CHAPTER ELEVEN

BEHAVIORAL FINANCE

Practical Investment Management Robert A. Strong

Outline
Introduction

Established Behaviors
Representativeness Heuristic Loss Aversion Fear of Regret Myopic Loss Aversion Herding Anchoring Illusion of Control Prospect Theory

South-Western / Thomson Learning 2004

11 - 2

Outline
Established Behaviors continued
Mental Accounting Asset Segregation Hindsight Bias Overconfidence Framing Availability Heuristic Illusion of Truth Biased Expectations Reference Dependence

South-Western / Thomson Learning 2004

11 - 3

Outline
Mistaken Statistics
The Special Nature of Round Numbers Extrapolation Percentages vs. Numbers Sample Size Apparent Order Regression to the Mean

South-Western / Thomson Learning 2004

11 - 4

Introduction
There are three sub fields to modern financial research.
Theoretical finance is the study of logical

relationships among assets.

Empirical finance deals with the study of

data in order to infer relationships.

Behavioral finance integrates psychology

into the investment process.

South-Western / Thomson Learning 2004

11 - 5

Introduction
Financial economists have been aware for a long time that in laboratory settings, humans often make systematic mistakes and choices that cannot be explained by traditional models of choice under uncertainty. Paul Pfleiderer

South-Western / Thomson Learning 2004

11 - 6

Introduction
Behavioral finance research focuses on
how investors make decisions to buy and

sell securities, and

how they choose between alternatives.

South-Western / Thomson Learning 2004

11 - 7

Established Behaviors
Representativeness Heuristic

The representativeness heuristic takes one characteristic of a company and extends it to other aspects of the firm. In particular, many investors believe a wellrun company represents a good investment.

South-Western / Thomson Learning 2004

11 - 8

Representativeness Heuristic

Insert Table 11-1 here.

South-Western / Thomson Learning 2004

11 - 9

Representativeness Heuristic

Insert Figure 11-1 here.

South-Western / Thomson Learning 2004

11 - 10

Established Behaviors
Loss Aversion Investors do not like losses and often engage in mental gymnastics to reduce their psychological impact. Their tendency to sell a winning stock rather than a losing stock is called the disposition effect in some of the behavioral finance literature.

South-Western / Thomson Learning 2004

11 - 11

Established Behaviors
Fear of Regret

Investors do not like to make mistakes.

Rather than being unable to decide among attractive alternatives, their focus is on the negative: What if they pick the wrong stock?

South-Western / Thomson Learning 2004

11 - 12

Established Behaviors
Myopic Loss Aversion

Investors have a tendency to assign too much importance to routine daily fluctuations in the market. Abandoning a long-term investment program because of normal market behavior is sub optimal behavior.

South-Western / Thomson Learning 2004

11 - 13

Established Behaviors
Herding

Herding refers to the lemming-like behavior of investors and analysts looking around, seeing what each other is doing, and heading in that direction.
There may not have been safety in numbers, but there probably was some comfort in them.

South-Western / Thomson Learning 2004

11 - 14

Established Behaviors
Anchoring

Our decisions can be influenced by extraneous information contained in the problem statement. For example, investors tend to remember the price they paid for a stock, and this information influences their subsequent decisions about what to do with it.

South-Western / Thomson Learning 2004

11 - 15

Established Behaviors
Illusion of Control

We like to pretend that we can influence the resulting score by varying the force with which we throw a dice.
Similarly, investors like to look at charts, although charts are theoretically not helpful in predicting the future prospects for a stock.

South-Western / Thomson Learning 2004

11 - 16

Established Behaviors
Prospect Theory

Risk averse investors get increasing utility from higher levels of wealth, but at a decreasing rate. Research shows that while risk aversion may accurately describe investor behavior with gains, investors often show risk seeking behavior when they face a loss.

South-Western / Thomson Learning 2004

11 - 17

Prospect Theory

Insert Figure 11-2 here.

South-Western / Thomson Learning 2004

11 - 18

Prospect Theory

Insert Figure 11-3 here.

South-Western / Thomson Learning 2004

11 - 19

Prospect Theory

Insert Table 11-2 here.

South-Western / Thomson Learning 2004

11 - 20

Established Behaviors
Mental Accounting

Mental accounting refers to our tendency to put things in boxes and track them individually. For example, investors tend to differentiate between dividend and capital dollars, and between realized and unrealized gains.

South-Western / Thomson Learning 2004

11 - 21

Established Behaviors
Asset Segregation

Asset segregation refers to our tendency to look at investment decisions individually rather than as part of a group. The portfolio may be up handsomely for the reporting period, but the investor will still be concerned about the individual holdings that did not perform well.

South-Western / Thomson Learning 2004

11 - 22

Asset Segregation

Insert Table 11-3 here.

South-Western / Thomson Learning 2004

11 - 23

Established Behaviors
Hindsight Bias

Hindsight bias refers to our tendency to remember positive outcomes and repress negative outcomes. Investors remember when their pet trading strategy turned up roses, but do not dwell on the numerous times the strategy failed.

South-Western / Thomson Learning 2004

11 - 24

Established Behaviors
Overconfidence

Overconfidence refers to our tendency to believe that certain things are more likely than they really are. For example, most investors think they are above-average stock pickers.

South-Western / Thomson Learning 2004

11 - 25

Established Behaviors
Framing

The concept of framing involves attempts to overlay a situation with an implied sense of gain or loss. It is easier to pay $3,400 for something that you expected to cost $3,300 than it is to pay $100 for something you expected to be free.

South-Western / Thomson Learning 2004

11 - 26

Established Behaviors
Availability Heuristic

The availability heuristic is the contention that things that are easier to remember are thought to be more common.

South-Western / Thomson Learning 2004

11 - 27

Established Behaviors
Illusion of Truth

People tend to believe things that are easier to understand more readily than things that are more complicated. Most investors prefer a low PE ratio, since they prefer to buy low-priced stocks with high earnings.

South-Western / Thomson Learning 2004

11 - 28

Established Behaviors
Biased Expectations

Our prior experience causes us to anticipate certain relationships or characteristics that may not apply outside our frame of reference.

South-Western / Thomson Learning 2004

11 - 29

Established Behaviors
Reference Dependence

Suppose you demand $75,000 in salary for the next year. Your boss offers you $60,000 and if things go to arbitration, $50,000. People currently earning $60,000 tend to accept the offer, while people currently earning $75,000 tend to take the gamble and go to arbitration.

South-Western / Thomson Learning 2004

11 - 30

Mistaken Statistics
There are some other tendencies that may have a behavioral influence on asset values. These involve innumeracy or a misunderstanding of the likeliness of an event or series of events.

South-Western / Thomson Learning 2004

11 - 31

Mistaken Statistics
The Special Nature of Round Numbers Given a giant lottery wheel with numbers from one to one thousand, many of us would find a random outcome like 287 to be more reasonable than the unusual outcome of 1,000. Similarly, investors tend to make disproportionate use of round numbers when placing stop or limit orders.
South-Western / Thomson Learning 2004 11 - 32

Mistaken Statistics
Extrapolation

We have a tendency to assume that the past will repeat itself and to give too much weight to recent experience. A belief that recent occurrences influence the next outcome in a sequence of independent events is known as the gamblers fallacy.

South-Western / Thomson Learning 2004

11 - 33

Mistaken Statistics
Percentages vs. Numbers

Suppose the incidence of a particular disease rose from 10 in a million to 13 in a million. We would likely find that to many people, 3 more cases is not a cause for concern, although a 30% increase is.

South-Western / Thomson Learning 2004

11 - 34

Mistaken Statistics
Sample Size

There are many instances where people draw incorrect inferences from statistical data. The probability of a given person winning the lottery twice is very remote. However, the probability of someone winning twice is actually reasonably good.

South-Western / Thomson Learning 2004

11 - 35

Sample Size

Insert Table 11-4 here.

South-Western / Thomson Learning 2004

11 - 36

Mistaken Statistics
Apparent Order

A single occurrence of an unlikely event becomes much more likely as the sample size increases. However, many people will find a run of six consecutive numbers in a daily state lottery extremely unlikely.

South-Western / Thomson Learning 2004

11 - 37

Mistaken Statistics
Regression to the Mean The regression to the mean concept states that given a series of random, independent data observations, an unusual occurrence tends to be followed by a more ordinary event. Hence, chasing last years winning mutual fund is likely to be a losing strategy, although many investors do precisely this.

South-Western / Thomson Learning 2004

11 - 38

Review
Introduction

Established Behaviors
Representativeness Heuristic Loss Aversion Fear of Regret Myopic Loss Aversion Herding Anchoring Illusion of Control Prospect Theory

South-Western / Thomson Learning 2004

11 - 39

Review
Established Behaviors continued
Mental Accounting Asset Segregation Hindsight Bias Overconfidence Framing Availability Heuristic Illusion of Truth Biased Expectations Reference Dependence

South-Western / Thomson Learning 2004

11 - 40

Review
Mistaken Statistics
The Special Nature of Round Numbers Extrapolation Percentages vs. Numbers Sample Size Apparent Order Regression to the Mean

South-Western / Thomson Learning 2004

11 - 41