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7/28/2019 Behavioral Finance - Group 5
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Behavioral Finance
Ashish MaliJosh CaversIan HerleLindsey Polishuk
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Standard Finance
Investors are rational
Markets are efficientInvestors should design their portfoliosaccording to the rules of Mean-Varianceportfolio theoryExpected returns are a function of risk andrisk alone
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What is behavioral finance?
Describes the behavior of investors and
managers; it describes outcomes of interactions between investors andmanagers in financial and capital markets
Doesnt follow four parts of standard finance
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Behavioral finance
Investors are not rational, they are normal
Markets are not efficientInvestors design portfolios according to therules of Behavioral Portfolio TheoryExpected returns are determined by morethan risk. Behavioral Asset Pricing Theory
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Normal?
Cognitive biases and emotions come into
playE.g. not realizing loses because it brings painand regretIll kick myself if I sell for $1 those dotcomshares I bought for $100. maybe I shouldwait to see if the stock recovers.
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Market Efficiency
Stocks are always equal to its intrinsic value
You can not beat the market Much evidence that stock prices regularlydeviate from priceE.g. crash in 1987
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Behavioral Portfolio Theory
People build portfolios like layered pyramids
Each layer represents a specific goalYour risk aversion depends on the specificgoal
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Behavioral Asset Pricing Theory
Stocks with desirable characteristics have
lower expected returnsMarket capitalization and price to book ratioare added to beta to get expected returnsSocial responsibility?
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Cognitive Biases
Identify biases affecting investors
Consultants duty to educate investorsScientific knowledge is key
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Availability Bias
Weigh decisions on recent information
Lottery winnersStock market Winners vs. losers
Retain perspective Long-term focus
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Winners vs. Losers
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Anchoring Bias
Attach to a reference point
Relevance New & novel concepts
Stock market Short-term volatility Company fundamentalsUse an array of perspectives
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Confirmation Bias
Preconceived opinion
Emphasize favorable informationHot stock tip Seek information to prove true Avoid red flags
Look for a sober opinion
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Hindsight Bias
The outcome was predictable
Resulting incorrect oversimplifications The .com bubble
Causes overconfidence
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Overconfidence
Fund managers & individuals
Overconfident manager More trades and lower yieldsConfident manager Less trades and higher yields
Ongoing battle to beat the market Investment techniques require constant
refinement
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Mental Accounting
Investors separate money
Subjective criteria Creates different functions for asset groups
Paying debt vs. savingsVarying values associated with assetsMoney is fungible
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Rational Choice & Framing of Decision
Decision Theory
Perception of SituationNormative Rules
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InvarianceImagine that you face the following pair of concurrent decisions
1): A. a sure gain of $240B. 25% chance to gain $1000 & 75% chance
to gain nothing2):
A. a sure loss of $750B. 75% chance to lose $1000 and 25%
chance to lose nothing
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Framing Outcomes
1) Assume yourself richer by $300 than youare today. You have to choose between:
A. a sure gain of $100B. 50% chance to gain $200 and 50% chance
to gain nothing
2) $500 richer than today A. a sure loss of $100B. 50% chance to lose nothing and 50% to
lose $200
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Rational Choice
Assumptions in economics occur when
certainty in market is present
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What Money Type Are You?
Our decisions about money are often driven
by psychological factors over which we havelittle conscious controlPersonality tests help to recognize whicherrors are commonly made and to use this
knowledge to prevent themSo, which type are you?
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Mostly As
Youre 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 dont indulge every whim
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Mostly Bs
Youre an Idealist Money just isnt 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
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Mostly Cs
Youre 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
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Mostly Ds
Youre a Rational
Cool reason conquers all You enjoy problem solving, fact finding, and havean 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 isnt always rational
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QUESTIONS