Personal Finance: Another Perspective

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Personal FinanceAnother Perspective

• Investments 10 -
• Behavioral Finance
• Much of this material is taken from the book The
  Psychology of Investing by John R. Nofsinger,
  Prentice Hall, 2008. This is for your enjoyment
  and learning onlyit will not be on an exam or
  quiz. John has given permissions for me to share
  this PowerPoint with my students.

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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

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Investment Plan Assignments

• Investments 10 Behavioral Finance
• 1. Review this PowerPoint for information. It
  gives some good insights on investing you might
  not have thought of.
• It will not be on any Quiz or Exam, but it may
  have a positive impact on how you invest and your
  investment returns

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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 of
  rationality and unbiased predictions?
• Behavioral finance tries to incorporate personal
  behavior in an effort to extend finance beyond
  its 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
• More news comes out, and Boston Scientific stock
  drops 20.
• 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 the difference between the grocery store and
  the stock market?

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Questions

• Any questions on behavioral finance?

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Why Should we Learn Behavioral Finance?

• Why should we learn behavioral finance?
• 1. Behavioral finance can help you learn about
  your psychological biases
• 2. You can understand how those psychological
  biases affect your investment decision making
  process
• 3. You can see how poor investment decisions
  affect your wealth
• 4. You can learn to recognize and avoid poor
  investment decisions which come from those
  psychological biases, which can help you 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
• We must be wise to these prediction errors so we
  can be better investors

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Behavioral Finance (continued)

• Activity 4
• Following are 10 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 at a minimum
  90 right (or at least 9 questions 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, but you must
  be 90 sure you are right.
• 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?
• 5. How many bones are in the human body?

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Behavioral Finance (continued)

• 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
  miles 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
• 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

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Behavioral Finance (continued)

• 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
• In an average class, fewer than 30 are 90 right

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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?
• Following are a few ideas that may be helpful

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Other Alternatives (continued)

• 1. Cooperation and Altruism
• Cooperation may be a viable investment strategy
• Peoples 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 13)
• What to do?
• Think about other alternatives, other
  perspectives. Learn to think outside the box

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Other Alternatives (continued)

• 2. Bidding and the Winners Curse
• Bidding may lead to a suboptimal result when you
  bid your fair value
• Assuming everyone else has the correct value, if
  you won you overpaid!
• What to do?
• Be careful in setting your bid prices
• Generally, dont bid your fair valuebid lower
• Dont get emotional in your bid prices for
  financial assets

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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 does
  not increase the value of that asset
• Do not get too emotionally attached to an asset
  that you own

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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
• Be open to new ideas as long as they follow the
  principles of successful investing discussed
  earlier

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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 weight in your
  analysis
• It is the gains and losses of the overall
  portfolio that are important

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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 investment account for the kids college
  savings (which are earning 2 annually)
• 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
• Save and 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 are lower
  cost and 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 portfolios of index funds
• You will at least get market returns and will
  generally beat most actively managed funds

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Other Alternatives (continued)

• 8. Seeking solace
• Sometimes we follow newspaper/newsletter advice
  which have been shown to under-perform
• We prefer to take others advice rather than
  doing our own homework
• If the performance goes bad, we can blame others
  (we dont have to take responsibility)
• What to do?
• Realize the limitations of these recommendations
• If you have no better knowledge, invest in index
  funds/ETFs which are passively managed

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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 portfoliothat
  way you dont lose too much
• What to do?
• If you want fun money, set up a trading account
  in a retirement vehicle (so you dont 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 from our Investment
  Plan)
• We get lower returns from increased trading costs
• What to do?
• Develop a good Investment Plan and rebalance as
  needed to your limits
• Work to reduce trading, taxes, 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.
  Institutions tend to window dress, i.e., sell
  unwanted and buy desired stocks for period-end
  reports
• What to do?
• Dont worry about calendar effects
• Invest for the long-term consistent with your
  Investment Plan 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) theory
• What to do?
• Invest for the long-term according to your
  Investment Plan and follow your strategy
• 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, true to your Investment Plan,
  and dont 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
• Long-term prices tend to revert to the mean
• What to do?
• Realize that the best performing stock or mutual
  fund last year will not be the best performer
  this year
• Winners revert to average performance over time
• Dont buy last years best performers
• Invest for the future--not from the past

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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. Articulate your ideas in your Investment
  Plan. 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 (NMD) 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 Investment Plan and 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 an Investment 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 Investment Plan, and follow that
  Plan closely
• Do not invest in areas outside of your Plan or in
  areas you know you do not add value

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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 Investment Plan, and it will save you
  thousands of dollars in the long-term

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Becoming Better Investors (continued)

• John 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
  doesnt meet your criteria, remember that it is
  unlikely that you know more than the market
• Do you really know more than the market?

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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 than the market.
• 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
  financial markets, asset classes, and financial
  assets. It includes knowing yourself.
• These main ideas and questions are from John R.
  Nofsinger, The Psychology of Investing Prentice
  Hall, 2008, 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?