Behavioral Finance: The Collision of Finance and Psychology - PowerPoint PPT Presentation

Behavioral Finance: The Collision of Finance and Psychology

Behavioral Finance: The Collision of Finance and Psychology Presented by: Dr. Joel M. DiCicco, CPA Florida Atlantic University

Order of Presentation Behavioral Finance 1) Definition 2) Research 3) Significance for Financial Planners 4) Behavioral Finance and Customer Profitability 5) Conclusion

Definition “Behavioral finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.” (R.A. Qawi)

Definition Behavioral Finance is a subset of Behavioral Economics

Definition: Next Generation of Behavioral Finance • According to Dr. Meir Statman of Santa Clara University, in the first generation, we took the notion from standard finance that said what people should only care about is getting high returns and not getting low ones. When we saw people who traded a lot, we described them as irrational.

Definition: Next Generation of Behavioral Finance • The idea of second-generation behavioral finance is that not everything people do that’s different from the recommendations of standard finance that causes low returns is irrational. It’s perfectly normal. • As opposed to the first generation thought, second-gen behavioral portfolio theory guides people to investments that “reflect tradeoffs between high expected returns, low risk, social responsibility and high social status

Research: Sleep Well or Eat Well?

Research • The idea behind behavioral finance is that people’s emotions affect prices. • Key Assumption : According to Dr. R. DeGennaro of the University of Tennessee, experienced investors are restricted in the amount of trading they can do. If not, smart investors would continuously trade, therefore, indirectly protecting emotional trading. • For example, if one panics and you want to sell the stock at a low price, the competition will bail you out as they will ensure, by their trading, that a fair value will still be obtained.

Research The Bottom Line Behavioral Finance seeks to address emotional patterns behind the mistakes investors make.

Research: Dr. David Hirshleifer- UC Irvine

Research Self- Deception • Overoptimism Bias- describes the mental state in which people believe that things will more likely go well for them than poorly. When playing a game, an individual is more inclined to think he or she will winrather than lose. Sometimes being in a good mood could cause this. (Dr. M. Schulmerich, CFA- Managing Director of PECUNDUS). • Overconfidence Bias- tendency to believe you have a skill or advantage that others don’t. (Dr. M. Schulmerich). This leads investors to overweight their private information causing stocks to overreact. Then a partial correction takes place. • Confirmation Bias- tendency to favor evidence that supports what we already believe. (Dr. M. Schulmerich). Tend to follow their investment guru(s).

Research Heuristic Simplification • Affect Heuristic/ Representativeness- how perception based purchase or sale of stock can influence the price of the stock. For example, when Fortune Magazine has its survey of corporate reputation, the ones that did well on the survey must also be good investments and vice-versa (Byrne and Brooks) • Anchoring/ Salience- is a phenomena used in the situation when people use some initial values to make estimation, which are biased toward the initial ones as different starting points yield different estimates (Kahneman & Tversky). In financial markets, anchoring arises when a value scale is fixed by recent observations. As an example, investors always refer to the initial purchase price when selling or analyzing. • Loss Aversion/ Prospect Theory- this theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics (Y. Liu, J. Nacher, et. al) (i.e. rather not lose $10 than gain $10).

Research Social • Herding- when investors in the financial marketplace imitate each other. This could lead to market booms and busts (Kourtidis, Sevic, et al)

Research • Heuristics (rules of thumb)- The behavioral asset pricing model, while not superior to other pricing models such as CAPM, should be considered in practice. Aspects of the behavioral asset pricing model are directly related to the various types of affect, such as social responsibility, prestige, etc. Therefore, its application may not be universal and it may include factors weighted differently (Dr. R. Qawi)

Significance to Financial Planners One could focus the significance of behavioral finance in the following finance sub-disciplines: • Corporate Finance- i.e. Irrational Managers- for instance, according to Malmendier and Tate, usually managers tend to overinvest when internal funds are abundant but refrain from investing when external funds are required.

Significance to Financial Planners • Portfolio Theory- According to Shefrin and Statman, for instance, behavioral portfolios are formed as layered pyramids in which each layer is aligned with an objective. The base layer may be intended as “protection from poverty” whereas a higher layer or risky assets represents “hopes for riches” WITHOUT ANY CONSIDERATION OF THE COVARIANCES BETWEEN THE LAYERS UNLIKE MODERN PORTFOLIO THEORY.

Significance to Financial Planners Due to the focus of this conference, the remaining portion of this presentation will be based on Individual Investors.

Significance to Financial Planners • A study by R. Wood (MBA, Director of Digital Strategy at Mediative and Dr. J. Zaichkowsky (Simon Fraser University) identifies and characterizes segments of individual investors based on their shared investing attitudes and behavior. • A cluster segmentation analysis was used and based on the responses to the questionnaires, four main segments of individual investors were determined.

Significance for Financial Planners • Cluster 1-Risk-Intolerant Traders • Cluster 2-Confident Traders • Cluster 3-Loss-Averse Young Traders • Cluster 4-Conservative Long-Term Investors

Significance for Financial Planners Cluster 1-Risk-Intolerant Traders • Extremely low risk tolerance. • Medium level of confidence. • They monitor their investments at least weekly but trade infrequently. • For their trading accounts, they invest heavily in blue-chips and technology based companies. • For their retirement, mutual funds are their vehicle of preference. • Reliance on financial advisors. • Analyze financial statements. It would seem prudent for financial advisors to concentrate their efforts and advice on diversification and risk management. Mutual funds and stable blue-chip investments might be appropriate for this segment.

Significance for Financial Planners Cluster 2-Confident Traders • Their portfolio values tend be larger than other clusters. • They trade more than 10 times per year and check their investments weekly. • Confident traders consult friends for advice, but do not consult advisors often. • Shorter-term investment horizon. • Tend to invest in tech stocks and small to mid-size companies and for retirement, they also chose mutual funds as the dominant investment vehicle. • The confident traders had a higher percentage of readership of almost all types of information. They read significantly more financial statements (not so much for volatile investments) and check the news readily.

Significance for Financial Planners Cluster 3-Loss-Averse Young Traders • This group does not mind taking risks, but feels terrible when they lose money. Cluster 3 investors have significantly lower levels of confidence than the confident traders in cluster 2. • These investors probably personalize their losses more because they are young, relatively inexperienced at investing, and cannot afford to lose their money. • Cluster 3 investors are also the most likely to use the Internet as their method of investment and they also trade quite frequently. • Like confident traders, they own technology and small stocks in their regular portfolios, but have more stable mutual funds in their retirement portfolios. • This group uses the Internet to evaluate volatile investments, but uses financial advisors for stable investments. Loss-averse traders find current news most useful for volatile investments.

Significance for Financial Planners Cluster 4-Conservative Long-Term Investors • Conservative long-term investors are almost the exact opposite of confident traders (Cluster 2). • They have low ratings in confidence and trade infrequently. • This group also owns the least number of stocks and does not check their investments often. They purchase long-term conservative mutual funds most often with the help of financial advisors . This applies to both their current holdings and for their retirement funds. • This group tends to use financial advisors for risk reduction because they do not want to be blamed for poor performance. • Cluster 4 do not find detailed financial statements useful in evaluating investments, but they do use current news to evaluate their volatile stocks.