1. Pauline Shum Schulich School of Business York University
Behavioral Finance
Pauline Shum
Schulich School of Business
York University

2. Agenda What is behavioral finance?
Behavioral biases and their implications for investment beliefs and decision making

3. 1. What is behavioral finance?
Relatively new school of thought
Gradually recognized as a legitimate field in finance in the 1990s
A marriage of psychology and finance
It says psychology plays a role in financial decision making
Is it a surprise that we are human?

4. 1. What is behavioral finance?
Cognitive errors and biases affect investment beliefs, and hence financial choices
Poses a challenge to the traditional idea that markets are always efficient

5. 1. What is behavioral finance?
Why should we care?
To better understand our own investment behavior, and that of others  set the right incentives for clients, pension plan design
To better understand asset management companies and active strategies that base their investment philosophy on behavioral finance
Even retail banking is talking to customers about it (e.g., CIBC Imperial Service: Investor Psychology 101)

6. 2. Behavioral biases
Summary of well-known cognitive errors and biases, and their impact on investment beliefs and decision making

7. Overconfidence Better than average: Illusion of control
“I’m a better than average driver.”
Illusion of control
“I won’t have a car accident.”

8. Overconfidence
As applied to investments, overconfidence may lead to excessive trading
“Trading is hazardous to your wealth” by Barber and Odean (2000)
Find that portfolio turnover is a good predictor of poor performance: Investors who traded the most had the lowest returns net of transaction costs
Mostly confined to one particular gender…

9. Why don’t they learn?
Why don’t overconfident investors learn from their mistakes?
Self-attribution bias
Attribute successes to their own ability
Blame failures on bad luck

10. Loss aversion Pleasure Small pleasure -10% Loss Gain +10% Big pain

11. Narrow framing Loss aversion may be a consequence of narrow framing
Narrow frame of evaluation
Limited set of metrics in evaluating investments
Myopic behavior even though investment is long-term
Obsessive about price changes in a particular stock
Can lead to over-estimation of risk

12. Narrow framing/loss aversion
Consequence:
Tendency to sell winners too soon, and hang on to losers for too long
E.g., Nortel
“If I haven’t realized the loss, then it isn’t yet a loss.”

13. Myopic loss aversion Example: Currency hedging
Influenced by recent events or stick with long-term view?
Combination of loss aversion and representativeness

14. Representativeness
Making decisions based on recent history, or a small sample size
Believe that it is representative of the future, or the full sample

15. Representativeness May lead to “excessive extrapolation”
Erroneously think that recent performance is representative of longer term prospects
Results: Investors chase past winners
Overreacts to glamour stocks (e.g., Technology bubble)
Overreacts to bad news which may be temporary (thus creating “value opportunities”)
Creates short-term momentum, but long-term reversal in returns

16. Representativeness Let’s look at performance of portfolio managers
Quartile 1 55 21 21 55 2 11 12 12 3 9 10 4 14
Based on a sample of 220 U.S. equity managers (Wood, 2006)

17. Representativeness
Another example of excessive extrapolation: Sample size
Erroneously think that a small sample size is representative of the population
E.g. opinion of a car vs. investing in the car company

18. Regret Avoidance Leads to procrastination and inertia
Status quo bias
Good intentions but poor follow-through
Results in delayed saving and investment choices
Defined Contribution Plans: A significant number of accounts are kept in their default allocation for a long time

19. Ambiguity aversion Sticking with the familiar
Results in under-diversification
Home bias, local bias
Bias is more substantial if take into account human capital

20. Impact on committee decision making
Lack of diversity in membership could pose a problem
Common knowledge syndrome: less willing to share unique or different information for the sake of social cohesion
It takes 16 similarly-minded committee members to generate the diversity of 4 different-minded members

21. Final Note
Some empirical findings are more respected in the profession than others
More controversial studies: Stock market returns affected by number of hours of sunshine, seasonal changes …etc.
More and more asset management companies are using the “behavioral finance” buzz word (mostly value strategies)

22. Final Note Can the two schools of thought co-exist?
How I like to think about it:
Short-term: markets can be inefficient due to investor behaviour
Long term, markets are efficient (on average)