Behavioral Finance by BI6e98EE

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									Behavioral Finance

               Ashish Mali
               Josh Cavers
               Ian Herle
               Lindsey Polishuk
         1.   Standard and
AGENDA        Behavioral
              Finance
         2.   Biases
         3.   Rational Choice
         4.   QUIZ
Standard Finance

   Investors are rational
   Markets are efficient
   Investors should design their portfolios
    according to the rules of Mean-Variance
    portfolio theory
   Expected returns are a function of risk and
    risk alone
What is behavioral finance?

   Describes the behavior of investors and
    managers; it describes outcomes of
    interactions between investors and
    managers in financial and capital markets

   Doesn’t follow four parts of standard finance
Behavioral finance

   Investors are not rational, they are normal
   Markets are not efficient
   Investors design portfolios according to the
    rules of Behavioral Portfolio Theory
   Expected returns are determined by more
    than risk. “Behavioral Asset Pricing Theory”
Normal?

   Cognitive biases and emotions come into
    play
   E.g. not realizing loses because it brings pain
    and regret
   “I’ll kick myself if I sell for $1 those dotcom
    shares I bought for $100. maybe I should
    wait to see if the stock recovers.”
Market Efficiency

   Stocks are always equal to its intrinsic value
   You can not “beat the market”
   Much evidence that stock prices regularly
    deviate from price
   E.g. crash in 1987
Behavioral Portfolio Theory

   People build portfolios like layered pyramids
   Each layer represents a specific goal
   Your risk aversion depends on the specific
    goal
Behavioral Asset Pricing Theory

   Stocks with desirable characteristics have
    lower expected returns
   Market capitalization and price to book ratio
    are added to beta to get expected returns
   Social responsibility?
Cognitive Biases

   Identify biases affecting investors
   Consultants duty to educate investors
   Scientific knowledge is key
Availability Bias

   Weigh decisions on recent information
    –   Lottery winners
   Stock market
    –   Winners vs. losers
   Retain perspective
    –   Long-term focus
Winners vs. Losers
Anchoring Bias

   Attach to a reference point
    –   Relevance
    –   New & novel concepts
   Stock market
    –   Short-term volatility
    –   Company fundamentals
   Use an array of perspectives
Confirmation Bias

   Preconceived opinion
    –   Emphasize favorable information
   Hot stock tip
    –   Seek information to prove true
    –   Avoid red flags
   Look for a sober opinion
Hindsight Bias

   The outcome was predictable
    –   Resulting incorrect oversimplifications
    –   The .com bubble
   Causes overconfidence
Overconfidence

   Fund managers & individuals
   Overconfident manager
    –   More trades and lower yields
   Confident manager
    –   Less trades and higher yields
   Ongoing battle to beat the market
    –   Investment techniques require constant
        refinement
Mental Accounting

   Investors separate money
    –   Subjective criteria
    –   Creates different functions for asset groups
   Paying debt vs. savings
   Varying values associated with assets
   Money is fungible
Rational Choice & Framing of Decision

   Decision Theory
   Perception of Situation
   Normative Rules
Invariance

Imagine that you face the following pair of concurrent decisions

1):
      A.   a sure gain of $240
      B.   25% chance to gain $1000 & 75% chance
           to gain nothing
2):
      A.   a sure loss of $750
      B.   75% chance to lose $1000 and 25%
           chance to lose nothing
Framing Outcomes

1) Assume yourself richer by $300 than you
   are today. You have to choose between:
A. a sure gain of $100
B. 50% chance to gain $200 and 50% chance
   to gain nothing
2) $500 richer than today
A. a sure loss of $100
B. 50% chance to lose nothing and 50% to
   lose $200
Rational Choice

   Assumptions in economics occur when
    certainty in market is present
What Money Type Are You?

   Our decisions about money are often driven
    by psychological factors over which we have
    little conscious control
   Personality tests help to recognize which
    errors are commonly made – and to use this
    knowledge to prevent them
   So, which type are you?
Mostly A’s

   You’re an Artisan
    –   Good instincts will prevail
    –   You are a “trust your gut” kind of person, who enjoys the
        thrill of investing
    –   Very comfortable at taking risks
    –   Tend to lack interest in long-term planning and discipline
   Advice from the experts
    –   Use your confidence
    –   But don’t indulge every whim
Mostly B’s

   You’re an Idealist
    –   Money just isn’t the top priority
    –   More concerned with assisting others and improving society
        rather than building personal wealth
    –   Your lack of interest in money matters can be a failure to
        reach any financial goals - that is, if you have set any
   Advice from the experts
    –   Put your investing on autopilot
    –   Have your cause and money too
Mostly C’s

   You’re a Guardian
    –   Discipline is key to security
    –   Greater emphasis is on financial security
    –   You are disciplined, patient, organized, and cautious
    –   Prefer fixed-income investments to relatively volatile
        equities
   Advice from the experts
    –   Deploy your discipline
    –   Conquer your timidity
Mostly D’s

   You’re a Rational
    –   Cool reason conquers all
    –   You enjoy problem solving, fact finding, and have
        an interest in science and technology
    –   You tend to stay calm in tense situations
   Advice from the experts
    –   Feed your taste for systematic thinking
    –   Remember: The market isn’t always rational
QUESTIONS

								
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