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, 2002. This is for your enjoyment
  and learning onlyit will not be on any quizzes
  or exams.

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Objectives

• Understand behavioral finance
• Understand why we should learn behavioral finance
• Understand other alternatives to traditional
  finance
• Understand how behavioral finance can help us
  become better investors

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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?
• Behavioral finance tries to incorporate personal
  behavior in an effort to extend finance beyond
  these 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
• News comes out, and Boston Scientific stock drops
  10.
• 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?

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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. You can learn psychological biases that
  affect investment decision making
• 2. You can understand how these biases affect
  investment decisions
• 3. You can see how poor decisions reduce your
  wealth
• 4. You can learn to recognize and avoid these
  poor decisions and 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

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Behavioral Finance (continued)

• Activity 4
• Following are 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 90 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
• 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?

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Behavioral Finance (continued)

• 5. How many bones are in the human body?
• 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
  mile 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
• 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.

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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?

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Other Alternatives (continued)

• 1. Cooperation and Altruism
• Cooperation may be a viable 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

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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 win you overpaid
• What to do?
• Be careful in setting your bid prices
• Generally, dont bid your fair value

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

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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
• Follow the principles of successful investing but
  be open to new ideas

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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 weights in your
  analysis

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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 kids college savings at 1
• 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
• 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 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 index funds
• You will at least get market returns

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Other Alternatives (continued)

• 8. Seeking solace
• Sometimes we follow newspaper/newsletter advice
  and recommendations 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
• What to do?
• Realize the limitations of these recommendations
• If you have no better ideas, invest in index
  funds and ETFs which dont try to beat the market

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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)
• We get lower returns from not reducing trading
  costs
• What to do?
• Rebalance as needed to your limits
• Work to reduce trading 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 and
  institutions window dress, i.e., want to make
  their portfolios look good, so they sell unwanted
  and buy desired stocks for period-end reports
• What to do?
• Dont worry about calendar effects
• Invest for the long-term 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)
• What to do?
• Invest for the long-term and 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, 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
• Prices tend to revert to the mean over the
  long-term
• What to do?
• Realize that the best performing stock or fund
  last year will not be the best year
• Winners revert to average performance over time
• Dont buy last years best performers
• Invest long-term

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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. 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 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 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 a 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 plan, and follow that plan closely
• Do not invest in areas outside of your plan or in
  areas specifically forbidden

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

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Becoming Better Investors (continued)

• Joseph 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?

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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. And 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
  stocks. It includes knowing yourself.
• These main ideas and questions are from John R.
  Nofsinger, The Psychology of Investing Prentice
  Hall, 2002, 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?