Transcript Technical Analysis

Personal Finance: Another Perspective
Investments 10 Behavioral Finance
Much of this material is taken from the book The Psychology of
Investing by John R. Nofsinger, Prentice Hall, 2008. This is for
your enjoyment and learning only—it will not be on an exam or
quiz. John has given permissions for me to share this
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PowerPoint with my students.
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
Investment Plan Assignments
Investments 10: Behavioral Finance
1. Review this PowerPoint for information. It gives
some good insights on investing you might not
have thought of.
•
It will not be on any Quiz or Exam, but it may
have a positive impact on how you invest and
your investment returns
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A. Understand Behavioral Finance
 What is behavioral finance?
• Behavioral finance is an upcoming field of financial
theory that attempts to further understand securities
prices through understanding 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 there specific aspects of “personal
behavior” that go contrary to these rigid
assumptions of rationality and unbiased
predictions?
• Behavioral finance tries to incorporate “personal
behavior” in an effort to extend finance beyond its
narrow assumptions
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Behavioral Finance (continued)
 Activity #1
• You go to the grocery store and you need to
purchase paper towels.
• You find they are on sale at 10% below their
normal price.
• What do you do?
• You buy a case of paper towels because you
know this is a good price
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Behavioral Finance (continued)
 Activity #2
• You invest in the stock market. You own 100
shares of Boston Scientific stock
• More news comes out, and Boston Scientific
stock drops 20%.
• What do you do?
• Instead of buying more, like the paper towels,
you immediately think about selling the stock
• Likewise, if the stock starts to appreciate in
value, you think to buy more, rather than sell
• Why the difference between the grocery store
and the stock market?
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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. Behavioral finance can help you learn about
your psychological biases
• 2. You can understand how those psychological
biases affect your investment decision making
process
• 3. You can see how poor investment decisions
caused by physchological biases affect your wealth
• 4. You can learn to recognize and avoid poor
investment decisions which come from those
psychological biases, which can help you become a
better investor
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Behavioral Finance (continued)
Activity #3
 Individual Biases: Illusion: Which is larger?
 While we all know the answer, the top line 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
• We must be wise to these prediction errors so
we can be better investors and better stewards
over our resources
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Behavioral Finance (continued)
 Activity #4
• Following are 10 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. You can guess as
high or as low as you want (or even a range),
realizing you want to get at a minimum 90% right
(or at least 9 questions 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. You can
guess any number or range, but you must be 90% sure
you are right.
 1. What is the average weight of an adult blue whale
in pounds?
 2. What year was the Mona Lisa was painted?
 3. What is the number independent countries in the
world in the year 2000?
 4. What is the air distance in miles between Paris,
France and Sydney, Australia?
 5. How many bones are in the human body?
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Behavioral Finance (continued)
 6. How many total combatants were killed in WW1
from all sides?
 7. How many books were in the Library of Congress in
2000?
 8. How long is the Amazon river in miles?
 9. How fast does the earth spin at the equator in miles
per hour?
 10. How many transistors are in the Pentium III
computer processor?
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Behavioral Finance (continued)
Following are the answers. Remember you were to be
90% sure with your guesses
 1. Weight of adult blue whale:
• 250,000 pounds
 2. Year the Mona Lisa was painted:
• 1513
 3. Independent countries in the world in 2000:
• 191
 4. Distance between Paris and Sydney Australia:
• 10,543
 5. Number of bones in the human body:
• 206
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Behavioral Finance (continued)
 6. Combatants killed in WW1:
• 8.3 million
 7. Books in the Library of Congress in 2000:
• 18 million
 8. Length of the Amazon river in miles:
• 4,000 miles
 9. Speed of the earth at the equator (how fast does it
spin):
• 1,044 mph
 10. Transistors in the Pentium III computer processor:
• 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
• In an average class, fewer than 30% are 90% right
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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?
• Following are a few ideas that may be helpful
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Other Alternatives (continued)
1. Cooperation and Altruism
• Cooperation may be a viable investment strategy
• People’s motives may lead to actions different
than conventional rationality, i.e. individual
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)
• What to do?
• Think about other alternatives, other
perspectives on investing.
• Learn to think “outside the box”
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Other Alternatives (continued)
2. 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 won you overpaid!
• What to do?
• Be careful in setting your bid prices
• Generally, don’t bid your fair value—bid
lower
• Don’t get emotional in your bid prices for
financial assets
• You don’t have to buy it at this price!
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Other Alternatives (continued)
3. Endowment Effect
• Sometimes we perceive that an asset’s value
increases by virtue of our ownership
• Once you own something, its value hasn’t
increased or changed
• Did the value really increase with your
purchase?
• What to do?
• Realize that just because you own something
does not increase the value of that asset
• Do not get too emotionally attached to a
financial or other asset that you own
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Other Alternatives (continued)
4. Status Quo Bias
• Sometimes 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 actually be good
• What to do?
• Try to be open minded with new ideas
• Be open to new ideas as long as they follow
the principles of successful investing and
your Investment Plan that you put together
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Other Alternatives (continued)
5. Loss Aversion
• Often losses are given more weight in our minds
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?
• What to do?
• Give gains and losses equal weight in your
analysis
• It is the gains and losses of the overall
portfolio that are important, not individual
securities
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Other Alternatives (continued)
6. Mental Accounts
• Often 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 investment account for the
kids college savings (which are earning 2%
annually)
• We know we may not pay it back if we
do not borrow from a bank
• What to do?
• Set up separate accounts for separate goals
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Other Alternatives (continued)
7. Winning by Losing
• Sometimes we actively trade stocks instead of
buying index funds or ETFs which we know are
lower cost and take a lot less time to invest
• We know index funds generally outperform the
actively managed funds
• And we do not have the time, energy, or the
money to try to beat the market
• What to do?
• If you do not have the time, energy, and money,
invest in “sleep-well” portfolios of index funds
• You will at least get market returns and will
generally beat most actively managed funds
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Other Alternatives (continued)
8. Seeking Solace (abdicating responsibility)
• Sometimes we follow newspaper/newsletter advice
which we know has been shown to under-perform
• We prefer to take other’s advice rather than
doing our own homework
• If the performance goes bad, we can blame
others (we don’t have to take responsibility)
• What to do?
• Realize the limitations of these
recommendations
• If you have no better knowledge, invest in
index funds/ETFs which are passively
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Other Alternatives (continued)
9. Fun
• Sometimes we trade for fun and entertainment
instead of financial performance
• 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
• What to do?
• If you want “fun” money, set up a trading
account in a retirement vehicle (so you don’t
have to pay taxes until later)
• Trade until the money is gone--then stop
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Other Alternatives (continued)
10. Percentages
• We sometimes move in and out of asset classes and
stocks instead of keeping specific asset class
percentages relatively constant (within our
minimum and maximum amounts from our
Investment Plan)
• We get lower returns from increased trading
costs and may have more risk than we want
• What to do?
• Develop a good Investment Plan and rebalance
as needed to your limits
• Work to reduce trading, taxes, and
transactions costs
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Other Alternatives (continued)
11. Calendar Effects
• The 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 tend to “window dress,” i.e., sell
unwanted and buy desired stocks for period-end
reports
• What to do?
• Don’t worry about calendar effects
• Invest for the long-term consistent with your
Investment Plan and calendar effects will
take care of themselves
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Other Alternatives (continued)
12. Cash Dividends
• Theory has shown that 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) theory
• What to do?
• Invest for the long-term according to your
Investment Plan and follow your strategy
• Emphasize capital gains over dividends
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Other Alternatives (continued)
13. Overreaction
• Many 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
event
• Overreaction is when they assign too high a
value
• What to do?
• Stay diversified, true to your Investment Plan,
and don’t invest on rumors
• Invest for the long-term, not on rumors
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Other Alternatives (continued)
14. Mean Reversion
• Prices tend to correct themselves as investors
correct for overreaction
• Long-term prices tend to revert to the mean
• What to do?
• Realize that the best performing stock or mutual
fund last year will not be the best performer this
year
• Winner’s revert to average performance over
time
• Don’t buy last years best performers
• Invest for the future--not from the past
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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
 There are specific strategies you can take for
overcoming psychological biases understood
through behavioral finance. Key principles
include:
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Becoming Better Investors (continued)
 1. Understand your psychological biases and
control your investing environment
• Recognizing biases is an important step in avoiding
them
• Are you overconfident or do you trade too
often?
• What to do?
• Limit the opportunity for these actions or biases.
Articulate your ideas in your well thought out
and well written Investment Plan. Ideas include:
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Becoming Better Investors (continued)
 a. Check your stocks once per week (when you do
your budget), not once per hour
• It avoids excess trading, rumors, and pride
 b. Make trades once per month on the same day of
each month
• This avoids too-frequent trading and trading on
rumors
 c. Review your portfolio annually and rebalance as
needed
• But rebalance in the most tax-effective manner
• Add to underweight assets with new funds
• Make asset allocation changes using donations
of appreciated assets (NMD) to charity
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Becoming Better Investors (continued)
 2. Know why you are investing
• Know your personal and family goals
• Investing is a means to an end, not an end in
itself.
• What to do?
• Review your goals often and invest according to
your Investment Plan and goals
• If you want to trade for fun, that is fine. But set
a specific dollar amount in a special retirement
account and only trade that account.
• Once the money is gone, stop trading
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Becoming Better Investors (continued)
 3. Have Quantitative Investment Criteria, i.e.
your thoughtful Investment plan, and follow it
• Having a written Investment Plan allows you to
avoid investing on rumor, emotion or other biases
• Write it well and then follow it closely
• What to do?
• Develop and write a good Investment Plan, and
follow that Plan closely
• Do not invest in areas outside of your Plan or in
areas you know you do not add value
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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
• We must determine correct principles and follow
them
• What to do:
• Know yourself, know your goals, invest low
cost and tax efficiently, invest long-term, know
what you invest in, monitor performance, etc.
• Follow your Investment Plan, and it will
save you thousands in the long-term
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Becoming Better Investors (continued)
 John Nofsinger adds these 5 additional
suggestions:
• 1. Avoid stocks selling for less than $5 per share
• Most investment scams are conducted in penny
stocks
• 2. Chat rooms 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 really know more than the market?
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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 than the market
• 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
financial markets, asset classes, and financial assets.
It includes knowing yourself
These main ideas and questions are from John R.
Nofsinger, The Psychology of Investing Prentice Hall,
2008, 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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