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Personal Finance: Another Perspective

Investments 10 - Behavioral Finance

Much of this material is taken from the book The Psychology of Investing by John R. Nofsinger, Prentice Hall, 2008. This is for your enjoyment and learning only—it will not be on an exam or

quiz. John has given permissions for me to share this PowerPoint with my students.

Objectives

A. Understand behavioral financeB. Understand why we should learn behavioral

financeC. Understand other alternatives to traditional

financeD. Understand how behavioral finance can help

us become better investors

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Investment Plan Assignments

Investments 10: Behavioral Finance1. Review this PowerPoint for information. It gives

some good insights on investing you might not have thought of.

• It will not be on any Quiz or Exam, but it may have a positive impact on how you invest and your investment returns

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A. Understand Behavioral Finance

What is behavioral finance?• Behavioral finance is an upcoming field of financial

theory that attempts to further understand securities prices through understanding investor behavior.

Why did it come about?• The field of Finance is based on two rigid

assumptions:• 1. People make rational decisions• 2. People are unbiased about their predictions

of the future• Are these assumptions really valid?

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Behavioral Finance (continued)

Are there specific aspects of “personal behavior” that go contrary to these rigid assumptions of rationality and unbiased predictions?• Behavioral finance tries to incorporate “personal

behavior” in an effort to extend finance beyond its narrow assumptions

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Behavioral Finance (continued)

Activity #1• You go to the grocery store and you need to

purchase paper towels.• You find they are on sale at 10% below their

normal price. • What do you do?

• You buy a case of paper towels because you know this is a good price

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Behavioral Finance (continued)

Activity #2• You invest in the stock market. You own 100 shares of

Boston Scientific stock• More news comes out, and Boston Scientific stock

drops 20%.• What do you do?

• Instead of buying more, like the paper towels, you immediately think about selling the stock

• Likewise, if the stock starts to appreciate in value, you think to buy more, rather than sell

• Why the difference between the grocery store and the stock market?

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Questions

Any questions on behavioral finance?

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B. Why Should we Learn Behavioral Finance?

Why should we learn behavioral finance?• 1. Behavioral finance can help you learn about your

psychological biases• 2. You can understand how those psychological biases

affect your investment decision making process• 3. You can see how poor investment decisions caused

by physchological biases affect your wealth• 4. You can learn to recognize and avoid poor

investment decisions which come from those psychological biases, which can help you become a better investor

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Behavioral Finance (continued)

Activity #3 Individual Biases: Illusion: Which is larger?

While we all know the answer, the top line still looks larger

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Behavioral Finance (continued)

Individual Biases: Prediction – be sure!!!• The brain does not work like a computer. Instead,

it processes information through shortcuts and emotional filters to shorten the analysis time

• These filters and shortcuts lead to predictable errors in investing

• We must be wise to these prediction errors so we can be better investors and better stewards over our resources

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Behavioral Finance (continued)

Activity #4• Following are 10 questions. Enter your best guess

so you are 90% sure the answer lies between the two guesses. If you follow this guidance, you should get 9 of 10 answers right. You can guess as high or as low as you want (or even a range), realizing you want to get at a minimum 90% right (or at least 9 questions right)

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Behavioral Finance (continued)

Answer the questions so you are 90% sure the answer is between your minimum and maximum guess. You can guess any number or range, but you must be 90% sure you are right.

1. What is the average weight of an adult blue whale in pounds?

2. What year was the Mona Lisa was painted? 3. What is the number independent countries in the

world in the year 2000? 4. What is the air distance in miles between Paris,

France and Sydney, Australia? 5. How many bones are in the human body?

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Behavioral Finance (continued)

6. How many total combatants were killed in WW1 from all sides?

7. How many books were in the Library of Congress in 2000?

8. How long is the Amazon river in miles? 9. How fast does the earth spin at the equator in miles

per hour? 10. How many transistors are in the Pentium III

computer processor?

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Behavioral Finance (continued)

Following are the answers. Remember you were to be 90% sure with your guesses

1. Weight of adult blue whale: • 250,000 pounds

2. Year the Mona Lisa was painted: • 1513

3. Independent countries in the world in 2000: • 191

4. Distance between Paris and Sydney Australia: • 10,543

5. Number of bones in the human body: • 206

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Behavioral Finance (continued)

6. Combatants killed in WW1: • 8.3 million

7. Books in the Library of Congress in 2000:• 18 million

8. Length of the Amazon river in miles: • 4,000 miles

9. Speed of the earth at the equator (how fast does it spin): • 1,044 mph

10. Transistors in the Pentium III computer processor:• 9.5 million

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Behavioral Finance (continued)

How many did you get right?• Since you were supposed to be 90% sure (and you

could make your guess as large as you wanted), you should have only missed 1 of 10

• Most will miss between 5 and 9 questions This is an example of prediction error

• We think we are more sure of our forecasts than we should be

• In an average class, fewer than 30% are 90% right

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Questions

Any questions on why we should learn behavioral finance?

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C. Are there Other Alternatives?

Are there other alternatives to explaining investor behavior than rational behavior and unbiased predictions? • Following are a few ideas that may be helpful

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Other Alternatives (continued)

1. Cooperation and Altruism• Cooperation may be a viable investment strategy

• People’s motives may lead to actions different than conventional rationality, i.e. individual selfishness, would suggest

• What about the people in 4th Nephi who had “all things in common among them; therefore there were not rich and poor” (4 Nephi 1:3)

• What to do?• Think about other alternatives, other perspectives

on investing. • Learn to think “outside the box”

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Other Alternatives (continued)

2. Bidding and the Winner’s Curse• Bidding may lead to a suboptimal result when you bid

your fair value• Assuming everyone else has the correct value, if

you won you overpaid!• What to do?

• Be careful in setting your bid prices• Generally, don’t bid your fair value—bid lower• Don’t get emotional in your bid prices for

financial assets• You don’t have to buy it at this price!

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Other Alternatives (continued)

3. Endowment Effect• Sometimes we perceive that an asset’s value

increases by virtue of our ownership• Once you own something, its value hasn’t

increased or changed• Did the value really increase with your

purchase?• What to do?

• Realize that just because you own something does not increase the value of that asset

• Do not get too emotionally attached to a financial or other asset that you own

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Other Alternatives (continued)

4. Status Quo Bias• Sometimes individuals prefer the status quo over a

new, more preferable position• There is an aversion to change, even if the

change is for the better• Change may actually be good

• What to do?• Try to be open minded with new ideas

• Be open to new ideas as long as they follow the principles of successful investing and your Investment Plan that you put together

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Other Alternatives (continued)

5. Loss Aversion• Often losses are given more weight in our minds than

potential gains in any position • These weights are more than utility theory would

suggest• What should this view on losses do to the way

you form portfolios?• What to do?

• Give gains and losses equal weight in your analysis• It is the gains and losses of the overall portfolio

that are important, not individual securities

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Other Alternatives (continued)

6. Mental Accounts• Often investors keep mental accounts rather than

viewing individual assets as part of a total portfolio• We try to save ourselves from ourselves

• We borrow 12% for a car versus taking the money from our investment account for the kids college savings (which are earning 2% annually)

• We know we may not pay it back if we do not borrow from a bank

• What to do?• Set up separate accounts for separate goals

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Other Alternatives (continued)

7. Winning by Losing• Sometimes we actively trade stocks instead of

buying index funds or ETFs which we know are lower cost and take a lot less time to invest

• We know index funds generally outperform the actively managed funds

• And we do not have the time, energy, or the money to try to beat the market

• What to do?• If you do not have the time, energy, and money,

invest in “sleep-well” portfolios of index funds• You will at least get market returns and will

generally beat most actively managed funds

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Other Alternatives (continued)

8. Seeking Solace (abdicating responsibility)• Sometimes we follow newspaper/newsletter advice

which we know has been shown to under-perform• We prefer to take other’s advice rather than doing

our own homework• If the performance goes bad, we can blame

others (we don’t have to take responsibility)• What to do?

• Realize the limitations of these recommendations • If you have no better knowledge, invest in

index funds/ETFs which are passively managed

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Other Alternatives (continued)

9. Fun• Sometimes we trade for fun and entertainment

instead of financial performance• This is OK, but make sure your fun money is no

more than 5% of the value of your portfolio—that way you don’t lose too much

• What to do?• If you want “fun” money, set up a trading

account in a retirement vehicle (so you don’t have to pay taxes until later)

• Trade until the money is gone--then stop

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Other Alternatives (continued)

10. Percentages• We sometimes move in and out of asset classes and

stocks instead of keeping specific asset class percentages relatively constant (within our minimum and maximum amounts from our Investment Plan)

• We get lower returns from increased trading costs and may have more risk than we want

• What to do?• Develop a good Investment Plan and rebalance as

needed to your limits• Work to reduce trading, taxes, and transactions

costs

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Other Alternatives (continued)

11. Calendar Effects• The impact of tax and reporting is not consistent with

theory. Behaviorists point out:• Returns are a function of cash flows, which tend

to be concentrated around calendar turns. Institutions tend to “window dress,” i.e., sell unwanted and buy desired stocks for period-end reports

• What to do?• Don’t worry about calendar effects

• Invest for the long-term consistent with your Investment Plan and calendar effects will take care of themselves

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Other Alternatives (continued)

12. Cash Dividends• Theory has shown that dividends are irrelevant in

the absence of taxes and transactions costs. Behaviorists suppose:

• Dividends can be justified by “mental accounts” which increase current income at the expense of “higher self control” equity accounts

• Older high-net worth investors value dividends more highly and concentrate in high income securities (preferred habitat) theory

• What to do?• Invest for the long-term according to your

Investment Plan and follow your strategy• Emphasize capital gains over dividends

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Other Alternatives (continued)

13. Overreaction• Many investors assign a probability to asset returns

based on past theory• Appropriate reaction to a negative event is to

update a prior probability to the most recent event

• Overreaction is when they assign too high a value

• What to do?• Stay diversified, true to your Investment Plan,

and don’t invest on rumors• Invest for the long-term, not on rumors

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Other Alternatives (continued)

14. Mean Reversion• Prices tend to correct themselves as investors

correct for overreaction• Long-term prices tend to revert to the mean

• What to do?• Realize that the best performing stock or mutual

fund last year will not be the best performer this year

• Winner’s revert to average performance over time

• Don’t buy last years best performers• Invest for the future--not from the past

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Questions

Any questions on behavioral finance and explaining individual behavior?

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D. How Behavioral Finance can Help us Become Better Investors

There are specific strategies you can take for overcoming psychological biases understood through behavioral finance. Key principles include:

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Becoming Better Investors (continued)

1. Understand your psychological biases and control your investing environment• Recognizing biases is an important step in avoiding

them• Are you overconfident or do you trade too

often?• What to do?

• Limit the opportunity for these actions or biases. Articulate your ideas in your well thought out and well written Investment Plan. Ideas include:

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Becoming Better Investors (continued)

a. Check your stocks once per week (when you do your budget), not once per hour• It avoids excess trading, rumors, and pride

b. Make trades once per month on the same day of each month• This avoids too-frequent trading and trading on

rumors c. Review your portfolio annually and rebalance as

needed• But rebalance in the most tax-effective manner

• Add to underweight assets with new funds• Make asset allocation changes using donations of

appreciated assets (NMD) to charity

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Becoming Better Investors (continued)

2. Know why you are investing• Know your personal and family goals

• Investing is a means to an end, not an end in itself.

• What to do?• Review your goals often and invest according to

your Investment Plan and goals• If you want to trade for fun, that is fine. But set

a specific dollar amount in a special retirement account and only trade that account.

• Once the money is gone, stop trading

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Becoming Better Investors (continued)

3. Have Quantitative Investment Criteria, i.e. your thoughtful Investment plan, and follow it• Having a written Investment Plan allows you to

avoid investing on rumor, emotion or other biases• Write it well and then follow it closely

• What to do?• Develop and write a good Investment Plan, and

follow that Plan closely• Do not invest in areas outside of your Plan or in

areas you know you do not add value

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Becoming Better Investors (continued)

4. Follow the Principles of Successful Investing• Following the principles discussed in class will help

you to avoid many of the problems faced by other investors

• We must determine correct principles and follow them

• What to do:• Know yourself, know your goals, invest low cost

and tax efficiently, invest long-term, know what you invest in, monitor performance, etc.

• Follow your Investment Plan, and it will save you thousands in the long-term

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Becoming Better Investors (continued)

John Nofsinger adds these 5 additional suggestions:• 1. Avoid stocks selling for less than $5 per share

• Most investment scams are conducted in penny stocks

• 2. Chat rooms and message boards are for entertainment purposes only

• Overconfidence is fostered in these places• 3. Before you place a trade on a stock that doesn’t meet

your criteria, remember that it is unlikely that you know more than the market

• Do you really know more than the market?

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Becoming Better Investors (continued)

4. Have a goal to earn the market return• Active trading is motivated by the desire to earn a

higher return than the market• Active trading usually fosters psychological biases and

ultimately contributes to lower returns 5. Review your psychological biases annually

• Successful investing is more than knowing about financial markets, asset classes, and financial assets. It includes knowing yourself

These main ideas and questions are from John R. Nofsinger, The Psychology of Investing Prentice Hall, 2008, p. 87-91.

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Review of Objectives

A. Do you understand behavioral finance?B. Do you understand why we should learn

behavioral finance?C. Do you understand other alternatives to

traditional finance?D. Do you understand how behavioral finance

can help us become better investors?