Behavioral Finance

Ashish Mali Josh Cavers Ian Herle Lindsey Polishuk

AGENDA

1.

2. 3. 4.

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 Doesnt 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 Ill 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

Lottery winners Winners vs. losers Long-term focus

Stock market

Retain perspective

Winners vs. Losers

Anchoring Bias

Attach to a reference point

Relevance New & novel concepts Short-term volatility Company fundamentals

Stock market

Use an array of perspectives

Confirmation Bias

Preconceived opinion

Emphasize favorable information Seek information to prove true Avoid red flags

Hot stock tip

Look for a sober opinion

Hindsight Bias

The outcome was predictable

Resulting incorrect oversimplifications The .com bubble

Causes overconfidence

Overconfidence

Fund managers & individuals Overconfident manager

More trades and lower yields Less trades and higher yields

Confident manager

Ongoing battle to beat the market

Investment techniques require constant refinement

Mental Accounting

Investors separate money

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
Imagine that you face the following pair of concurrent decisions

1):
A. B.

a sure gain of $240 25% chance to gain $1000 & 75% chance to gain nothing a sure loss of $750 75% chance to lose $1000 and 25% chance to lose nothing

2):
A. B.

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

Youre an Artisan

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 dont indulge every whim

Mostly Bs

Youre an Idealist

Money just isnt 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 Cs

Youre a Guardian

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 Ds

Youre a Rational

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 isnt always rational

QUESTIONS