Behavioral Finance

1. Behavioral Finance Pauline Shum Schulich School of Business York University

2. Agenda • What is behavioral finance? • Behavioral biases and their implications for investment beliefs and decision making

3. 1. What is behavioral finance? • Relatively new school of thought • Gradually recognized as a legitimate field in finance in the 1990s • A marriage of psychology and finance • It says psychology plays a role in financial decision making • Is it a surprise that we are human?

4. 1. What is behavioral finance? • Cognitive errors and biases affect investment beliefs, and hence financial choices • Poses a challenge to the traditional idea that markets are always efficient

5. 1. What is behavioral finance? • Why should we care? • To better understand our own investment behavior, and that of others  set the right incentives for clients, pension plan design • To better understand asset management companies and active strategies that base their investment philosophy on behavioral finance • Even retail banking is talking to customers about it (e.g., CIBC Imperial Service: Investor Psychology 101)

6. 2. Behavioral biases • Summary of well-known cognitive errors and biases, and their impact on investment beliefs and decision making

7. Overconfidence • Better than average: • “I’m a better than average driver.” • Illusion of control • “I won’t have a car accident.”

8. Overconfidence • As applied to investments, overconfidence may lead to excessive trading • “Trading is hazardous to your wealth” by Barber and Odean (2000) • Find that portfolio turnover is a good predictor of poor performance: Investors who traded the most had the lowest returns net of transaction costs • Mostly confined to one particular gender…

9. Why don’t they learn? • Why don’t overconfident investors learn from their mistakes? • Self-attribution bias • Attribute successes to their own ability • Blame failures on bad luck

10. Loss aversion Pleasure Small pleasure -10% Loss Gain +10% Big pain Pain

11. Narrow framing • Loss aversion may be a consequence of narrow framing • Narrow frame of evaluation • Limited set of metrics in evaluating investments • Myopic behavior even though investment is long-term • Obsessive about price changes in a particular stock • Can lead to over-estimation of risk

12. Narrow framing/loss aversion • Consequence: Tendency to sell winners too soon, and hang on to losers for too long • E.g., Nortel • “If I haven’t realized the loss, then it isn’t yet a loss.”

13. Myopic loss aversion • Example: Currency hedging • Influenced by recent events or stick with long-term view? • Combination of loss aversion and representativeness

14. Representativeness • Making decisions based on recent history, or a small sample size • Believe that it is representative of the future, or the full sample

15. Representativeness • May lead to “excessive extrapolation” • Erroneously think that recent performance is representative of longer term prospects • 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

16. Representativeness • Let’s look at performance of portfolio managers Quartile 1998-2001 2002-2005 1998-2001 2002-2005 21 21 55 1 55 11 12 2 12 3 9 10 4 14 Based on a sample of 220 U.S. equity managers (Wood, 2006)

17. Representativeness • Another example of excessive extrapolation: Sample size • Erroneously think that a small sample size is representative of the population • E.g. opinion of a car vs. investing in the car company

18. Regret Avoidance • Leads to procrastination and inertia • Status quo bias • Good intentions but poor follow-through • Results in delayed saving and investment choices • Defined Contribution Plans: A significant number of accounts are kept in their default allocation for a long time

19. Ambiguity aversion • Sticking with the familiar • Results in under-diversification • Home bias, local bias • Bias is more substantial if take into account human capital

20. 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

21. Final Note • Some empirical findings are more respected in the profession than others • More controversial studies: Stock market returns affected by number of hours of sunshine, seasonal changes …etc. • More and more asset management companies are using the “behavioral finance” buzz word (mostly value strategies)

22. Final Note • Can the two schools of thought co-exist? • How I like to think about it: • Short-term: markets can be inefficient due to investor behaviour • Long term, markets are efficient (on average)