InvestorPsychology/Behavioral InvestmentManagementWorkshop: Finance EuromoneyTraining August,2009 Instructor: JohnM.Longo,PhD,CFA
Exercise
Completethequestionnairethatyouwill behanded. Itisdesignedtomeasureyourinvestment behavioralbiases. Whatinvestmentbiasesdoyousuffer from?
BehavioralFinanceisHOT!
The2002NobelPrizeinEconomicswas awardedtoDanielKahnemanand VernonSmithfortheirworkin BehavioralFinance. BehavioralFinancemaybetterexplain theexistenceandpoppingofinvestment bubbles. Ex:JDSUduringtheInternetBubble
WhyBotherWithThisTopic?
Investmentmanagerssufferfrom behavioralbiasesthatmayimpacttheir investmentresults. Yourclientssufferfrombehavioral biasesthatmayaffecttheirinvestment choices. Andyesyou(andI)sufferfrom behavioralbiasesthatmayimpactthe resultsoftheportfolioswerecommend.
Q:WhyIsTheirSoMuchTradingInThe Market?
Twoinvestorscanlookatthesame companyandcometodifferent conclusions. Bothinvestorsmaybelievetheyareacting rationally,butonlyoneiscorrect. Humansarenotcomputers.Theymay makemistakesthatyoumaypotentially profitfrom.
3GeneralAreasofHumanMistakes
1)BiasesofJudgment. 2)ErrorsofPreference. 3)LivingwiththeConsequences ofDecisions.
(examplestofollow)
BiasesofJudgment
Overconfidence Optimism Hindsight OverreactiontoChanceEvents
OverconfidenceExample
Q:Whatisyourbestestimateofthevalueof theFTSEorS&P5003monthsfrom today? Next,pickavaluewhichyouare99%sure thatitwillbelessthan(ceilingestimate).
Next,pickavaluewhichyouare99%sure thatitwillbegreaterthan(floorestimate).
OverconfidenceExample(Contd)
Thethreeestimatescombinedarecalled apointestimateanda(98%)confidence interval. Psychologistshaveconductedmanyof thesetypesofinvestmentsandguess what???
OverconfidenceExample(Contd)
Investorspredictionsareterrible! Ifsomeonesaystheyareabout99%sureof something,empiricallytheyarecorrectabout 85%ofthetime. InplainEnglish,investorsexhibit overconfidenceintheirpredictions. Whydoyouthinkthereissomuchtrading volumeinthestockmarket?
OptimismExample
(Note:Optimismisrelatedto Overconfidence,butthereisno confidenceintervalhere.) Q:Areyouanaboveaveragedriver? A:
OptimismExample(Contd)
A: 80% of respondents say they are above average!
Implication: Many respondents are too optimistic of their abilities since, by definition, only 50% of drivers can be aboveaverage.
Clearly many are looking at their driving abilities through rose colored glasses. (toooptimistic)
OptimismExampleII
Investingexample: Q:Ifanacquaintancepurchasedastock thatlaterdidbadly,doyouthinkofthisas amistake,oracaseofbadluck? A:
OptimismExampleII(Contd)
Mostpeoplesay Itwasbadluckinmycasebutthe acquaintancescrewedup! Optimists 1)Exaggeratetheirtalents. 2)Underestimatethelikelihoodofbad outcomesoverwhichtheyhavenocontrol (.e.g.,struckbylightning.)
OptimismExampleII(Contd)
Optimists(continuedfrompreviousslide) 3) Are prone to an illusion of control (i.e. exaggerate the degree to which they control theirfate.) 4) They tend to underestimate the role of chance in human affairs and tend to misperceive games of chance as games of skill(rouletteanyone???!!!)
OptimismRecap
The combination of overconfidence and optimism is a potent brew often causing a multitudeofmistakes.
(Recapofmistakes)
1)Overestimateknowledge. 2)Underestimaterisks. 3)Exaggeratetheirabilitytocontrolevents. 4) Leaves them vulnerable to statistical surprises.
Hindsight(is20/20)Bias
There will be a G8 meeting in October. Whatisthechancetheywilllowerinterest rates? After the fact, there is a lot of Monday morning quarterbacking or second guessing. Afterthefact,chanceeventsseemalmost inevitable. (e.g. growth of Internet and poppingofbubble.)
HindsightErrors
1) Promote overconfidence by fostering the illusion that the world is more predictable thanitis. turns 2)Often reasonable investments into foolish mistakes in the minds of investors. (Fire your broker after a bad stock tip like EnronorWorldCom.)
OverreactiontoChanceEvents
Q: What sequence of outcomes is more likelyifyouweretoflipafaircoin6times? (H=Heads;T=Tails) Sequence1:HHHTTT Sequence2:HTHTTH
OverreactiontoChanceEvents
A:Theyarebothequallylikely.Theexact probabilityis(1/2)**6=1.5625% (Hindsightisanimportantelementofregret atopicwewilldiscussinamoment.)
HotHandIllusion
Thehothandisanillusionaccordingto researcherswhohavestudiedthistopic. Examplesofhothand Basketball(orothersports)player. CrapsShooter. FundManagerWhoOutperforms
HotHandIllusion(Contd)
Thehumanmindisapatternseeking device. Itisstronglybiasedtoadoptthe hypothesisthatthereisacausalfactorat workbehindanynotablesequenceof events.
ErrorsofPreference
1)Nonlinearweightingofprobabilities. 2)Peoplevaluechanges,notstates. 3)Valueofgainsandlossesfunction.
ErrorsofPreference(Contd)
4)Purchasepriceasareferencepoint. 5)Framingerrors/mentalaccounting. 6)Shortandlongviews/horizons.
NonlinearWeightingofProbabilities
Investorstendtooverreact>Givemore weighttoeventsinrecentpastandlessto distantpast. Example:Todaymanyinvestorsare shunningfinancial/realestatestocks, while2yearsagotheycouldntgetenough ofthem.Peopleflocktowhatispopular andavoidwhatisnot.
PeopleValueChanges,NotStates
Example: PersonA:Loses$1duetoholeinpocket, finds$2instreet. PersonB:Finds$1instreet. Q:Whichpersonishappier,AorB?
PeopleValueChanges,NotStates
A:Bothmade$1,butpersonBishappier. Rationalinvestorsonlycareaboutthe endresult. Investorssubjecttopsychologicalbiases careaboutthepathalongtheway.
ValueofGainsandLossesFunction
Empiricalestimates:Losseshurt twiceasmuchasgainshelp.(see graph) of Gains & Losses Function Value
150 100 Happiness 50 Profit / Loss -11 -27 -43 -59 -75 -50 -100 -150 -200 -250 Proft or Loss -91 0 85 69 53 37 21 5 Happiness
PurchasePriceAsAReferencePoint
Q:WhichinvestorismoreupsetTODAY?
InvestorA:BoughtIBMat$100share
InvestorB:BoughtIBMat$200share
ThevalueofIBMwas$160yesterdayand droppedto$150today.
PurchasePriceAsAReferencePoint
Continuedfrompreviousslide
A:InvestorBismoreupset.Reasonbeing, theincreaseinlosshurts(2x)morethan reductioningain.
NarrowFraming/MentalAccounting
Rational thing to do consider whole portfolio. Make a global decision. (MarkowitzPortfolioTheory). In reality, most investors do mental accounting or framing. (e.g., establish childs education account at 5% interest and borrow money for a car at 8% interest.)
ShortandLongViews/Horizons
Evidence has shown that investors with long horizonsshouldinvestprimarilyinstocks.
Many investors talk long term but act short
term.
Theytendto panicduringtimesofdistress
>flighttoquality.
Monitoring your portfolio too frequently often causesyoutotakeshorttermactionsthatare inconsistentwithyourlongtermgoals.
LivingWithTheConsequences OfYourDecisions
Rational investors have no emotional baggage Actualinvestors 1)Regreterrorstheycommitted(e.g.Bought WCOMat$70). 2)Regretinvestmentstheynevermade(e.g. Bidu.com3yearsago). Q:Whichregrethurtsmore,1or2?
LivingWithTheConsequences OfYourDecisions A:StudiesfindthatRegret1)tends tocauseinvestorsmoredistressthan Regret2)
HedgeFundManagerBiases
Hedge fund managers may be especially susceptibletothefollowingbiases:
Overreaction Optimism IllusionofControl AsymmetryofGainsandLossesFunction Calloptionnatureofhedgefundcompensation. Importanceofpositivemonthlyreturns.
It
is important to discover a hedge fund managersbiasesbeforeinvesting.
Reference
Thislectureisbasedlargelyonthefollowing article: AspectsofInvestorPsychology,Kahneman& Riepe,TheJournalofPortfolioManagement, Summer1998,(pp.5264.)