Transcript Technical Analysis

BM410: Investments
Behavioral Finance
Much of this material is taken from the
book The Psychology of Investing
by John R. Nofsinger, Prentice Hall,
2002
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Objectives
A. Understand behavioral finance
B. Understand why we should learn behavioral
finance
C. Understand other alternatives to traditional
finance
D. Understand how behavioral finance can
help us become better investors
A. Understand Behavioral Finance
 What is behavior finance?
• Behavioral finance is an upcoming field of financial
theory that attempts to further understand securities
prices and investor behavior.
 Why did it come about?
• The field of Finance is based on two rigid
assumptions:
• 1. People make rational decisions
• 2. People are unbiased about their predictions of
the future
• Are these assumptions really valid?
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Behavioral Finance (continued)
 Are their specific aspects of “personal
behavior” that go contrary to these rigid
assumptions?
• Behavioral finance tries to incorporate “personal
behavior” in an effort to extend finance beyond
these narrow assumptions
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Questions
 Any questions on behavioral finance?
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B. Why should we learn
Behavioral Finance?
 Why should we learn behavioral finance?
• 1. You can learn psychological biases that affect
investment decision making
• 2. You can understand how these biases affect
investment decisions
• 3. You can see how poor decisions reduce your
wealth
• 4. You can recognize and avoid these poor
decisions and become a better investor
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Behavioral Finance (continued)
 Individual Biases: Illusion: Which is larger?
 While we all know the answer, it still looks
larger
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Behavioral Finance (continued)
 Individual Biases: Prediction – be sure!!!
• The brain does not work like a computer. Instead, it
processes information through shortcuts and
emotional filters to shorten the analysis time
• These filters and shortcuts lead to predictable errors
in investing
 Activity
• Following are questions. Enter your best guess so
you are 90% sure the answer lies between the two
guesses. If you follow this guidance, you should
get 9 of 10 answers right
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Behavioral Finance (continued)
 Answer the questions so you are 90% sure the answer
is between your minimum and maximum guess.
 1. Average weight of adult blue whale (lbs)?
 2. Year the Mona Lisa was painted?
 3. Number independent countries in 2000?
 4. Air distance (miles) between Paris and Sydney?
 5. How many bonds in the human body?
 6. How many total combatants were killed in WW1?
 7. How many books are in the Library of Congress in
2000?
 8. How long is the Amazon river (miles)?
 9. How fast does the earth spin at the equator (mph)?
 10. How many transistors are in the Pentium III
computer processor
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Behavioral Finance (continued)
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1. Weight of adult blue whale
250,000 lbs
2. Year the Mona Lisa was painted?
1,513
3. Independent countries in 2000?
191
4. Distance between Paris and Sydney? 10,543
5. How many bonds in the human body? 206
6. Combatants killed in WW1?
8.3 million
7. Books are in the Library of Congress? 18 million
8. How long is the Amazon river (miles)? 4,000 miles
9. How fast does the earth spin?
1,044 mph
10. Transistors in the Pentium III?
9.5 million
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Behavioral Finance (continued)
 How many did you get right?
• Since you were supposed to be 90% sure (and you
could make your guess as large as you wanted), you
should have only missed 1 of 10.
• Most will miss between 5 and 9 questions.
 This is an example of prediction error.
• We think we are more sure of our forecasts than we
should be.
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Questions
 Any questions on why we should learn
behavioral finance?
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C. Are there Other Alternatives?
 Are there other alternatives to explaining
investor behavior than rational behavior and
unbiased predictions? What about:
• Cooperation and Altruism
• Cooperation may be a viable strategy.
• People’s motives may lead to actions
different than conventional rationality, i.e.
selfishness, would suggest
• What about the people in 4th Nephi who
had “all things in common among them;
therefore there were not rich and poor.”
(4 Nephi 1:3)
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Other Alternatives (continued)
• Bidding and the Winner’s Curse
• Bidding may lead to a suboptimal result when
you bid your fair value
• Assuming everyone else has the correct
value, if you win you overpaid
• Don’t bid your fair value
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Other Alternatives (continued)
• Endowment Effect
• Value increases by virtue of ownership
• Once you own something, its value
increases, at least to you
• Did the value really increase with your
purchase?
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Other Alternatives (continued)
• Status Quo Bias
• Individuals prefer the status quo over a new,
more preferable position
• There is an aversion to change, even if the
change is for the better
• Change may be good
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Other Alternatives (continued)
• Loss Aversion
• Losses are given more weight than potential
gains in any position
• These weights are more than utility theory
would suggest
• What should this view on losses do to
the way you form portfolios
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Other Alternatives (continued)
• Mental Accounts
• Investors keep mental accounts rather than viewing
individual assets as part of a total portfolio
• We try to save ourselves from ourselves
• We borrow 12% for a car versus taking the
money from our kids college savings at 1%
• We know we may not pay it back if we do not
borrow from a bank
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Other Alternatives (continued)
• Winning by Losing
• We actively trade stocks instead of buying index
funds which generally outperform (and we do
not have the time, energy, or the money to try to
beat the market)
• Yes, but at least we have the chance of
higher returns and we are staying in the
market
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Other Alternatives (continued)
• Seeking solace
• We follow newspaper/newsletter advice and
recommendations which have been shown to underperform
• Yet, but at least we are investing
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Other Alternatives (continued)
• Fun
• We trade for fun and excitement instead of gain
• This is OK, but make sure your fun money is
no more than 5% of the value of your
portfolio—that way you don’t lose too much
• At least we are in the market
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Other Alternatives (continued)
• Percentages
• We move in and out of asset classes and stocks
instead of keeping specific asset class
percentages relatively constant (within our
minimum and maximum amounts) and reducing
trading costs which results in lower returns
• True, but it may be better than keeping your
assets in a money market account
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Other Alternatives (continued)
• Calendar effects
• Impact of tax and reporting is not consistent
with theory. Behaviorists point out:
• Returns are a function of cash flows, which
tend to be concentrated around calendar
turns
• Institutions “window dress,” i.e., want to
make their portfolios look good, so they sell
unwanted and buy desired stocks for periodend reports
• Print media generally print recommendations
around calendar turns and reporting periods
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Other Alternatives (continued)
 Cash dividends
• Dividends are irrelevant in the absence of taxes and
transactions costs. Behaviorists suppose:
• Dividends can be justified by “mental accounts”
which increase current income at the expense of
“higher self control” equity accounts
• Older high-net worth investors value dividends
more highly and concentrate in high income
securities (preferred habitat)
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Other Alternatives (continued)
• Overreaction
• Investors assign a probability to asset returns
based on past theory
• Appropriate reaction to a negative event is to
update a prior probability to the most recent
even
• Overreaction is when they assign too high a
value
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Other Alternatives (continued)
• Mean reversion
• Prices tend to correct themselves as investors
correct for overreaction
• Prices tend to revert to the mean
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Questions
 Any questions on behavioral finance and
explaining individual behavior?
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D. How Behavioral Finance can
help us become Better Investors
 Strategies for overcoming psychological biases
• 1. Understand your biases
• Recognizing them is an important step in
avoiding them
• Are you overconfident, trade too often, or
just like to trade?
• 2. Know why you are investing
• Know your goals.
• Investing is a means to an end, not an end in
itself.
• Review your goals often
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Becoming Better Investors (continued)
 3. Have Quantitative Investment Criteria, i.e.
your Investment plan, and follow that plan
• Having a plan allows you to avoid investing on
rumor, emotion or other biases
• Develop a good plan, and follow that plan
closely
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Becoming Better Investors (continued)
 4. Follow the Principles of Successful
Investing
• Following the principles discussed in class will help
you to avoid many of the problems faced by other
investors
• Remember:
• Know yourself, know your goals, invest low
cost and tax efficiently, invest long-term, etc.
• It will save you thousands of dollars in the longterm
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Becoming Better Investors (continued)
 5. Control your investing environment
• Limit activities that magnify your psychological
biases
• 1. Check your stocks once per week (when you
do your budget), not once per hour
• It avoids excess trading, rumors, pride,
playing, and may help you to keep your job
• 2. Make trades once per month on the same day
of each month
• This avoids the problem of too-frequent
trading and trading on rumors
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Becoming Better Investors (continued)
• 3. Review your portfolio annually and rebalance
as needed
• But rebalance in the most tax-effective
manner
• Add to underweight assets with new
funds from investing
• Make asset allocation changes using
donations of appreciated assets to
charity, then use those funds you would
have donated to buy the underweight
assets
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Becoming Better Investors (continued)
 Joseph Nofsinger adds these additional
suggestions:
• 1. Avoid stocks selling for less than $5 per share.
Most investment scams are conducted in penny
stocks.
• 2. Chatrooms and message boards are for
entertainment purposes only. Overconfidence is
fostered in these places.
• 3. Before you place a trade on a stock that doesn’t
meet your criteria, remember that it is unlikely that
you know more than the market. Do you?
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Becoming Better Investors (continued)
 4. Have a goal to earn the market return. Active
trading is motivated by the desire to earn a higher
return. And active trading usually fosters
psychological biases and ultimately contributes to
lower returns.
 5. Review your psychological biases annually.
Successful investing is more than knowing about
stocks. It includes knowing yourself.
John R. Nofsinger, The Psychology of Investing
Prentice Hall, 2002, p. 87-91.
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Review of Objectives
A. Do you understand behavioral finance?
B. Do you understand why we should learn
behavioral finance?
C. Do you understand other alternatives to
traditional finance?
D. Do you understand how behavioral finance
can help us become better investors?
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