Download Behavioral Finance

Behavioral Finance
Pauline Shum
Schulich School of Business
York University
Agenda
1. What is behavioral finance?
2. Behavioral biases and their
implications for investment
beliefs and decision making
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1. What is behavioral finance?
 Relatively new school of thought
 Gradually recognized as a legitimate field in
finance in the 1990s
 A marriage of psychology and finance
 It says psychology plays a role in
financial decision making
 Is it a surprise that we are human?
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1. What is behavioral finance?
 Cognitive errors and biases affect
investment beliefs, and hence
financial choices
 Poses a challenge to the traditional
idea that markets are always efficient
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1. What is behavioral finance?
 Why should we care?
 To better understand our own investment behavior,
and that of others  set the right incentives for
clients, pension plan design
 To better understand asset management
companies and active strategies that base their
investment philosophy on behavioral finance
 Even retail banking is talking to customers about it
(e.g., CIBC Imperial Service: Investor Psychology
101)
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2. Behavioral biases
 Summary of well-known
cognitive errors and biases, and
their impact on investment
beliefs and decision making
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Overconfidence
 Better than average:
 “I’m a better than average driver.”
 Illusion of control
 “I won’t have a car accident.”
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Overconfidence
 As applied to investments, overconfidence
may lead to excessive trading
 “Trading is hazardous to your wealth” by Barber and
Odean (2000)
 Find that portfolio turnover is a good predictor of poor
performance: Investors who traded the most had the
lowest returns net of transaction costs
 Mostly confined to one particular gender…
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Why don’t they learn?
 Why don’t overconfident investors
learn from their mistakes?
 Self-attribution bias
 Attribute successes to their own ability
 Blame failures on bad luck
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Loss aversion
Pleasure
Loss
Small pleasure
Gain
+10%
-10%
Big pain
Pain
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Narrow framing
 Loss aversion may be a consequence
of narrow framing
 Narrow frame of evaluation
 Limited set of metrics in evaluating investments
 Myopic behavior even though investment is longterm
 Obsessive about price changes in a particular
stock
 Can lead to over-estimation of risk
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Narrow framing/loss aversion
 Consequence:
Tendency to sell winners too soon,
and hang on to losers for too long
 E.g., Nortel
 “If I haven’t realized the loss, then it isn’t yet a
loss.”
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Myopic loss aversion
 Example: Currency hedging
 Influenced by recent events or stick with
long-term view?
 Combination of loss aversion and
representativeness
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Representativeness
 Making decisions based on recent
history, or a small sample size
 Believe that it is representative of
the future, or the full sample
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Representativeness
 May lead to “excessive extrapolation”
 Erroneously think that recent performance is
representative of longer term prospects
 Results: Investors chase past winners
 Overreacts to glamour stocks (e.g., Technology
bubble)
 Overreacts to bad news which may be temporary
(thus creating “value opportunities”)
 Creates short-term momentum, but long-term reversal
in returns
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Representativeness
 Let’s look at performance of portfolio managers
Quartile
1998-2001
2002-2005
1998-2001
2002-2005
1
55
21
21
55
2
11
12
3
9
12
4
14
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Based on a sample of 220 U.S. equity managers (Wood, 2006)
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Representativeness
 Another example of excessive
extrapolation: Sample size
 Erroneously think that a small
sample size is representative of the
population
 E.g. opinion of a car vs. investing in the car
company
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Regret Avoidance
 Leads to procrastination and
inertia
 Status quo bias
 Good intentions but poor follow-through
 Results in delayed saving and
investment choices
 Defined Contribution Plans: A significant
number of accounts are kept in their default
allocation for a long time
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Ambiguity aversion
 Sticking with the familiar
 Results in under-diversification
 Home bias, local bias
 Bias is more substantial if take into
account human capital
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Impact on committee decision
making
 Lack of diversity in membership could
pose a problem
 Common knowledge syndrome: less willing to
share unique or different information for the sake of
social cohesion
 It takes 16 similarly-minded committee members to
generate the diversity of 4 different-minded
members
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Final Note
 Some empirical findings are more respected in
the profession than others
 More controversial studies: Stock market returns
affected by number of hours of sunshine,
seasonal changes …etc.
 More and more asset management companies
are using the “behavioral finance” buzz word
(mostly value strategies)
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Final Note
 Can the two schools of thought co-exist?
 How I like to think about it:
 Short-term: markets can be inefficient due to investor
behaviour
 Long term, markets are efficient (on average)
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