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Applied Behavioural Finance: Insights into irrational minds and marketApplied Behavioural Finance: Insights into irrational minds and market
James Montier: Global Equity Strategy
Strictly Private & Confidential
2
“The brain is my second favourite organ”
Woody Allen
“The market can stay irrational, longer than you can stay solvent”
JMK
“There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world”
JMK
“Economists are people who look at reality, and wonder whether it would work in theory”
Ronald Reagan
3
2Global Strategy Unit
Taxonomy of biasesTaxonomy of biases
Cognitive dissonance
Regret theory
Hindsight bias
Confirmation bias
Self Attribution bias
Overconfidence
OveroptimismIllusion of control
Illusion of knowledge
Self Deception(Limits to learning)
Loss aversion/Prospect theory
Cue Competition
Availability bias
Anchoring/Salience
Catergorization
Framing
Representativeness
Ambiguity aversion
Self control(Hyperbolic discounting)
Mood
Emotion/Affect
Heuristic Simplification(Information processing errors)
Casacades
Herding
Contaigon
Imitation
Social Interaction
Biases
4
3Global Strategy Unit
The bias blind spot: Everyone else, not meThe bias blind spot: Everyone else, not me
Fundamental
4
5
6
7
8
Self serving
Self interest
Reactive
devaluation
attributionerror
Halo effect
Biased
assimilation
Cognitive
dissonance
Average American Self
5
4Global Strategy Unit
Dual processing theories of thoughtDual processing theories of thought
System One/ X- systemIntuitive
System Two C- SystemReflective
Process Characteristics
Automatic Controlled
Effortless Effortful
Associative Deductive
Rapid, parallel Slow,serial
Process opaque Self aware
Skilled action Rule application
Content on which processes act
Affective Neutral
Causal propensities Statistics
Concrete, specific Abstract
Prototypes Sets
6
5Global Strategy Unit
Neuropsychology of dual processing (Liberman)Neuropsychology of dual processing (Liberman)
X-system
Amygdala
Basal ganglia
Lateral temporal cortex
C-system
Anterior cingulate cortex
Prefrontal cortex
Medial temporal lobe
7
6Global Strategy Unit
Klein’s factors for NDM (X-system)Klein’s factors for NDM (X-system)
System X is more likely when:
The problem is ill-structured & complex
Information is incomplete, ambiguous and changing
Goals are ill defined, shifting and competing
Stress is high (time constraints and/or high stakes)
Decisions involve multiple participants
8
7Global Strategy Unit
X-system can dominateX-system can dominate
2.5
2.6
2.7
2.8
2.9
3
3.1
1 2
Class B players
Masters
Blitz (6 sec per move) Standard (2.25 mins per move)
9
8Global Strategy Unit
AffectAffect
The rational model
Perceptions -> attitudes
I like this person because I think she is smart and honest
I like this company because it is low risk and high return
The affect model
Attitude -> perceptions
Because like this person, I think she is smart and honest
Because I like this company, it is low risk and high return
10
9Global Strategy Unit
Biased assimilation: When attitudes drive perceptionsBiased assimilation: When attitudes drive perceptions
-2.5
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
Participants pro death penalty Participants anti death penalty
Studies supporting death penaltyStudies opposing death penalty
11
10Global Strategy Unit
Panda and affectPanda and affect
10
12
14
16
18
20
22
24
1 Panda 4 Panda
Dots
Pictures
12
11Global Strategy Unit
The dark side of emotionThe dark side of emotion
0
10
20
30
40
50
60
70
80
90
No invest Invest and lost Invest and won
Target patients Normal players Patient controls
13
12Global Strategy Unit
No sign of learningNo sign of learning
4045505560657075808590
1st 5 2nd 5 3rd 5 4th 5
Target patients Normals Patient controls
14
Self deception or perception is realitySelf deception or perception is reality
15
14Global Strategy Unit
Self deceptionSelf deception
Over-optimism
People tend to exaggerate their own abilities
Illusion of control
Illusion of knowledge
Over-confidence
People are surprised more often than they expect. Not well calibrated.
Confidence intervals around a forecast which should yield 2% error, actually get a 30-40% error
16
15Global Strategy Unit
OverconfidenceOverconfidence
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Weather men
Doctors
17
16Global Strategy Unit
Overconfidence and investmentOverconfidence and investment
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0.55 0.65 0.75 0.85 0.95 1
Lay people
Professionals
18
17Global Strategy Unit
Overconfidence driven by the illusion of knowledgeOverconfidence driven by the illusion of knowledge
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
Previousmonth's results
Other knowledge Intuition Guessing
Laypeople Professionals
19
18Global Strategy Unit
Does more information improve your accuracy?Does more information improve your accuracy?
20
19Global Strategy Unit
The walk down to beatable earnings: average scale of forecast error at the earnings level – US (%, 1986-2000)The walk down to beatable earnings: average scale of forecast error at the earnings level – US (%, 1986-2000)
Source: DrKW Macro research and IBES
-5
0
5
10
15
20
-23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10 -9 -8 -7 -6 -5 -4 -3 -2 -1 0
Months
Fore
cast
Err
or
21
20Global Strategy Unit
Trading is hazardous to your wealthTrading is hazardous to your wealth
0
10
20
30
1 2 3 4 5
Net return Turnover
Low Turnover High turnover
22
21Global Strategy Unit
Should traders be women? Should traders be women?
0
20
40
60
80
100
All Women All Men SingleWomen
SingleMen
-8
-6
-4
-2
0
All Women All Men SingleWomen
SingleMen
23
22Global Strategy Unit
Bubble echoes in the laboratoryBubble echoes in the laboratory
Source: Ackert and Church
0
1
2
3
4
5
6
7
8
9
10
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Novices
Once experienced
Fundamental value
Mixture of twice experienced and novice players(Ratio of 4/7)
24
23Global Strategy Unit
Keynes’s beauty contest and investment professionalsKeynes’s beauty contest and investment professionals
0123456789
10
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Over 1000 playersAverage number picked 26
2/3rds: 17Average level of thinking 1.6 steps
25
24Global Strategy Unit
Self deceptionSelf deception
E 4 K 7
26
25Global Strategy Unit
Self attribution biasSelf attribution bias
Good outcomes are a testament to your skill, bad outcomes are sheer bad luck.
How often do you say that’s just a blip?
27
26Global Strategy Unit
Hindsight biasHindsight bias
It is a common observation that events in the past appear simple, comprehensible, and predictable in comparison to events in the future. Everyone has had the experience of believing that they knew all along the outcome of a football game, a political election or a business investment. The hindsight bias is the tendency for people with outcome knowledge to believe falsely that they would have predicted the reported outcome of an event. After learning of the occurrence of an event, people tend to exaggerate the extent to which they had foreseen the likelihood of its occurrence.
28
II. Heuristic Simplification
Or
There is no such thing as context free decision making
Psychological FoundationsPsychological Foundations
29
28Global Strategy Unit
Heuristic SimplificationHeuristic Simplification
Conservatism Bias
Hard to give up a view once it has formed. Leads to:
Anchoring and slow adjustment
Depends upon saliency of the anchor
i.e. analysts will change their views from their forecasts slowly
30
29Global Strategy Unit
Analysts lag realityAnalysts lag reality
-8
-6
-4
-2
0
2
4
6
8
10
12
Jan-
86
Jan-
87
Jan-
88
Jan-
89
Jan-
90
Jan-
91
Jan-
92
Jan-
93
Jan-
94
Jan-
95
Jan-
96
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Earnings
Forecasts
31
30Global Strategy Unit
The Fed modelThe Fed model
Source: Thomson Financial Datastream
85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 020.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
0.60
0.70
0.80
0.90
1.00
1.10
1.20
1.30
1.40
1.50
1.60
1.70
32
31Global Strategy Unit
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Apr
-53
Apr
-56
Apr
-59
Apr
-62
Apr
-65
Apr
-68
Apr
-71
Apr
-74
Apr
-77
Apr
-80
Apr
-83
Apr
-86
Apr
-89
Apr
-92
Apr
-95
Apr
-98
Apr
-01
Apr
-04
Equities vs. bonds in the US: the Fed model since the 1950sEquities vs. bonds in the US: the Fed model since the 1950s
Source: DrKW Macro research
33
32Global Strategy Unit
Simple maths leads to anchoringSimple maths leads to anchoring
8*7*6*5*4*3*2*1 = median answer 2250
1*2*3*4*5*6*7*8 = median answer 512
Actual answer = 40,320
34
33Global Strategy Unit
Estate agents and anchoringEstate agents and anchoring
80,000
90,000
100,000
110,000
120,000
130,000
140,000
150,000
160,000
1 2
Given Appraisal valueListing Price Lowest acceptable offer
35
34Global Strategy Unit
Anchoring and valuationAnchoring and valuation
0
10
20
30
40
50
60
Cordlessmouse
Cordlesskeyboard
AverageWine
Rare Wine Designbook
BelgianChocolates
0
0.5
1
1.5
2
2.5
3
3.5
4
Low SS No.High SS No.
Ratio
36
35Global Strategy Unit
Cheap? Surely some mistake - USCheap? Surely some mistake - US
Various valuation measures (x) Current level 1997-2004 Long run*
Trailing reported PE 21.1 29.0 14.0Operating PE 17.5 22.5 14.9Forward operating PE 15.6 19.7 12.5PB 3.0 4.0 2.4PC 13.0 14.9 9.2Graham and Dodd PE 27.5 37.0 16.4Hussman PE 19.3 23.5 11.0Trend PE 22.0 29.0 13.9Source: DrKW Macro research * the term long run refers to the longest run of data we have which varies from starting in the 1870s to starting in the mid 1980s. All long run measures end at the end of 1996, effectively stripping out the bubble years.
37
36Global Strategy Unit
Psychological foundationsPsychological foundations
Linda is 31, single, outspoken and very bright. She majored in philosophy. As a student she was deeply concerned with issues surrounding equality and discrimination.
Is it more likely that Linda is
Works in a bank
Works in a bank and is active in the feminist movement
38
37Global Strategy Unit
Psychological FoundationsPsychological Foundations
Representativeness Heuristic
Aka law of small numbers – belief that random samples of a population will resemble each other and the population more closely than statistical sampling theory would predict.
Which is more likely HTHTTH or HHHTTT?
39
38Global Strategy Unit
Earnings growth as representativenessEarnings growth as representativeness
Source: Montier, & Chan et al
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0
Q1 Q2 Q3 Q4 Q5
Trailing 5 year Forward 5 year
Actual 1 Actual 3
Actual 5
Source: Montier, and Chan et al
40
39Global Strategy Unit
Great stories ≠ Great investmentsGreat stories ≠ Great investments
02468
1012141618
Glamour (1) Glamour (2) Value (9) Value (10)
41
40Global Strategy Unit
Under-reaction and Over-reactionUnder-reaction and Over-reaction
Information is judged in two dimensions – strength and weight
Letter of reference – judged by strength i.e. number of appealing traits
Weight is neglected. i.e. who wrote it
42
41Global Strategy Unit
Over-reaction and Under-reaction : Information analysisOver-reaction and Under-reaction : Information analysis
Over-reaction
High
Under-reaction
Low
HighLow
Weight
Strength
43
42Global Strategy Unit
Analysis of over-reaction and under-reactionAnalysis of over-reaction and under-reaction
Dividend omissions, initiations
Earnings surprises
Analyst recommendations
Z-scores
Buybacks on value stocks
Goodwill write-offs
Valuations
IPOs, SEOs
High earnings growth
Cap ex.
Buybacks on growth stocks
Quarterly earnings announcements
Under-reaction Over-reaction
44
43Global Strategy Unit
Bias of JudgementBias of Judgement
Availability Bias
Which is a more likely cause of death in the US – being killed by a lightening strike or as a result of a shark attack?
Shark attacks receive more publicity, they are easier to imagine (thanks to Jaws). However, the chance of dying from a lightening strike are 30x greater than chances of being killed by a shark.
45
44Global Strategy Unit
Narrow FramingNarrow Framing
Context sensitivity. Aka frame dependence or mental accounting.
We can’t see through how things are actually framed.
Separate funds for separate purposes – holiday money, house keeping
46
45Global Strategy Unit
When is a buyback not a buy back?announced, actual and net share buy-backs in the USWhen is a buyback not a buy back?announced, actual and net share buy-backs in the US
Source: DrKW Macro research
-50,000
0
50,000
100,000
150,000
200,000
250,000
300,000
350,00019
87
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Announced
Completed
Net
47
46Global Strategy Unit
Repurchases & their impact:dividend, repurchase & total yield for the S&P500 (%)Repurchases & their impact:dividend, repurchase & total yield for the S&P500 (%)
Source: DrKW Macro research
-1.00
0.00
1.00
2.00
3.00
4.00
5.00
6.00
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
Total yield
Dividend yield
Net repurchase yield
48
47Global Strategy Unit
Prospect TheoryProspect Theory
People value changes not states. Rational man tries to maximise the utility of wealth.
Real people worry far more about gains and losses than levels.
-12
-10
-8
-6
-4
-2
0
2
4
-20 -15 -10 -5 0 5 10 15 20
49
48Global Strategy Unit
Stock broker SampleStock broker Sample
0
5
10
15
20
25
50 100
101
110
150
201
320
500
1000
1000
00
50
49Global Strategy Unit
Prospect theoryProspect theory
• Leads to
• Endowment effect
• Status quo bias
• Disposition effect
51
50Global Strategy Unit
Endowment effect/Status quo biasEndowment effect/Status quo bias
0
1
2
3
4
5
6
7
8
1 2 3
Sellers Choosers Buyers
52
51Global Strategy Unit
US mutual fund managers and the disposition effect (1980-2002)US mutual fund managers and the disposition effect (1980-2002)
Source: Frazzini (2004)
0
5
10
15
20
25
Low return 2 3 4 High
return
All
Proportion of losses realized
Proportion of gains realized
53
52Global Strategy Unit
Top tips for better decision makingTop tips for better decision making
This applies to me, you and everyone else
You know less than you think you do
Be less certain in your views, aim for timid forecast and bold choices
Don’t get hung up on one technique tool, approach or view – flexibility and pragmatism are the order of the day
Listen to those who don’t agree with you
54
53Global Strategy Unit
Top tips for better decisionsTop tips for better decisions
You didn’t know it all along, you just think you did
Forget relative valuation, forget market prices, work out what the stock is worth (Use reverse DCFs)
Don’t take information at face value, think carefully about how it was presented to you
Don’t confuse good firms with good investments, or good earnings growth with good returns
55
54Global Strategy Unit
Top tips for better decisionsTop tips for better decisions
Vivid, easy to recall events are less likely than you think they are, subtle causes are underestimated
Try to focus on facts, not stories
Sell your losers and ride your winners
56
55Global Strategy Unit
Beating the biasesBeating the biases
Being aware of the biases is not enough. It is just an important first step.
Need to create a framework that incorporates mental best practice. Easier said than done. Mental bad habits are persistent.
The good news, we continue to create new brain cells throughout our lives.
57
Applied Behavioural Finance: Are two heads better than one? The psychology of group decisions
Applied Behavioural Finance: Are two heads better than one? The psychology of group decisions
James Montier: Global Equity Strategy
Strictly Private & Confidential
58
“Madness is a rare thing in individuals – but in groups...it is the rule”
Friedrich Nietzsche
“To associate with other like-minded people in small, purposeful groups is for the great majority of men and women a source of profound psychological satisfaction..”
Aldous Huxley
“Deliver us from committees”
Robert Frost
“Committees are groups of people who keep minutes but waste hours”
Berle Milton
“A committee is an animal with four back legs”
John le Carre
“A committee is a group of the unwilling, chosen from the unfit, to do the unnecessary “
Unknown
59
58Global Strategy Unit
Types of groups Types of groups
Statistical groups = large number of people asked for an answer, take the mean.
Deliberative groups = discussion is necessary
Evidence suggests that statistical groups outperform deliberative groups and individuals
E.g. when judging the number of beans in a jar, the group average is almost always better than the vast majority of the individual members. In one such experiment, a group of 56 students was asked about a jar containing 850 beans; the group estimate was 871, a better guess than all but one of the students
60
59Global Strategy Unit
Statistical groupsStatistical groups
Only work when:
People are unaffected by others’ decisions (errors are uncorrelated)
Probability of being correct must be independent of the probability of everyone else being correct
The participants must be unaffected by their own vote possibly being decisive
When participants have some idea of the answer.
Anchors are avoided
61
60Global Strategy Unit
Deliberative groupsDeliberative groups
Such groups seem to amplify:
Representativeness
Framing
Overconfidence (simple repetition of views leads to people having greater confidence)
Anchoring
Availability
62
61Global Strategy Unit
The establishment of norms (Sherif 1936)The establishment of norms (Sherif 1936)
0
1
2
3
4
5
6
7
8
Alone Session 1 Session 2 Session 3
123
63
62Global Strategy Unit
Conformity (Asch 1955)Conformity (Asch 1955)
64
63Global Strategy Unit
On 12 of the 18 rounds, confederates unanimously agreed on a wrong answer
¾ of participants agreed with the confederates in at least one round. Half agreed in 6 or more rounds. Only 25% resisted in all rounds!
65
64Global Strategy Unit
Does group size matter? (% conforming to wrong answers)Does group size matter? (% conforming to wrong answers)
0
5
10
15
20
25
30
35
1 2 3 4 15
66
65Global Strategy Unit
Herding when uncertain – Baron et alHerding when uncertain – Baron et al
0
0.5
1
1.5
2
2.5
3
3.5
4
Unimportant Important
Low uncertainityHigh uncertainty
67
66Global Strategy Unit
Sharing information (Stasser et al 1989)Sharing information (Stasser et al 1989)
0
10
20
30
40
50
60
70
80
Unstructured Structured
SharedUnshared
68
67Global Strategy Unit
Why are we so bad at sharing information? Why are we so bad at sharing information?
Shared information is more likely to be discussed and repeated and this will influence the individuals in the group, and hence influence the group’s eventual outcome.
Social pressure
Cascades
69
68Global Strategy Unit
Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)Social pressure : Those who conform are rewarded (Wittenbaum et al 1999)
55.2
5.45.65.8
66.26.4
6.66.8
7
Shared Unshared
SelfOthers
70
69Global Strategy Unit
CascadesCascades
Private signal
a a b b b b
Source: Anderson and Holt (2004)
Cascade creation: Actual pot used B
Player 1 2 3 4 5 6
Decision A A A A A A
71
70Global Strategy Unit
Group polarisationGroup polarisation
• Group polarization is the tendency for members of a group to end up in a more extreme position in line with their original beliefs after talking to one another. The increased confidence in view mentioned earlier, begins to create feedback into the extremity of view, generally creating a loop of increased confidence in more and more extreme views
72
71Global Strategy Unit
GroupthinkGroupthink
A tendency to examine too few alternatives
A lack of critical assessment on each other’s ideas
A lack of contingency plans
Poor decisions are often rationalized
Illusion of group invulnerability and shared morality
True feelings and beliefs are suppressed
Illusion of unanimity is maintained
Mind guards are appointed to protect the group from negative information
73
72Global Strategy Unit
SolutionsSolutions
Secret ballots
Devil’s advocates
Authentic dissent
Respect for other group members
74
73Global Strategy Unit
Beware of authority – Milgram experimentsBeware of authority – Milgram experiments
75
74Global Strategy Unit
Bandura’s driving forces – turning good people badBandura’s driving forces – turning good people bad
• Moral justification
• Euphemistic labelling
• Advantageous comparison
• Displacement of responsibility
• Diffusion of responsibility
• Disregard or distortion of consequences
• Dehumanisation
76
75Global Strategy Unit
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© Dresdner Kleinwort Wasserstein Securities Limited 2004
DRESDNER KLEINWORT WASSERSTEIN RESEARCH – RECOMMENDATION DEFINITION (Except as otherwise noted, expected performance over next 12 months)
Buy 10% or greater increase in share price Reduce 5-10% decrease in share price Add 5-10% increase in share price Sell 10% or more decrease in share price Hold +5%/-5% variation in share price
Distribution of DrKW equity recommendations as of 1 Apr 2004
All covered companies Companies where a DrKW company has provided
investment banking services (in the last 12 months)
Buy/Add 337 53% 55 57%Hold 188 30% 31 32%Sell/Reduce 108 17% 11 11%Total 633 97
Source: DrKW