1 Personal Finance: Another Perspective Investments 10 - Behavioral Finance Much of this material is taken from the book The Psychology of Investing by

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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.

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

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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?• Behavioral finance tries to incorporate “personal

behavior” in an effort to extend finance beyond these narrow assumptions

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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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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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Activity #3 Individual Biases: Illusion: Which is larger?

While we all know the answer, the top line still looks larger

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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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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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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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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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Following are the answers. Remember you were to be 90% sure with your guesses

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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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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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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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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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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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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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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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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8. Seeking solace• Sometimes we follow newspaper/newsletter advice and

recommendations which have 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

• 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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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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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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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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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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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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14. Mean reversion• Prices tend to correct themselves as investors

correct for overreaction

• Prices tend to revert to the mean over the long-term

• 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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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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• 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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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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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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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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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?

Documents

1 Personal Finance: Another Perspective Investments 10 - Behavioral Finance Much of this material is taken from the book The Psychology of Investing by