Introduction two behavioral phenomena amiliarity (bias of availability is related to the ease of recall) rational

Transcription

1 Behavioral Biases

2 Lecture Contents Introduction Framing Mental accounting Regret avoidance Herd Instincts and Overreaction Media response Evidence of irrationality Role of Behavioral Factors in decision making process Strategies to Overcome Psychological Biases

3 Introduction We put our observations through a number of filters manufactured by our experiences which are called behavioral biases. It also implies in investment decision making. In particular, two behavioral phenomena have emerged as relevant: 1. The way investors react to prior gains and losses 2. Familiarity bias. (bias of availability is related to the ease of recall) - The combined effect of these two phenomena - potentially inconsistent with standard rational investment theories

4 Role of Investor Behavior Bounded Rationality: Information processing limitations. Example: memory limitations. Investor Sentiment: beliefs based on heuristics rather than Bayesian rationality. Investors may react to irrelevant information and hence may trade on noise rather than information.

5 Framing Framing is one of the most well-known cognitive biases Research has shown that investors are just as susceptible to framing in finance as in other areas of life Patient decisions were much different when the doctor said you have a 90% chance of survival versus you have a 10% chance of mortality. This test, called the Müller- Lyer illusion, was devised in 1889 and is often used to show how our visual perception can be distorted by framing. Although this is a long way from investing, framing is also crucial in how we make decisions, and how we evaluate investment opportunities.

6 Framing Decisions seem to be affected by how choices are framed. The cognitive aspects relate to how people organize information mentally, in particular how they code outcomes into gains and losses. The emotional aspects pertain to how people feel as they register information. Individuals may act risk averse in terms of gains but risk seeking in terms of losses. For example, an individual may reject a bet when it is posed in terms of the risk surrounding possible gains but may accept that same bet when described in terms of risk surrounding potential losses.

7 Framing Conti.. Difference between form and substance -Framing is about form oit reflects a mix of cognitive and emotional elements! - Regret is an emotion opeople who have difficulty controlling emotions aresaid to lack self control opeople use framing effects to constructively help themselves deal with self control difficulties!

8 What would you do? Imagine that you are about to purchase a t-shirt from Marks and Spencers at the corner for $15. The salesman informs you that the t-shirt is on sale for $10 at other branch of the store, located 20 minutes drive away. Would you make the trip to other store?

9 What would you do? Imagine that you are about to purchase a black trouser suit from Marks and Spencers at the corner for $150. The salesman informs you that the t-shirt is on sale for $145 at other branch of the store, located 20 minutes drive away. Would you make the trip to other store?

10 The way the decision is made will not alter choices if the decision maker is using a wealth based analysis! oyou save $5 in either case! o$5 is a significant saving on a $15 purchase but not so on a $150 purchase!

11 Have you ever? Bought something because it was on sale? Invested windfall gains into something luxurious?

12 Mental Accounting Tversky and Kahneman (1981,p.456) define a mental account as a Frame for evaluation. Thaler (1999) define Mental accounting as the entire process of coding, categorizing, and evaluating events. Accounting -a system of recording, classifying, and summarizing business and financial transactions in books and analyzing, verifying, and reporting results.

13 Mental Accounting People often do not focus on their overall state of wealth Instead they focus independently on their different accounts Retirement Children s education Taxable investment accounts Dividends Company stock or stock options

14 You have recently subjected yourself to a weekly lunch budget and are going to purchase a $6 sandwich for lunch. As you are waiting in line, one of the following things occurs: 1) You find that you have a hole in your pocket and have lost $6; or 2) You buy the sandwich, but as you plan to take a bite, you stumble and your delicious sandwich ends up on the floor. In either case (assuming you still have enough money), would you buy another sandwich?

15 How much would you pay? Holiday time! You are in Southern France! You are lying on the beach on a hot day! A companion has to make a phone call and gets up to go and offers to bring back a pint of beer from the only nearby place beer is sold. A fancy resort hotel! He says beer might be expensive and asks you how much you are willing to pay. A small run-down corner shop! He says beer might be expensive and asks you how much you are willing to pay.

16 Mental Accounting Understand that keeping separate mental accounts often makes investors more conservative than they naturally are Measure success in terms of your overall state of wealth

17 Regret Avoidance Prospect of regret pain generates avoidance behavior. People blame themselves for unconventional choices that turn out badly, avoid regret by making conventional decisions. For example, People avoid selling stocks that have gone down in value, rush to sell those that have gone up (disposition effect).

18 Regret The Story of John and Mary John owns shares of Company A. He considers selling his shares and buying stock in Company B, but decides against it. He now finds he would have been better off by $20,000 if he had switched to Company B Mary owns shares in Company B, but switched to Company A. She finds she would have been better off by $20,000 if she had kept her shares of Company B Who is more upset, John or Mary?

19 Regret Answer: Mary People typically regret errors of commission more than errors of omission.

20 Media Response Study of the effects of news on investment decisions: Two groups: one received news and one did not The group with no news outperformed the group that received news

21 Media Response People often feel the need to react to new information News is often irrelevant to long-term performance and is often misinterpreted Information overload can cause stress

22 Media Response Advice: Stick with a long-term investment strategy Don t feel you need to react to every bit of information you hear

23 Herd Instincts and Overreaction There is a natural desire on the part of human beings to be part of group (People tend to herd together). Moving with the herd, however, magnifies the psychological biases. It induces one to decide on he or she feel of the herd rather than on rigorous independent analysis. This theory says that large trends or crazes begin when individuals ignore their private information, but take signals from the action of others. Information cascade/flows lead investors to overreact to both good and bad news, causing stock market bubbles and crashes.

24 Evidence of irrationality In Mexico, stock prices increased by over seven times and then declined by 73% from the peak during the period Taiwan stocks rose nearly ten times and then sharply declined by 80% during the period The Nikkei share Index in Japan fell by more than 50% from end 1989 to mid In Sensex rose by more than 100% in a period of 2-3 months and then lost over 45% in a short time in 1992.

25 The Role of Behavioral Factors There are numerous identified psychological biases in Behavioral finance literature. Each has implications on financial decisionmaking and behavior: Bias Key effects on investor Consequence Overconfidence Representativeness Herding Anchoring Too many trades, too much risk, failure to diversify Tendency to associate new event to a known event and make investments based on it. Lack of individuality in decision making Tendency to consider logically irrelevant price level as important in the process of decision making Pay too much brokerage and taxes, chance of high losses. Purchasing overpriced stocks Bubbles, and bubble bursts Missed investment opportunities, or bad entry timing into the market

26 The Role of Behavioral Factors Conti Bias Key effects on investor Consequence Cognitive Dissonance Ignore new information that contradicts known beliefs and decisions Reduced ability to make rational and fair investment decision. Regret Aversion Selling winners too soon, holding losers too long Reduced returns Gambler s Fallacy Taking too much risk after a lucky win Chance of high losses Mental Accounting Low or no diversification Irrational and negative effects on returns Hindsight The tendency to feel that a past event was obvious when it really was not, at onset Incorrect oversimplification of decision making

27 Strategies to Overcome Psychological Biases 1. Understand the Biases 2. Focus on the Big Picture 3. Follow a set of Quantitative Investment Criteria 4. Diversify 5. Control your investment environment 6. Strive to earn market return 7. Review your Biases periodically

28 Thanking You