Transcript FIN 365 Business Finance

FIN 462
Private Wealth Management
Topic 18–Behavioral Finance
Larry Schrenk, Instructor
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Today’s Outline
• Standard Theory of Finance
• Overview of Behavioral Finance
• The importance of Behavioral
Finance
• Survey of behavioral characteristics
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Standard Theory of Finance
• Investors
– Are rational beings
– Consider all information and accurately assess its
meaning
– Some individuals/agents may behave irrationally
or against predictions, but in the aggregate they
become irrelevant.
• Markets
– Quickly incorporate all known information
– Represent the true value of all securities
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Behavioral Finance Provides an Overlay to
the Standard Theory of Finance by Stating:
• Investors
– Are not totally rational
– Often act based on imperfect information
– There are systematic patterns or cognitive errors
that do not go away in the aggregate, such that
there is a positive probability that the ‘marginal
investor’ will exhibit a cognitive bias.
• Markets
– May be difficult to beat in the long term
– In the short term, there are anomalies and
excesses
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Behavioral Characteristics
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•
•
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Loss aversion
Narrow framing
Anchoring
Mental
accounting
• Diversification
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Disposition effect
Herding
Regret
Media response
Optimism
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Loss Aversion
• Flip a coin.
• Heads? You lose $10,000.
• Tails? You win!
• How much would you have to win before you
take the bet?
• Write it down.
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Loss Aversion
The Disproportion of Gain and Loss
• Most people want to gain between 2
and 2.5 times as much as they put at risk
• Most people will want a chance to win
at least $20,000 before they will play
• Simply put, people don’t like to lose
money
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Loss Aversion
The Nature of Risk
• Your risk profile will change over
time– often based on market
conditions
• Your risk pendulum can swing
dramatically
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Loss Aversion
To Do List
• Devote significant attention to
assessing risk
• Assess your risk tolerance at least
once per year possibly using a risk
tolerance questionnaire
• Assess your gains and losses less
frequently
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Narrow Framing
• Would you accept this proposition?
– A 50% chance to win $15,000
– A 50% chance to lose $10,000
• Most people would say No
– They want a chance to win at least
twice what they might lose (from Loss
Aversion)
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Narrow Framing
• Now, assume you have a net worth
of $2 million. Would you accept the
proposition now?
• Most people say Yes
– People become less risk averse as their
frame of reference broadens
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Narrow Framing
• Now assume you’ll flip the coin 100
times. Would you accept the
gamble now?
• Again, most people say Yes
– Loss aversion is diminished by
aggregation
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Narrow Framing
• Investing is a series of “propositions,” not
a single event
• Performance should always be viewed
within the context of your total net worth
(as opposed to individual investments)
• Look at long-term goals, not short-term
results
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Disposition Effect
• The disposition effect refers to
people’s tendency to:
– Hang on to losers too long
– Sell the winners too soon
• This allows them to enjoy the
feeling of winning faster and defer
the pain of loss
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Disposition Effect
Terrance Odeon study determined:
• Investors are 1½ times more likely
to sell winners over losers
• One-year after sale the losers
under-performed the winners that
were sold by an average of 3.5%
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Disposition Effect
To Do List
• Consider some of the tax
advantages
of selling losing investments
• Always measure success in terms of
progress toward long-term goals
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Anchoring
• Take the last three numbers of your
Social Security number and add 400.
• Now. . .
• Attila and the Huns invaded Europe
and penetrated deep into what is now
France where they were defeated
and forced to return eastward.
• In what year did Attila’s defeat occur?
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Anchoring
Answer: 451 AD
Results:
•
•
•
•
•
•
Anchor
400-599
600-799
800-999
1000-1199
1200-1399
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Mean Answer
626
660 The artificial date
789 affects the estimate!
865
988
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Anchoring
• Anchors affect an investor’s frame
of reference
• Common investment anchors
– Investment indices (DJIA, S&P 500)
– CNN
– Other financial advisors
– Cocktail party chatter
– Neighbors, relatives, co-workers
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Anchoring
• Be aware of investment anchors
• Use relevant benchmarks in
comparing your investment
portfolio
• Be cognizant of long-term goals,
not short-term fluctuations
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Naïve Diversification
Allocation of various retirement plans:
• TIAA-CREF: One Stock Fund, One Fixed Income
– 50/50 Stock/Bond
• TWA Pilots: Five Stock, One Fixed Income
– 75/25 Stock/Bond
• University of California: One Stock, Four Fixed
Income
– 34/66 Stock/Bond
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Naïve Diversification
• Make sure you are properly
diversified
• Don’t let investment options
dictate your asset allocation
• Work with your financial advisor to
determine asset classes that will
maximize return and reduce risk
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Mental Accounting
• You have just been given $300.
Choose between:
– 50% chance to win $100 and
50% chance to lose $100
(A)
– No further bets
(B)
• 70% chose “A”
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Mental Accounting
• You’ve not been given anything.
Choose between:
– 50% chance to win $400 and
50% chance to win $200
(A)
– A sure gain of $300
(B)
• Now only 43% choose “A.” Why?
• The “House Money Effect”
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Mental Accounting
• People often do not focus on their overall
state of wealth
• Instead they focus independently on their
different accounts
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–
–
–
–
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Retirement (401(k), IRA, etc.)
Children’s education
Taxable investment accounts
Dividends
Company stock or stock options
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Mental Accounting
To Do List
• Understand that keeping separate
“mental accounts” often makes
investors more conservative than
they naturally are
• Measure success in terms of your
overall state of wealth
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Herding
• Investors have a tendency toward
“herd behavior”
• “Line” study on the effects of herd
behavior
• Disproportionate flow of money into four
and five-star rated mutual funds
• Ratings have a lack of predictive value
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Regret
The Story of John and Mary
• John owns shares of Company A. He considers
selling his shares and buying stock in Company
B, but decides against it. He now finds he
would have been better off by $20,000 if he
had switched to Company B
• Mary owns shares in Company B, but switched
to Company A. She finds she would have been
better off by $20,000 if she had kept her shares
of Company B
• Who is more upset, John or Mary?
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Regret
• Answer: Mary
• People typically regret errors of
commission more than errors of
omission.
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Media Response
• Study of the effects of news on
investment decisions:
– Two groups: one received news and
one did not
– The group with no news
outperformed
the group that received news
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Media Response
• People often feel the need to react
to new information
• News is often irrelevant to long-term
performance and is often
misinterpreted
• Information overload can cause
stress
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Media Response
• Advice:
– Stick with a long-term investment
strategy
– Turn your televisions off when it
comes to investment news
– Don’t feel you need to react to
every bit
of information you hear
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Optimism
• People believe it is likely that:
– Good things will happen to them
– Bad things will happen to others
• They believe others are more likely to:
– Become an alcoholic
– Have a heart attack
– Develop cancer
• They believe others are less likely to:
– Become rich
– Become famous
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Summing Up The Issues
• Physiological and emotional pain associated
with Loss Aversion and Regret
• Excessive conservatism associated with
Narrow Framing and Mental Accounting
• Loss of confidence caused by Media
Response, Herding and Anchoring
• Optimism minimizes the roles of uncertainty
and chance in investing
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What you should do…
• Recognize that behavioral issues affect us all–you
are not alone
• Don’t focus on the short-term market trends, “hot
dot” products and day-to-day performance. Stick
with a long-term investment strategy
• Work with a financial professional. Financial
professionals determine how these tendencies may
be affecting the way you invest and take steps to
remedy these tendencies
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