Transcript Lecture 1 - University of Washington

Lecture 14
Behavioral Finance

The primary source of this lecture
is from the book by
Hersh Shefrin, “Beyond Greed and
Fear; Understanding Behavioral
Finance and the Psychology of
Investing,” Harvard Business
School Press, 2000.
Behavioral Finance
Financial practitioners commit errors
because:
1. They use rules of thumb or
heuristics.
2. They are influenced by form
as well as substance.
 These errors cause market prices to
deviate from fundamental values.

Heuristic-Driven Bias

Heuristic refers to the process by
which people find things out for
themselves, usually by trial and
error.

Trial and error leads people to
develop rules of thumb which
often causes errors.
Heuristic-Driven Bias

Representativeness
> Refers to judgments based on
stereotypes.
> People believe that a small
sample is representative of the
entire population.
Heuristic-Driven Bias

Gambler’s fallacy
> In a coin toss, what is the
probability of a tail after five
straight heads?
> The law of large numbers.
If x is a random variable with
E[x]=m, then the sample mean
of x approaches m as the
sample size increases.
Heuristic-Driven Bias

Overconfidence
> People set overly narrow
confidence intervals.
> They get surprised more
frequently than they
anticipate.
Heuristic-Driven Bias

Anchoring-and-Adjustment
> People do not adjust their
expectations sufficiently in
response to new information.
> They are anchored to their
initial expectations.
Predictions
DeBondt’s study “Betting on
Trends.”
 People tend to naively project
trends that they perceive in the
charts.
 They are overconfident about their
ability to predict accurately.
 Their confidence intervals are
skewed.

Heuristic Diversity

Those that bet on trends
extrapolate.

Those who commit gambler’s
fallacy predict reversal.

Both predictions stem from
representativeness.

They differ because of different
perspectives.
Heuristic-Driven Bias

Confirmation bias—the illusion of
validity.
> Most people have difficulty
assessing the validity of
statements like “if X, then Y”.
> They look for confirming
evidence (X and Y hold) instead
of disconfirming evidence
(where X and not-Y hold.)
Bullish Sentiment Index
The Bullish Sentiment Index
measures the percent of newsletter
writers that are bullish.
 The indicator is viewed as a
contrarian indicator.
 “Since most advisory services are
trend followers, they are most
bearish at market bottoms and
least bearish at market tops.”

Heuristic-Driven Bias

The fear of regret leads to loss
aversion.

Regret is more than the pain of a
loss. It is the pain associated with
feeling responsible for the loss.

Hindsight bias—events are viewed
as far more likely than they looked
before the fact.
Heuristic-Driven Bias

Loss aversion—regret makes losses
very painful.

Faced with a loss, which choice
would you make.
A. A sure loss of $7,500.
B. A 25% chance of losing $0 and
a 75% chance of losing $10,000.
Heuristic-Driven Bias

“My intention was to minimize my
future regret. So I split my
contribution fifty-fifty between
bonds and stocks.”
Harry Markowitz
Heuristic-Driven Bias

Aversion to ambiguity—There is a
fear of the unknown.

The bailout of Long-Term Capital
Management.
“It was a very large unknown. It
wasn’t worth a jump into the abyss
to find out how deep it was.”
Herbert Allison, Merrill Lynch President.
Frame Dependency

The form used to describe a decision
problem is called its frame.

Traditional finance assumes that
frames are transparent.

Non-transparent frames can affect
decisions, thereby making behavior
frame dependent.
Frame Dependency
First decision: Choose
A. A sure gain of $2,400, or
B. A 25% chance to gain $10,000
and a 75% chance to gain nothing.
 Second decision: Choose
C. A sure loss of $7,500, or
D. A 75% chance to lose $10,000
and a 25% chance to lose nothing.

Frame Dependency
People separate choices into mental
accounts in order to help maintain
self control.
 The dividend puzzle.
 For some investors dividends are a
way to maintain self control.
 Don’t dip into capital is a self control
mechanism.

Frame Dependency

People split dividends and capital
gains into separate mental
accounts to protect funds
designated for other goals.

Selling assets to satisfy current
consumption can cause regret if
the security price increases after it
is sold.
Frame Dependence

Money illusion.
> People naturally think in terms of
nominal values.
> Emotional reaction is driven by
nominal values even though
people know the affect of
inflation.
Picking Stocks

Investors are consistent in the
mistakes that they make.

They believe that:
1. Growth stocks outperform value
stocks.
2. Winners continue to be winners
and losers continue to be losers.
3. Strong revenue growth will
continue.
Picking Stocks

Analysts recommend stocks of past
winners more often than stocks of
past losers.

Investors believe that good stocks
and the stocks of good companies.

The DeBondt and Thaler study.
Picking Stocks
It is difficult to arbitrage away
these heuristic-driven biases.
 Some losers will continue to be
losers.
 The strategy may not work in any
given year.
 Hindsight bias will set in and the
investor will feel like a fool.

Picking Stocks
Long Term Capital Management
example.
 Royal Dutch Petroleum and Shell
Transport and Trading jointly own
Royal Dutch/Shell.
 All cash flow of Royal Dutch/Shell
are divided on a 60/40 basis.
 The market value of Royal Dutch
should be 1.5 times that of Shell.

Picking Stocks
Shell Transport has traditionally
traded at an 18% discount relative
to Royal Dutch.
 When the discount widened, LTCM
bought Shell Transport and sold
Royal Dutch short.
 Unfortunately, the discount
widened.

Analysts’ Earnings Predictions

Positive (negative) earning
surprises are followed by positive
(negative) earning surprises for up
to three quarters.

Trading strategies based on postearnings-announcement drift
generate abnormal returns.
Analysts’ Earnings Predictions

Analysts and investors remain
overconfidently anchored to their
prior view of the company’s
prospects.

They underweight evidence that
disconfirms their prior views and
overweight confirming evidence.
Analysts’ Earnings Predictions

Analysts and investors place little
weight on changes in earnings
unless there is salient news
associated with the announcement.

They tend to overreact to salient
information.
Analysts’ Earnings Predictions

Analysts long-term forecasts are
overly optimistic.

Analysts are highly dependent on
executives of companies they follow
for their information.

Analysts are rewarded for bringing
business to their company.
Analysts’ Earnings Predictions

Analysts’ short-term forecasts tend
to be pessimistic.

Companies try to encourage
pessimism just prior to earning
announcements.

Stock prices jump when earnings
beat the forecasts.
Earnings Manipulation
People have a tendency to evaluate
outcomes relative to some
benchmark.
 Three thresholds.
1. Zero earnings.
2. The previous periods earnings.
3. Analysts’ consensus forecast.

“Get-Evenitis”

Most people exhibit loss aversion.

Consequently, they tend to hold
their loses too long and sell their
winners too early.

Realizing a loss is painful, despite
the possible tax advantage.
“Get-Evenitis”

Most people exhibit loss aversion.

Consequently, they tend to hold
their loses too long and sell their
winners too early.

Realizing a loss is painful, despite
the possible tax advantage.
“Get-Evenitis”

Collapse of Barings Bank.

Apple Computer’s Newton project.

“The definition of a good trader is a
guy who takes loses.”
Alan Greenberg, Bear Stearns
Company chairman
Portfolio Decisions

Investor’s decisions are driven by
fear, hope and goal aspirations.

Most investors think about portfolios
in layers.
> Bottom layer for security.
> Middle layers for specific goals.
> Top layer earmarked for potential.

Each layer is treated separately.
Portfolio Decisions

Investors are overconfident about
their abilities to pick winners.

They take bad bets because they
fail to realize that they are at an
informational disadvantage.
Portfolio Decisions
Investors trade more frequently than
prudent because of over-confidence
and a false sense of control.
 Individual’s fail to diversify.
> The rule of five.
> Naive diversification—place an
equal amount across all funds
available in their 401(k) plan.

Security Design

Financial markets are beginning to
provide securities that appeal to
both hope and fear.

British premium bonds—safe
principal plus lottery tickets in lieu
of interest.

Life USA’s Annu-a-dex—guaranteed
45% return over 7 years plus 50%
of the market’s return over 45%.
Security Design

Dean Witter’s Principle Guaranteed
Portfolio—$50,000 investment in a
zero-coupon bond with face value
of $50,000 and risky stocks.

A home made version—buy money
market funds and use the interest
to purchase call options.
Financial Advisors

Having a financial advisor is like
holding a psychological call option.

Self-attribution bias—the investor
attributes good outcomes to skill
and bad outcomes to someone
else or bad luck.