and risk alone

What is behavioral finance? Describes the behavior of investors and managers; it describes outcomes of interactions between investors and managers in financial and capital markets Doesn’t follow four parts of standard finance

Behavioral finance Investors are not rational, they are normal Markets are not efficient Investors design portfolios according to the rules of Behavioral Portfolio Theory Expected returns are determined by more than risk. “Behavioral Asset Pricing Theory”

Normal? Cognitive biases and emotions come into play E.g. not realizing loses because it brings pain and regret “I’ll kick myself if I sell for $1 those dotcom shares I bought for $100. maybe I should wait to see if the stock recovers.”

Market Efficiency Stocks are always equal to its intrinsic value You can not “beat the market” Much evidence that stock prices regularly deviate from price E.g. crash in 1987

Behavioral Portfolio Theory People build portfolios like layered pyramids Each layer represents a specific goal Your risk aversion depends on the specific goal

Behavioral Asset Pricing Theory Stocks with desirable characteristics have lower expected returns Market capitalization and price to book ratio are added to beta to get expected returns Social responsibility?

Cognitive Biases Identify biases affecting investors Consultants duty to educate investors Scientific knowledge is key

Availability Bias Weigh decisions on recent information Stock market Lottery winners Stock market Winners vs. losers Retain perspective Long-term focus

Winners vs. Losers

Anchoring Bias Attach to a reference point Stock market Relevance New & novel concepts Stock market Short-term volatility Company fundamentals Use an array of perspectives

Confirmation Bias Preconceived opinion Hot stock tip Emphasize favorable information Hot stock tip Seek information to prove true Avoid red flags Look for a sober opinion

Hindsight Bias The outcome was predictable Causes overconfidence Resulting incorrect oversimplifications The .com bubble Causes overconfidence

Overconfidence Fund managers & individuals Overconfident manager More trades and lower yields Confident manager Less trades and higher yields Ongoing battle to beat the market Investment techniques require constant refinement

Mental Accounting Investors separate money Paying debt vs. savings Subjective criteria Creates different functions for asset groups Paying debt vs. savings Varying values associated with assets Money is fungible

Rational Choice & Framing of Decision Decision Theory Perception of Situation Normative Rules

Invariance 1): a sure gain of $240 Imagine that you face the following pair of concurrent decisions 1): a sure gain of $240 25% chance to gain $1000 & 75% chance to gain nothing 2): a sure loss of $750 75% chance to lose $1000 and 25% chance to lose nothing

Framing Outcomes 1) Assume yourself richer by $300 than you are today. You have to choose between: a sure gain of $100 50% chance to gain $200 and 50% chance to gain nothing 2) $500 richer than today a sure loss of $100 50% chance to lose nothing and 50% to lose $200

Rational Choice Assumptions in economics occur when certainty in market is present

What Money Type Are You? Our decisions about money are often driven by psychological factors over which we have little conscious control Personality tests help to recognize which errors are commonly made – and to use this knowledge to prevent them So, which type are you?

Mostly A’s You’re an Artisan Advice from the experts Good instincts will prevail You are a “trust your gut” kind of person, who enjoys the thrill of investing Very comfortable at taking risks Tend to lack interest in long-term planning and discipline Advice from the experts Use your confidence But don’t indulge every whim

Mostly B’s You’re an Idealist Advice from the experts Money just isn’t the top priority More concerned with assisting others and improving society rather than building personal wealth Your lack of interest in money matters can be a failure to reach any financial goals - that is, if you have set any Advice from the experts Put your investing on autopilot Have your cause and money too

Mostly C’s You’re a Guardian Advice from the experts Discipline is key to security Greater emphasis is on financial security You are disciplined, patient, organized, and cautious Prefer fixed-income investments to relatively volatile equities Advice from the experts Deploy your discipline Conquer your timidity

Mostly D’s You’re a Rational Advice from the experts Cool reason conquers all You enjoy problem solving, fact finding, and have an interest in science and technology You tend to stay calm in tense situations Advice from the experts Feed your taste for systematic thinking Remember: The market isn’t always rational

QUESTIONS ?