Behavioral Finance: The Collision
of Finance and Psychology
BehavioralFinance: TheCollision
ofFinanceandPsychology
Presentedby:
Dr.JoelM.DiCicco,CPA
FloridaAtlanticUniversity
OrderofPresentation
BehavioralFinance
1) Definition
2) Research
3) SignificanceforFinancialPlanners
4) BehavioralFinanceandCustomerProfitability
5) Conclusion
Definition
“Behavioralfinanceisafieldoffinancethatproposes
psychology-basedtheoriestoexplainstockmarketanomalies.
Withinbehavioralfinance,itisassumedthattheinformation
structureandthecharacteristicsofmarketparticipants
systematicallyinfluenceindividuals'investmentdecisionsaswell
asmarketoutcomes.”(R.A.Qawi)
Definition
BehavioralFinanceisasubsetofBehavioralEconomics
Definition:NextGenerationofBehavioral
Finance
• AccordingtoDr.MeirStatmanofSantaClara
University,inthefirstgeneration,wetookthe
notionfromstandardfinancethatsaidwhat
peopleshouldonlycareaboutisgettinghigh
returnsandnotgettinglowones.Whenwesaw
peoplewhotradedalot,wedescribedthemas
irrational.
Definition:NextGenerationof
BehavioralFinance
• Theideaofsecond-generationbehavioralfinanceisthatnot
everythingpeopledothat’sdifferentfromthe
recommendationsofstandardfinancethatcauseslowreturns
isirrational.It’sperfectlynormal.
• Asopposedtothefirstgenerationthought,second-gen
behavioralportfoliotheoryguidespeopletoinvestmentsthat
“reflecttradeoffsbetweenhighexpectedreturns,lowrisk,
socialresponsibilityandhighsocialstatus
Research:SleepWellorEatWell?
Research
• Theideabehindbehavioralfinanceisthatpeople’semotions
affectprices.
• KeyAssumption:AccordingtoDr.R.DeGennaro ofthe
UniversityofTennessee,experiencedinvestorsarerestricted
intheamountoftradingtheycando.Ifnot,smartinvestors
wouldcontinuouslytrade,therefore,indirectlyprotecting
emotionaltrading.
• Forexample,ifonepanicsandyouwanttosellthestockata
lowprice,thecompetitionwillbailyououtastheywillensure,
bytheirtrading,thatafairvaluewillstillbeobtained.
Research
TheBottomLine
BehavioralFinanceseekstoaddressemotional
patternsbehindthemistakesinvestorsmake.
Research:Dr.DavidHirshleiferUCIrvine
Research
Self- Deception
• OveroptimismBias- describesthementalstateinwhich
peoplebelievethatthingswillmorelikelygowellforthem
thanpoorly.Whenplayingagame,anindividualismore
inclinedtothinkheorshewillwin ratherthanlose.
Sometimesbeinginagoodmoodcouldcausethis.(Dr.M.
Schulmerich,CFA- ManagingDirectorofPECUNDUS).
• OverconfidenceBias- tendencytobelieveyouhaveaskillor
advantagethatothersdon’t. (Dr.M.Schulmerich).Thisleads
investorstooverweighttheirprivateinformationcausing
stockstooverreact.Thenapartialcorrectiontakesplace.
• ConfirmationBias- tendencytofavorevidencethatsupports
whatwealreadybelieve. (Dr.M.Schulmerich).Tendtofollow
theirinvestmentguru(s).
Research
HeuristicSimplification
• AffectHeuristic/Representativeness- howperceptionbased
purchaseorsaleofstockcaninfluencethepriceofthestock.For
example,whenFortuneMagazinehasitssurveyofcorporate
reputation,theonesthatdidwellonthesurveymustalsobegood
investmentsandvice-versa(ByrneandBrooks)
• Anchoring/Salience- isaphenomenausedinthesituationwhen
peopleusesomeinitialvaluestomakeestimation,whicharebiased
towardtheinitialonesasdifferentstartingpointsyielddifferent
estimates(Kahneman &Tversky).Infinancialmarkets,anchoring
ariseswhenavaluescaleisfixedbyrecentobservations.Asan
example,investorsalwaysrefertotheinitialpurchasepricewhen
sellingoranalyzing.
• LossAversion/ProspectTheory- thistheorystatesthatpeoplemake
decisionsbasedonthepotentialvalueoflossesandgainsrather
thanthefinaloutcome,andthatpeopleevaluatetheselossesand
gainsusingcertainheuristics(Y.Liu,J.Nacher,et.al)(i.e.rathernot
lose$10thangain$10).
Research
Social
• Herding- wheninvestorsinthefinancialmarketplaceimitate
eachother.Thiscouldleadtomarketboomsandbusts
(Kourtidis,Sevic,etal)
Research
• Heuristics(rulesofthumb)- Thebehavioralassetpricing
model,whilenotsuperiortootherpricingmodelssuchas
CAPM,shouldbeconsideredinpractice.Aspectsofthe
behavioralassetpricingmodelaredirectlyrelatedtothe
varioustypesofaffect,suchassocialresponsibility,prestige,
etc.Therefore,itsapplicationmaynotbeuniversalanditmay
includefactorsweighteddifferently(Dr.R.Qawi)
SignificancetoFinancialPlanners
Onecouldfocusthesignificanceofbehavioral
financeinthefollowingfinancesub-disciplines:
• CorporateFinance- i.e.IrrationalManagers- for
instance,accordingtoMalmendierandTate,
usuallymanagerstendtooverinvestwhen
internalfundsareabundantbutrefrainfrom
investingwhenexternalfundsarerequired.
SignificancetoFinancialPlanners
• PortfolioTheory- AccordingtoShefrinand
Statman,forinstance,behavioralportfoliosare
formedaslayeredpyramidsinwhicheachlayer
isalignedwithanobjective.Thebaselayermay
beintendedas“protectionfrompoverty”
whereasahigherlayerorriskyassetsrepresents
“hopesforriches”WITHOUTANY
CONSIDERATIONOFTHECOVARIANCES
BETWEENTHELAYERSUNLIKEMODERN
PORTFOLIOTHEORY.
SignificancetoFinancialPlanners
Duetothefocusofthisconference,the
remainingportionofthispresentationwill
bebasedonIndividualInvestors.
SignificancetoFinancialPlanners
• AstudybyR.Wood(MBA,DirectorofDigitalStrategyat
MediativeandDr.J.Zaichkowsky (SimonFraserUniversity)
identifiesandcharacterizessegmentsofindividualinvestors
basedontheirsharedinvestingattitudesandbehavior.
• Aclustersegmentationanalysiswasusedandbasedonthe
responsestothequestionnaires,fourmainsegmentsof
individualinvestorsweredetermined.
SignificanceforFinancialPlanners
• Cluster1-Risk-IntolerantTraders
• Cluster2-ConfidentTraders
• Cluster3-Loss-AverseYoungTraders
• Cluster4-ConservativeLong-TermInvestors
SignificanceforFinancialPlanners
Cluster1-Risk-IntolerantTraders
• Extremelylowrisktolerance.
• Mediumlevelofconfidence.
• Theymonitortheirinvestmentsatleastweeklybuttrade
infrequently.
• Fortheirtradingaccounts,theyinvestheavilyinblue-chips
andtechnologybasedcompanies.
• Fortheirretirement,mutualfundsaretheirvehicleof
preference.
• Relianceonfinancialadvisors.
• Analyzefinancialstatements.
Itwouldseemprudentforfinancialadvisorstoconcentratetheir
effortsandadviceondiversificationandriskmanagement.
Mutualfundsandstableblue-chipinvestmentsmightbe
appropriateforthissegment.
SignificanceforFinancialPlanners
Cluster2-ConfidentTraders
• Theirportfoliovaluestendbelargerthanotherclusters.
• Theytrademorethan10timesperyearandchecktheir
investmentsweekly.
• Confidenttradersconsultfriendsforadvice,butdonot
consultadvisorsoften.
• Shorter-terminvestmenthorizon.
• Tendtoinvestintechstocksandsmalltomid-sizecompanies
andforretirement,theyalsochosemutualfundsasthe
dominantinvestmentvehicle.
• Theconfidenttradershadahigherpercentageofreadership
ofalmostalltypesofinformation.Theyreadsignificantly
morefinancialstatements(notsomuchforvolatile
investments)andcheckthenewsreadily.
SignificanceforFinancialPlanners
Cluster3-Loss-AverseYoungTraders
• Thisgroupdoesnotmindtakingrisks,butfeelsterriblewhenthey
losemoney.Cluster3investorshavesignificantlylowerlevelsof
confidencethantheconfidenttradersincluster2.
• Theseinvestorsprobablypersonalizetheirlossesmorebecausethey
areyoung,relativelyinexperiencedatinvesting,andcannotaffordto
losetheirmoney.
• Cluster3investorsarealsothemostlikelytousetheInternetas
theirmethodofinvestmentandtheyalsotradequitefrequently.
• Likeconfidenttraders,theyowntechnologyandsmallstocksintheir
regularportfolios,buthavemorestablemutualfundsintheir
retirementportfolios.
• ThisgroupusestheInternettoevaluatevolatileinvestments,but
usesfinancialadvisorsforstableinvestments.Loss-aversetraders
findcurrentnewsmostusefulforvolatileinvestments.
SignificanceforFinancialPlanners
Cluster4-ConservativeLong-TermInvestors
• Conservativelong-terminvestorsarealmosttheexact
oppositeofconfidenttraders(Cluster2).
• Theyhavelowratingsinconfidenceandtradeinfrequently.
• Thisgroupalsoownstheleastnumberofstocksanddoesnot
checktheirinvestmentsoften.Theypurchaselong-term
conservativemutualfundsmostoftenwiththehelpof
financialadvisors.Thisappliestoboththeircurrentholdings
andfortheirretirementfunds.
• Thisgrouptendstousefinancialadvisorsforriskreduction
becausetheydonotwanttobeblamedforpoor
performance.
• Cluster4donotfinddetailedfinancialstatementsusefulin
evaluatinginvestments,buttheydousecurrentnewsto
evaluatetheirvolatilestocks.
BehavioralFinanceandCustomerProfitability
On-LineTradingCompanies.
Whatdotheylookforinpotentialcustomers?Whattypesof
profiles?
Remember,thereisacostforholdingcustomeraccounts.The
goalistohaveprofitablecustomersandnotcustomersforthe
sakeofhavingcustomers.
Traderprofilesaresometimesreferredtoas“Personas.”
BehavioralFinanceandCustomerProfitability
Inaparticularstudy,L.Xinwu,lookedatanon-linetrading
companyandperformedacustomerclusteringwiththese
attributes:
• MonthlyFrequencyofWebsiteLogin,MonthlyWebsite
StayingTime,MonthlyTimesofPurchasing,MonthlyAmount
ofPurchasing,TypeofConsumerProductsPurchased,Times
ofServiceFeedback,ServiceSatisfaction,Customer
Profitability,CustomerProfit,RepeatPurchases,
RecommendedNumberofCustomers,PurchasingGrowth
Rate.
BehavioralFinanceandCustomerProfitability
CaseStudyResults
ConclusionandQuestions?
Formoreinformation,feelfreetocontact:
Dr.JoelM.DiCicco,CPA,PFS,CFF,BCA
• Email:[email protected]
• Cell:954-547-2908