Behavioral Finance - Group 5

Embed Size (px)

Citation preview

  • 7/28/2019 Behavioral Finance - Group 5

    1/27

    Behavioral Finance

    Ashish MaliJosh CaversIan HerleLindsey Polishuk

  • 7/28/2019 Behavioral Finance - Group 5

    2/27

  • 7/28/2019 Behavioral Finance - Group 5

    3/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    4/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    5/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    6/27

    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.

  • 7/28/2019 Behavioral Finance - Group 5

    7/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    8/27

    Behavioral Portfolio Theory

    People build portfolios like layered pyramids

    Each layer represents a specific goalYour risk aversion depends on the specificgoal

  • 7/28/2019 Behavioral Finance - Group 5

    9/27

    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?

  • 7/28/2019 Behavioral Finance - Group 5

    10/27

    Cognitive Biases

    Identify biases affecting investors

    Consultants duty to educate investorsScientific knowledge is key

  • 7/28/2019 Behavioral Finance - Group 5

    11/27

    Availability Bias

    Weigh decisions on recent information

    Lottery winnersStock market Winners vs. losers

    Retain perspective Long-term focus

  • 7/28/2019 Behavioral Finance - Group 5

    12/27

    Winners vs. Losers

  • 7/28/2019 Behavioral Finance - Group 5

    13/27

    Anchoring Bias

    Attach to a reference point

    Relevance New & novel concepts

    Stock market Short-term volatility Company fundamentalsUse an array of perspectives

  • 7/28/2019 Behavioral Finance - Group 5

    14/27

    Confirmation Bias

    Preconceived opinion

    Emphasize favorable informationHot stock tip Seek information to prove true Avoid red flags

    Look for a sober opinion

  • 7/28/2019 Behavioral Finance - Group 5

    15/27

    Hindsight Bias

    The outcome was predictable

    Resulting incorrect oversimplifications The .com bubble

    Causes overconfidence

  • 7/28/2019 Behavioral Finance - Group 5

    16/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    17/27

    Mental Accounting

    Investors separate money

    Subjective criteria Creates different functions for asset groups

    Paying debt vs. savingsVarying values associated with assetsMoney is fungible

  • 7/28/2019 Behavioral Finance - Group 5

    18/27

    Rational Choice & Framing of Decision

    Decision Theory

    Perception of SituationNormative Rules

  • 7/28/2019 Behavioral Finance - Group 5

    19/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    20/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    21/27

    Rational Choice

    Assumptions in economics occur when

    certainty in market is present

  • 7/28/2019 Behavioral Finance - Group 5

    22/27

    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?

  • 7/28/2019 Behavioral Finance - Group 5

    23/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    24/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    25/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    26/27

    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

  • 7/28/2019 Behavioral Finance - Group 5

    27/27

    QUESTIONS