Transcript MBA620-19 Investments 10 - Behavioral

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, 2002. This is for your enjoyment
and learning only—it will not be on any quizzes
or exams.
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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 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?
• Behavioral finance tries to incorporate “personal
behavior” in an effort to extend finance beyond
these 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
• News comes out, and Boston Scientific stock
drops 10%.
• 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?
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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 learn to recognize and avoid these poor
decisions and 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
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Behavioral Finance (continued)
 Activity #4
• 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. You can guess as high or
as low as you want (or even a range), realizing you
want to get 90% 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
 1. What is the average weight of an adult blue
whale (lbs)?
 2. What was the year that 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 and Sydney?
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Behavioral Finance (continued)
 5. How many bones are in the human body?
 6. How many total combatants were killed in
WW1 from all sides?
 7. How many books are 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 mile 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

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
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1. Weight of adult blue whale
250,000 lbs
2. Year the Mona Lisa was painted?
1513
3. Independent countries in 2000?
191
4. Distance between Paris and Sydney?
10,543
5. How many bones 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?
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Other Alternatives (continued)
1. Cooperation and Altruism
• Cooperation may be a viable 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
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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 win you overpaid
• What to do?
• Be careful in setting your bid prices
• Generally, don’t bid your fair value
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Other Alternatives (continued)
3. Endowment Effect
• Sometimes we perceive that 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?
• What to do?
• Realize that just because you own something it
does not increase the value of that asset
• Do not get too emotionally attached to an
asset
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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 be good
• What to do?
• Try to be open minded with new ideas
• Follow the principles of successful investing but
be open to new ideas
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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 weights in your
analysis
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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 kids college savings at 1%
• 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
• Invest wisely
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Other Alternatives (continued)
7. Winning by Losing
• Sometimes we actively trade stocks instead of
buying index funds or ETFs and which take a lot
less time to invest
• And 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” index funds
• You will at least get market returns
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Other Alternatives (continued)
8. Seeking solace
• Sometimes we follow newspaper/newsletter advice and
recommendations which have been shown to underperform
• We prefer to take other’s advice rather than doing our
own homework
• If the performance goes bad, we can blame others
• What to do?
• Realize the limitations of these recommendations
• If you have no better ideas, invest in index funds and
ETFs which don’t try to beat the market
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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)
• We get lower returns from not reducing trading
costs
• What to do?
• Rebalance as needed to your limits
• Work to reduce trading 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 and
institutions “window dress,” i.e., want to make
their portfolios look good, so they sell unwanted
and buy desired stocks for period-end reports
• What to do?
• Don’t worry about calendar effects
• Invest for the long-term 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)
• What to do?
• Invest for the long-term and 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
even
• Overreaction is when they assign too high a
value
• What to do?
• Stay diversified, and don’t invest on rumors
• Invest for the long-term
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Other Alternatives (continued)
14. Mean reversion
• Prices tend to correct themselves as investors
correct for overreaction
• Prices tend to revert to the mean over the longterm
• What to do?
• Realize that the best performing stock or fund
last year will not be the best year
• Winner’s revert to average performance over
time
• Don’t buy last years best performers
• Invest long-term
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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 trade too often?
• What to do?
• Limit the opportunity for these actions or
biases. Ideas include:
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Becoming Better Investors (continued)
 1. Check your stocks once per week (when you do
your budget), not once per hour
• It avoids excess trading, rumors, and pride
 2. Make trades once per month on the same day of
each month
• This avoids too-frequent trading and trading on
rumors
 3. 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 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 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 Investment plan, and follow that plan
• Having a plan allows you to avoid investing on
rumor, emotion or other biases
• Write it well and then follow it closely
• What to do?
• Develop a good plan, and follow that plan
closely
• Do not invest in areas outside of your plan or in
areas specifically forbidden
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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
• Principles are key to success
• 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 plan, and it will save you
thousands of dollars in the long-term
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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. 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?
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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.
These main ideas and questions are from 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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