Behavioral finance

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					Behavioral finance
  The real world impact of
    Behavioural biases
 Financial decision making
   Behavioral finance
   The stuff based on emotion & belief

Anger                                                         Grief
Hatred                                                        Envy
Guilt                                                        Malice
Shame                                                   Indignation
Jealousy        A mind capable of all of this has for    Contempt
Pride          the last 50 years been expected to act      Disgust
                 RATIONALLY when it has to make
Liking               decisions about money ??                 Fear
Regret                                                        Love
Two brain system

 In the next hour we want chocolate; next week, we want fruit

Limbic system (gut) vs. fronto-parietal system (analytic)
We are impatient in the here and now, but more patient in the long-term
- saving is similar to cleaning the attic, quitting smoking, going to gym or
   starting to exercise
- we want what makes us feel good in the short term, while we want what is
   good for us in the long term
   Behavioral finance
   … or fear & greed explained

The seduction of the market               The seduction of the market
(part one):                                                  (part two):
We seek patterns                           But when the pattern breaks
- the anterior cingulate &                          (i.e. share prices fall)
  nucleus accumbens                            - the amygdala is fired up
If we find them, we are happy               This leads to fear & anxiety
- dopamine is released                     (the fight or flight response –
This naturally makes us addicted              we are mammals after all)
- this causes bull markets, bubbles and     - this causes market crashes,
   irrational exuberance                    bear markets and pessimism
   Behavioral finance
   … and the ever-present asset bubble

“Each age has its peculiar folly, some scheme, project or phantasy into which
it is plunged, spurred on either by the love of gain, the necessity of
excitement, or the mere force of imitation… Money has often been the cause
of the delusion of multitudes. Sober nations have all at once become
desperate gamblers and risked almost their existence upon the turn of a
piece of paper… Men, it has been well said, think in herds; it will be seen that
they go mad in herds, while they only recover their senses slowly and one by

    - Charles MacKay, Extraordinary Popular Delusions & the Madness of Crowds, 1852
 Behavioral finance
 … and reluctance to accept the market cycle

   “Both bull and bear markets begin slowly, because there is always a
   disposition in people’s minds to think that existing conditions will be
 permanent. When the market is down and dull, it is hard to make people
 believe that this is the prelude to a period of activity and advance. When
  prices are up and the country is prosperous, it is always said that while
preceding booms have not lasted, this time there are unique circumstances
                 which will make prosperity permanent.”

                                     - Charles Dow, The Wall Street Journal, 1899
Behavioral finance
… a brief overview

  What it is & isn’t
  Kahneman & Tversky’s Prospect Theory
  Further examples
  Applications & some conclusions
Behavioral finance
Some definitions

 The study of how psychology affects financial
 decision making & markets
 Combines psychology & economics to explain why
 people make seemingly irrational decisions about
 It deals with the influence of psychology on the
 behaviour of investors and market practitioners
Behavioral finance
Context: What it is useful for

 Asset pricing: it explains why both value and momentum investing

 Corporate finance: It suggests that CEO’s will typically be
 overconfident when making deals
 Personal finance: Explains procrastination, why advisors are
 necessary & why most people will not save enough for retirement
 It may help the investor to:
        Avoid buying risky assets when they are very expensive / in
        overheated markets
        Understand / explain their own & client behaviour better
        Differentiate between noise and valuable information
Behavioral finance
Context: What it cannot (yet) do

 Cannot tell you when bubbles will pop, or afterwards,
 when the market will hit the bottom
 Does not tell you how to pick stocks (or most other
 Does not help you to make money from market
 Cannot predict the future (but it explains, with the
 benefit of hindsight, what happened in the past)
Behavioral finance

 1900-1950: Economics was a social science
   John Maynard Keynes & co focused on psychological explanations for
   economic behavior.

 1950-??: Economic models started assuming rationality
   Rational expectations hypothesis [Muth & Lucas]
   No arbitrage principle [Miller & Modigliani]
   Modern portfolio theory [Harry Markowitz]
   Capital asset pricing model [Bill Sharpe]
   Efficient market hypothesis [Eugene Fama]
   Option-pricing theory [Black, Scholes & Merton]
Behavioral finance
Rational models: The important stuff

 Expected utility theory
 (i.e. the rational expectations hypothesis)
 All rational models assume investment decisions are unbiased, the investor
 is risk averse, and every additional Rand of return is worth less than the
 previous one.)
                                    Standard Utility Function                Value Function

      The utility function:

                                    U = ln (W)

Behavioral finance
Rational models: The important stuff

 Expected utility theory
    All rational models assume investment decisions are unbiased, the
    investor is risk averse, and every additional Rand of return is worth less
    than the previous one.)

 Efficient markets hypothesis
     Market prices incorporate all (publicly) available info
     Market prices are the best estimate of true investment value at all
     In aggregate, investors understand & accurately applies expected
     utility theory
     Market prices take a random walk through time (and is therefore
     It is therefore impossible to beat the market over time (except if you
     take more risk).
Behavioral finance

 1900-1950: Economics was a social science
 1950-??: Economic models started assuming rationality

 1979-??: Behavioral finance
    Acknowledges the way in which individuals gathers & deals with information
    Attempts to combine economic & psychological principles
    Challenges market efficiencies by statistically proving pricing anomalies
          (e.g. abnormal price movements with IPOs & the existence of market bubbles)
    Highlights illogical investor actions
          (e.g. overconfidence, changing decisions depending on how choices are framed)
    It all started in 1979 with Kahneman & Tversky’s “Prospect Theory”
Prospect theory
The certainty effect

     Proves that investors are sometimes not that rational

 The experiment:
 Choice 1: 25% chance of winning R3,000 (750) or 20% chance of R4,000 (800)
     [65% of subjects wanted 20% chance of winning R4,000]
 Choice 2: 100% chance of winning R3,000 (3,000) or 80% of R4,000 (3,200)
     [80% of subjects wanted 100% chance of winning R3,000]

     If expected utility theory holds, investors should not pick differently.
     BUT Investors prefer a certain outcome
     Also, people think of extremely probable events as certain, & extremely
     improbable events as impossible
     Can be expressed mathematically as follows (the value function):
  Prospect theory
  The value function explains behaviour better

          Standard Utility Function                Value Function


          U = ln (W)
                                          Losses (or a return                      Gains (or a return
                                          less than a certain                     more than a certain
                                          level)                                                level)


    The utility function: Investors are
    always risk averse                    The value function: Investors are risk averse above
                                          their target wealth, but risk seekers below target
Prospect theory
Loss aversion

 How do people actually behave when faced with uncertainty?
   Losses are nearly twice as painful as the pleasure of equivalent gains
   Investors will gamble in losses: Likely to hold on to losing investments

                                                                   As an aside:
 Another experiment:
 Would you accept a bet that paid you R200                       This is one of the
                                                            justifications for investing
 (50% probability) or lost you R100 (50% probability)?       in a fund of hedge funds

 Answer: Yes, but only if you can take a 100 of them.

   Myopic loss aversion: When outcomes are evaluated too frequently,
   investors will more than likely take less risk than they can afford.
Prospect theory
Framing (mental accounting)

   Frame dependence = a problem expressed in two different (but equivalent
 ways will lead people to come to different conclusions)
   Mental accounting = separating particular events into different mental
 accounts based on superficial attributes (i.e. ignores portfolio or time effect)
   It is very difficult closing a mental account at a loss once one is
         Not wanting to sell a dog because it trades at less than the purchase price
         Putting dividends and capital gains in separate “accounts”
         Financing consumption out of income earned only (ignoring capital gains)
         Having a “safe part” of the portfolio for surviving and a “risky part” for
         getting rich
         Helping with self-control: Setting up “off-limits” accounts not used for
         spending urges
         Good money being thrown after bad to keep an unprofitable venture afloat
Prospect theory
Regret / Cognitive dissonance

   Many people want to avoid the pain of regret (i.e. the remorse for having
   made a bad decision)
   What it explains:
        Accelerating the sale of stocks that have gone up (to realise a profit before it
        falls again)
   Cognitive dissonance = the mental conflict experienced when
   presented with evidence that proves your beliefs or assumptions wrong
   (i.e. regret over mistaken beliefs)
   What it leads to:
        Avoiding new information
        Concocting contorted arguments to maintain beliefs
   What it explains:
        Why money flows into unit trusts that has performed well recently
        Why herd behaviour is experienced in times when speculative bubbles form
Rules of thumb can be dangerous!

   Comes from the same Greek root as “eureka!” (to find)
   Information overload necessitates the use of rules of thumb
   Can cause cognitive biases (reduce time but may be misleading)
       Affect – The stock market is more likely to rise on days that the sun shines
       (or when SA sports teams win!)
       Availability – Vivid information is more likely to be remembered and often
       leads to overreaction on good presentation (useful for closing that sale!)
       Price bias – People will believe that a more expensive bottle of wine is
       better, even when labels are switched
   Most important heuristics causing irrational behaviour (can cause the
   whole market to react incorrectly initially):
       herd behaviour
Herd behaviour
We are social beings (or pack animals)

   People who communicate regularly react similarly
   It seems very rational to change your ‘wrong’ opinion when the large
   majority of people judges otherwise
   Need to conform explains fashions & fads (also bubbles & crashes)
   A strong tendency exists to observe ‘winners’ closely (blame the
   media), especially when good performance repeats itself a couple of times
   Even if you think that the herd is wrong, you may go along if you expect
   the stampede to continue for a long time (this is the justification for
   momentum investing)
   It causes investors to irrationally act on noise, as if it were information
   that gave them an edge
   Impact of word of mouth: People trust other people more than they do
   the media
   Many investors choose to not waste their time to form an opinion about
   asset prices, leading to mispricing in the markets
People are mostly too optimistic

        believe they are better forecasters than they actually are
        exaggerate their talents
        underestimate the likelihood of uncontrollable bad outcomes
   People overreact to unexpected & dramatic news events
   People confidently see patterns in data that is truly random
   Causes investors to ignore that very few companies keep growing in a
   straight line more than five to ten years on the trot
   Good newsflow over a long period is typically bad news for investors
   (because the stock then tends to become overpriced)
   People are slow to change their opinions (only after two to five
   Most people think they are above average (this explains why there are so
   many active fund managers, and why they trade so much!)
People are mostly too optimistic

   When reference points (anchors) influence your estimation of share
   Happens because
         Market prices are inherently ambiguous – it is hard to tell what the
         value of the JSE ALSI should be. Past prices are therefore important
         when deciding what future prices should be.
   Explains why
         Investors focus on recent price movements and ignore longer term
         Share prices are typically very similar from one day to the next
         Share indices & P/E ratios regresses to the mean
         The correlation between individual stock movements is high
         Shares listed in specific countries have similar P/E ratios, rather than
         shares of the same size & in the same industry
   Many more examples…

Adaptive    Aversion to    Barn Door          Base Rate
Attitudes   Ambiguity      Closing            Neglect
Bubbles     Cascades       Certainty Effect   Closed end      Clustering
          Confirmatory     Conjunction        Conservatism
Dissonanc                                                     Contrarian
          Bias             Fallacy            Bias
Curse of  Disposition                         Endowment
                           Dividends                          Equity premium
knowledge Effect                              Effect
            False                             Frequency       Gamblers
Utility                    Framing
            Consensus                         Illusions       Fallacy
Glamour/V Global/Domesti
                           Herding/Crowd      Heuristics      Hindsight Bias
alue      c
            Illusion of    Law of Small                       Loss
Hot Hand                                      Loss Aversion
            Validity       Numbers                            Realization
            Magical                           Mental
Lunar                      Mean reversion                     Momentum
            Thinking                          Accounting

 The financial market euphoria cycle           Royal Dutch & Shell
 The psychological impact of bear markets
 US Bubbles of the late 20th century         IMPACT OF INSTITUTIONAL INVESTORS
                                               Rule of thumb asset allocation strategies
 The Commonsense Investment Guide            IMPACT OF THE UNIT TRUST INDUSTRY
 Growth in equity investing through mutual     The impact of narrow mandate unit trusts
 funds & pension accounts                      Small cap funds in SA: 1997 – 2003
 The heady days of 1996
 The conversion of Allan Greenspan           OTHER EXAMPLES
 Aversion to short internet stocks in 1999     LTCM’s collapse
                                               Fooled by Randomness: Taleb’s Black Swan
                                               Greed & fear: Impact on management
  Market cycles & asset bubbles
  The financial euphoria cycle

A short history of Financial Euphoria – John
 Kenneth Galbraith:
  The “new new thing” captures the imagination
  If it lasts for a while, past evidence of previous
 cycles are dismissed as irrelevant
  Everyone starts to make money
  People of average intelligence are rated as
  The bubble inevitably bursts and the ‘geniuses’
 become the focus of investor anger
Market cycles & asset bubbles
The boom/bust cycle

Some new and exciting advance is made.
Investors do not know how to value its benefit for investors.
Because it’s a new field, not enough money is available for investment
Underinvestment is addressed constructively through the creation of new
businesses, IPOs and bull markets.
Early investors make fortunes, causing a rush of liquidity into the new thing
Eventually, too much liquidity chases too few opportunities
Overinvestment requires constructive demolition: Bankruptcies, bear markets &
The benefit: Cycles drive markets, price movements, capital gains
Market cycles & asset bubbles
The boom/bust cycle
  Bear markets
  Their psychological impact

“[A bear market] normally has two stages. & investor sentiment also goes
through two fairly predictable stages. First there is the guillotine stage –
the sharp decline. That creates fear (This is what happened in 1974). Then,
     the second phase goes more slowly – there is the feeling of being
sandpapered to death. In place of fear becomes feelings of apathy, lack of
interest, and finally, hopelessness. That’s what happened for the rest of the
                                                       - Bob Farell, Merill Lynch
         Bear markets
         Their psychological impact

1100                                                                                                                                  1400

                                                                                                 Dow Jones Jan 1972-Jan

                                                                                                 S&P 500 Jan 2000-Dec 2003            1300







 500                                                                                                                                  700











  US bubbles
  … in the past 50 years

May ’62:      IPO boom leads to biggest one day loss since 1929 (34.9 points!)
Feb ’66:      “-ionics” companies boom came to an end
      “The game is being played by the gullible, self-hypnotized & demented”
                                                            - Warren Buffet in 1969
  US bubbles
  … in the past 50 years

May ’62:     IPO boom leads to biggest one day loss since 1929 (34.9 points!)
Feb ’66:     “-ionics” companies boom came to an end
1973/4       The demise of the Nifty Fifty
1987         Black Monday, when the Dow dropped 22.6% in a day
1988/9       Junk bonds, Michael Milken & the Savings & Loans
1996         Momentum & aggressive growth mutual funds got in trouble (the M&A
1997/8       Emerging markets fall dramatically after the Russian debt default,
             Asian contagion & LTCM
1999/2000    The NASDAQ & TMT stocks tanks, losing 1/3 the value of the US
             housing market ($3.3trillion) by the end of 2000
The US bull market
The US bull market

The Common Sense Investment Guide sold 800,000 copies in 1993
The stock market becomes democratic (i.e. the small guy provided the liquidity)
       1990: $50bn inflows into US equity mutual funds
       2001: $300bn inflows into US equity mutual funds
       First time equity investing according to the ICI:
       If you had more than $500,000 to invest, only 1 in 5 bought 1st equities after 1990
       Between $100,000 & $500,000: 1 in 2 bought 1st equities only after 1990
       Between $25,000 & $100,000: 1 in 3 bought 1st equities only after 1990
       Less than $25,000: 2 out of 3 only bought 1st equities after 1996
The US bull market

The Common Sense Investment Guide sold 800,000 copies in 1993
The stock market becomes democratic (i.e. the small guy provided the liquidity)
During 1996…
        3,000 new mutual funds were launched
        22 new business magazines were launched
        CNBC became the most popular daytime TV channel in the US
        CNN launched CNNfn
        AOL launched an on-line mutual fund centre
…. it was surely the age of noise!
The US bull market

The Common Sense Investment Guide sold 800,000 copies in 1993
The stock market becomes democratic (i.e. the small guy provided the liquidity)
1996, was the ultimate age of noise
The conversion of Allan Greenspan
      March ’96:      Forbes Magazine runs “In Greenspan we Trust” cover

      Sep ’96:        Allan recognizes the potential stock market bubble problem

      Nov ’96:        Dow up by another 15% in two months

      Dec ’96:        Talks about “irrational exuberance” and compares the US
                      stock market to Japan. Market participants & economists protests
      Jan ’97:        Changes tack completely: Because of the breath-taking
                      performance of the economy & large productivity gains, makes the
                      case for ‘rational exuberance’
Pricing anomalies
Royal Dutch/ Shell

    The current company emerged from a 1907 alliance between Royal Dutch
    and Shell Transport in which the two companies agreed to merge their
    interests on a 60/40 basis
    Royal Dutch trades primarily in the United States and the Netherlands
    and is part of the S&P 500 Index; Shell trades primarily in London and is
    part of the FTSE 100 Index
    According to any rational model, the shares of these two components
    (after adjusting for foreign exchange) should trade in a 60–40 ratio.
    They do not; the actual price ratio has deviated from the expected one by
    more than 35%
    Simple explanations, such as taxes and transaction costs, cannot explain
    the disparity
                                                              Richard Thaler
Role of institutional investors
Rule of thumb asset allocation

 The largest investors—pension funds, endowments, and
 wealthy individuals—typically use some rule of thumb for
 asset allocation, such as 60 percent in equities, and are
 thus relatively insensitive to the level of asset prices. Second,
 such insensitivity is even more characteristic of individual
 investors in 401(k) plans, who rarely rebalance their

                                                      Richard Thaler
Impact of CIS
Small investors forced into setting prices

    Many unit trusts have narrow mandates and are forced to remain fully
    Even if the fund manager is not comfortable with valuation levels, most
    continue to allow new investments into “hot funds”
         Until 1999, the Regulator did not allow a unit trust to be closed
         There is a significant agency problem preventing fund closure
    Individual investors piling into these ‘hot funds’, without understanding
    the price levels at which they buy the underlying equities, are essentially
    running the show (i.e. setting market prices)

  The SA small cap example…
Small caps in SA
Rear-view mirror driving

            R6bn (20% of UT
            inflows) invested in
            small cap funds,
            while market drops
            by 46%.


       Index nearly                                           R0.4bn
       doubles in value in                                    (0.8%)
       36 months
Investment pointers
Practical implications

  Remember that asset prices go up when there are more buyers than sellers
         (ask who will provide the next leg of liquidity before expecting large gains)
  Beware excess liquidity
         (be scared when the media waxes lyrical)
  When bubbles collapse, it historically gave back all, not part, of the gain
  When market momentum really gets going, it doesn’t die quickly
  Treat stock tips with skepticism
         (professionals must sell, word of mouth is probably influenced by noise)
  The first rule is not to lose money
         (it’s all about the price you pay)
  Good businesses do not necessarily make good investments
  Because no one really knows what stock markets should be worth, the long run
  averages are important reference points
Some conclusions

The rationality debate continues – indexing remains popular
Perspective is more important to successful investing than anything else
It is becoming rational to build irrationality into trading and forecasting
models (but behavioural change is difficult)
Past bear markets have lasted longer than most people would want to
know – it often requires a generational change for market sentiment to
change permanently
Financial advisors are primarliy commitment agents
Product design should exploit / overcome passivity

Kahneman, Tsversky, Thaler, Shilling, de Bondt, Laibson amongst many others.

Against the Gods – The Amazing Story of Risk         Peter L. Bernstein
Bull! – The History of the Bull Market               Maggie Mahar
The Intelligent Investor                             Benjamin Graham, with commentary by
                                                     Jason Zweig
Fooled by Randomness – The role of chance in
markets and in life                                  Nicholas Nassim Taleb
When Genius Failed – The Story of LTCM               Roger Lowenstein

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