Experience Schulich 2010
Mini-lecture: Finance
As Far as Investors were
concerned…
S
the last decade was a miss!
S&P 500 Return (%)
The Lost Decade
-24.1%
S&P 500 Price index
Twin Peaks
1800
1600
1400
1200
1000
800
600
400
200
0
Bubbles
Traditional belief: Financial Markets are efficient, in that
they reflect all available information correctly and quickly.
- Is there an alternative view about the markets?
Behavioural Finance
• Relatively new school of thought
• A marriage of psychology and finance
• It says psychology plays a role in financial decision
making
• Cognitive errors and biases affect investment
beliefs, and hence financial choices
• Challenges the traditional idea that financial
markets are always efficient
Why Should We Care?
• To better understand our own investment
behaviour, and that of others
• Set the right incentives for clients, pension plan design,
financial product design
• CIBC Imperial Service: Investor Psychology 101
• To better understand asset management companies
that base their investment philosophy on behavioural
finance. Examples:
• The Behavioural Finance group at JPMorgan Asset
Management manages $10 billion
• LSV Asset Management manages $56 billion
Common Behavioural Biases
Overconfidence
Loss aversion
Narrow framing
Representativeness
Regret avoidance
Ambiguity aversion
Mental
accounting
Anchoring
Overconfidence
• Better than average
– “I am a better than average driver.”
– 95% of British drivers believe they are better than average
(Sutherland 1992)
• Illusion of control
– “I am unlikely to be involved in a car accident.”
Overconfidence
• As applied to investments, overconfidence may lead
to excessive trading
– “Trading is hazardous to your wealth” by Barber and
Odean (2000a)
– Find that portfolio turnover is a good predictor of
poor performance: Investors who traded the most
had the lowest returns net of transaction costs
Barber and Odean (2000a)
Barber and Odean (2000b): Result mostly confined to one
particular gender…
Why Don’t They Learn?
• Similar results in other studies: Overconfident
traders contribute less to desk profits (FentonO’Creevy et al. 2007)
• Why don’t overconfident investors learn from their
mistakes?
– Self-attribution bias
– Attribute successes to their own ability
– Blame failures on bad luck
Loss Aversion
Pleasure
Loss
Small Pleasure
Gain
+10%
-10%
Big Pain
Prospect Theory
Pain
Narrow Framing
• Loss aversion may be a consequence of narrow
framing
• Narrow frame of evaluation
– Limited set of metrics in evaluating investments
– Obsessive about price changes in a particular stock
– Myopic behavior even though investment is long-term
– Can lead to over-estimation of risk
Narrow Framing / Loss Aversion
• Consequence
– “Disposition effect”: Tendency to sell winners too soon,
and hang on to losers for too long (Shefrin and Statman,
1985, Odean 1998))
– Affects design of financial products
• If investor cares more about loss, rather than risk, then
products that limit downside risk is more attractive
than products that have low volatility
• Another rationale for asset-liability management
(ALM), rather than asset-only management
Myopic Loss Aversion
• Example: Currency hedging
– Influenced by recent events or stick with long-term view?
Representativeness
• Making decisions based on recent history, or a small
sample size
• Believe that it is representative of the future, or the
full sample
• May lead to “excessive extrapolation”
– Erroneously think that recent performance is
representative of longer term prospects
Representativeness
• 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
Regret Avoidance
• Leads to procrastination and inertia
– Status quo bias
– Good intentions but poor follow-through
• Consequences:
– Delayed saving and investment choices
– Limit divergence from peers’ average asset allocation, if
sensitive to peer comparison  herding behaviour of asset
managers
Ambiguity Aversion
• Sticking with the familiar
– Results in under-diversification
– Investors may exhibit home bias, local bias
– Bias is more substantial if take into account human capital
• From a diversification point of view, DC plans should
restrict company share ownership
Mental Accounting
• Tendency to divide total wealth into separate accounts
and buckets
– Ignores correlation between assets across portfolio
– May result in tax-inefficient allocations
• Naïve diversification in DC pension plans (Benartzi and
Thaler 2001)
– 1/n is found to be the predominant rule
– Authors find that “the proportion invested in stocks depends
strongly on the proportion of stock funds in the plan”
– Plan sponsor’s menu of options and choices very important
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
Lessons on Investing
• Do not extrapolate the past too far into the
future
• Do not wrongly equate a good company with a
good investment irrespective of price
• Do not develop a "mindset" about a company
• Take a “total portfolio” view
Final Note
• Some empirical findings are more respected in
the profession than others
• Stock market returns affected by number of
hours of sunshine, seasonal changes …etc.
– Point of disagreement
Questions?