Behavioral Finance

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Behavioral Finance

• Pauline Shum
• Schulich School of Business
• York University

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Agenda

• What is behavioral finance?
• 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
• Im a better than average driver.
• Illusion of control
• I wont 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 dont they learn?

• Why dont 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
Small pleasure
-10
Loss
Gain
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
  long-term
• 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 havent realized the loss, then it isnt
  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

• Lets look at performance of portfolio managers

Quartile 1998-2001 2002-2005
1998-2001 2002-2005
21
21
55
55
1
11
12
2
12
9
3
10
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)