Behavioral Finance and The Psychology of Investing.

RAVIN ALIKHANOGLUDENISLAM BILALUTDNOV

SIMON TSORAI 127612

Summary

Introduction (behavioral finance)

Fads, Social Dynamics and Stock bubbles

Excessive Trading, Overconfidence, Prospect Theory.

Rules for Avoiding Behavioral Traps.

Contrarian Investing and Investor Sentiment.

Conclusion

What is Behavioral Finance? The broad impression of a typical man is that

understanding stocks entails understanding of economics, accounting, and mathematics. I presume nobody ever heard the word psychology used in any of those subjects very neatly. There is a division of economics called behavioral finance, behavioral finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent and subsequent effects on markets. Up until as of late, finance was subjugated by philosophies that anticipated investors exploited their expected utility, or well-being, and always acted sensibly. This was a lee way of the lucid philosophy of consumer choice under certainty applied to indefinite consequences.

Continuous

In the 1970s two psychologists, Amos Tversky and Daniel Kahneman, distinguished that many persons did not perform as this theory foreseen. They established a new model—called prospect theory—of how people actually perform and make judgments when faced with ambiguity. Their model established them as the gurus of behavioral finance, and their study has been making much progress in the finance line of work.  

When everybody is enthusiastic about the market, an investor should be exceptionally vigilant. Stock prices are not based just on economic values but on psychological factors that sways the market. Yale economist Robert Shiller, one of the frontrunners of the behavioral finance movement, has highlighted that fads and social dynamics play a large role in the determination of asset prices.

Psychologists have long identified how hard it is to keep on separate from a crowd. This was long-established by a social psychologist named Solomon Asch. He piloted a famous experiment where subjects were offered with four lines and requested to pick the two that were the same length. The right answer was obvious, but when confederates of Dr. Asch presented conflicting views, the subjects often gave the incorrect answer.

Follow-up experiments confirmed that it was not social force that led the subjects to act in contradiction of their own best judgment but their skepticism that a large group of people could be wrong. Psychologists call this tendency to follow the crowd the herding instinct—the intention of individuals to adapt their thinking to the prevalent opinion.

Excessive Trading, Overconfidence, Prospect Theory.

A solemn error in judgment you can make as an investor is to be overconfident. To lay it in additional way, the regular individual—whether a lecturer, a maid, a nurse, or anything else—believes he or she is superior than average, which of course is wrong. We are all overconfident about our capabilities in numerous ways.

Relating to investment behavior, overconfidence comes from several sources. First, there is what is called a self-attribution bias that causes one to take credit for a favorable turn of events when credit is not due. Your early success fed your overconfidence. You and your friends attributed your stock gains to skillful investing, even though those outcomes were frequently the result of chance, for example, those who bet on games always win on their first attempt but afterwards a series of losses lay ahead of them.

Definition of Prospect Theory. It is a theory that entails that people value gains

and losses in a different way and, as such, will base conclusions on superficial gains rather than alleged losses. Thus, if an individual was given two equal choices, one articulated in terms of possible gains and the other in possible losses, individuals would choose the prior. Also known as "loss-aversion theory. "Prospect theory is a behavioral economic theory that defines the way people choose between probabilistic substitutes that involve risk, where the probabilities of aftermaths are known.

The theory asserts that people make choices based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain knowledge. The model is descriptive: it tries to model real-life choices, rather than optimal decisions. The theory was developed by Daniel Kahneman and Amos Tversky in 1979 as a psychologically more accurate description of decision making, comparing to the anticipated utility theory. 

Loss Aversion.

Is the tendency for individuals to prefer avoiding losses rather than accruing gains. The theory was first introduced in 1979 by Kahneman and Tversky under the assumption that losses have a larger impact on preferences than that of the advantages of gains.

To be a effective long-term investor, you must set up guidelines and incentives to keep your investments on track, this is termed precommitment .

Guidelines for Dodging Behavioral Traps. Set an asset allocation rule

Don’t try to second-guess your rules

Self-controlled investment strategy

Set up a stop-loss order to minimize your losses

Don’t tell your networks about your trades

Advice for risk lovers

Set up a small trading account that is completely separate from the rest of your portfolio. All brokerage costs and all taxes must be paid from this account.

Myopic Loss Aversion

Myopic loss aversion-is tendency to base decision on the short-term fluctuations in the market. It is the combination of a greater sensitivity to losses than to gains and a tendency to evaluate outcomes frequently. Two implications of myopic loss aversion are tested experimentally.

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1. Investors who display myopic loss aversion will be more willing to accept risks if they evaluate their investments less often

2. If all payoffs are increased enough to eliminate losses, investors will accept more risk. In a task in which investors learn from experience, both predictions are supported. The investors who got the most frequent feedback (and thus the most information) took the least risk and earned the least money

Contrarian Investing and Investor Sentiment:Strategies to Enhance Portfolio Returns.

An investor who takes a dissimilar view is said to be a contrarian, one who conflicts from the principal opinion.

Some contrarian tactics are based on psychologically driven indicators such as investor “sentiment”. The fundamental idea is that most investors are excessively optimistic when stock prices are high and excessively pessimistic when they are low.

But in what way do we know when the market is too pessimistic and too optimistic?

Answer

From Investors Intelligence data, we computed an index of investor sentiment by finding ratio of bullish newsletters to bullish plus bearish newsletters.

Whenever the index of investor sentiment is high , subsequent returns on the market are poor and when the index is low, subsequent returns are above average. The index is a particularly strong predictor of market return over the next 9 to12 months.

Table 11970 - 2006

Annualized Returns Subsequent to Sentiment Readings

(January 2, 1970 - June 2, 2006)

Sentiment Frequency Three Month Six Month Nine Month Twelve Month

0.2 - 0.3 1.14% 18.52% 15.40% 22.79% 20.74%

0.3 - 0.4 8.34% 12.24% 13.79% 16.52% 15.82%

0.4 - 0.5 15.28% 20.30% 15.02% 13.06% 13.43%

0.5 - 0.6 27.29% 15.98% 13.61% 11.10% 10.21%

0.6 - 0.7 27.60% 8.61% 6.75% 6.66% 6.03%

0.7 - 0.8 15.95% 10.45% 7.17% 7.03% 6.74%

0.8 - 0.9 3.83% -0.39% 0.23% -3.32% -1.79%

0.9 - 1.0 0.57% 0.35% -3.87% -9.17% -10.18%

Overall 100.00% 12.72% 10.35% 9.45% 9.02%

Table 21990 - 2006 Annualized Returns Subsequent to Sentiment Readings

Sentiment Frequency Three Month Six Month Nine Month Twelve Month

.30 - .35 1.28% 20.43% 15.83% 15.51% 20.66%

.35 - .40 3.27% 16.69% 18.19% 18.63% 20.85%

.40 - .45 4.78% 30.10% 22.52% 20.99% 21.24%

.45 - .50 7.12% 33.39% 18.61% 15.25% 15.24%

.50 - .55 15.17% 21.80% 17.98% 15.74% 14.81%

.55 - .60 17.97% 12.92% 11.61% 11.36% 11.05%

.60 - .65 24.85% 4.65% 5.67% 6.91% 6.25%

.65 - .70 14.35% 5.37% 5.34% 4.38% 5.35%

.70 - .75 8.63% 10.64% 7.04% 6.63% 6.43%

.75 - .80 2.57% 3.03% 6.86% 4.51% 5.02%

Overall 100.00% 13.19% 11.04% 10.38% 10.33%

Continued

The Crash of October 1987 was accompanied by investor pessimism.

May and December 1988 and February 1990, investors feared another crash and sentiment dropped sharply.

The Iraqi invasion Kuwait.

The Bond market collapse of 1994.

The Asian crisis of October 1997.

The LTCM bailout of the summer of 1998

The terrorist attacks of September 2001 and the market bottom of October 2002.

FigureInve sto rs In te lligen ce S en tim en t Ind ica to r, 1986 to 2007

0.90

0.80

0.70

0.60

0.50

0.40

0.30

October Market Crash

Iraqi Invasion of

Bond

Asian Crisis

LTCM/ Russia

Terrorist Attacks

Bear M arket

Bottom

0.20

Fears of Crash

Kuw ait M arket Crash

0.10 Induced by Decline

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Conclusion

The chief idea of this exhibition is that, firstly give the some information about behavioral finance and also about fads, stock bubbles, prospect theory, loss aversion and etc.

Secondly, we can try to answer the queries which are very significant for the investors. And some guidance for the investors about how they do psychology of investing.

Thank you all for giving us your time to listen to us…

have a splendid day