BBA FN415 (18) Lect 17 Psychological Risks.pptx

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Psychological Risk Psychological Risk

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Agenda

1. What is behavioral finance?

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Pain Scale

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Psychological Biases of Investors



_{Review of the behavioral finance}

as it relates to investors.



_{Examine common investment}

mistakes caused by an investor’s

cognitive and emotional

weaknesses.



_{Two categories: how investors}

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Introduction



_{Cognitive and emotional}

weaknesses affect all people



_{Traditional or standard}

finance ignores these biases.



_{It assumes that people always}

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Introduction



_{Standard Finance – Investors}

are rational.



_{Behavioural Finance –}

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Introduction



_{Traditional finance has}

developed.



_{Behavioral finance examines how}

real people actually behave in a

financial setting and is, therefore,

descriptive.



_{Thaler (1993) calls “open-minded}

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Framing Bias (1)



_{Imagine your country is preparing for}

the outbreak of a disease expected to

kill 600 people.



_{If program X: is adopted, exactly 200}

people will be saved.



_{If program Y: There is a 1/3rd}

probability that 600 people will be

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Framing Bias (2)



_{Imagine your country is preparing for}

the outbreak of a disease expected to

kill 600 people.



_{If program M: is adopted, exactly 400}

people will die.



_{If program N: There is a 1/3rd}

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How biased are you!!! FN415 2017

Program A: If adapted, exactly 200 people will be saved.

Program B: If adapted, there is 1/3 probability that 600 people will be saved, and 2/3 probability

that no people will be saved.

Program A: If adapted, exactly 400 people will die.

Program B: If adapted, there is 1/3 probability that 0 people will die, and 2/3

probability that 600 will die.

58% Chose A

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Framing Bias

"Imagine your country is preparing for the

outbreak of a disease expected to kill 600 people.

If program X is adopted, exactly 200 people will be saved.

If program Y is adopted there is a 1/3 probability that 600 people will be saved and a 2/3

probability that no people

"Imagine your country is preparing for the

outbreak of a disease expected to kill 600 people.

If program M is adopted, exactly 400 people will die.

If program N is adopted there is a 1/3 probability that no one will die and a 2/3 probability that 600 people will die."

72%

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Framing Bias

 Participants saw a film of a traffic accident and then answered questions about the event, including the question ‘About how fast were the cars going when they contacted each other?’

 Other participants received the same information, except that the verb ‘contacted’ was replaced by either hit, bumped, collided, or smashed.

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Framing Bias



_{One week later, the participants were}

asked whether they had seen broken

glass at the accident site.



_{Although the correct answer was ‘no,’}

32% of the participants who were given

the ‘smashed’ condition said that they

had.



_{Hence the wording of the question can}

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Behavioral finance

 _{The application of psychology to financial}

behavior.

 _{People may not always be “rational,” but they}

are always “human.”

 _{“Investors’ deviations from the maxims of}

economic rationality turn out to be highly pervasive and systematic.”

 _{For example, psychologists have known for a}

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Two categories: How investors think and how investors feel.



_{How investors think}

_:

_heuristic

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Loss Aversion

Gain Loss

Pleasure

Pain

+10%

-10% Small pleasure

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Kahneman and Tversky (1979).



_{Decision-making involves two}

processes:

editing

and

evaluation

.



_{The editing phase organizes,}

simplifies, and reformulates the

prospects.



_{The evaluation phase places a value}

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Familiarity bias:

 _{People often prefer things that have some}

familiarity to them

 _{Put too much faith in familiar stocks.}

 _{Because those stocks are familiar, investors}

tend to believe that they are less risky than other companies or even safer than a

diversified portfolio.

 _{Investors also buy a disproportionate}

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Representativeness bias

 _{The brain makes the assumption that}

things sharing similar qualities are alike.

 _{Representativeness is judgment based on}

stereotypes.

 _{For example, investors confuse a good}

company with a good investment.

 _{Opinion of a car vs. investing in the car}

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Representativeness bias

 _{Lakonishok, Shleifer & Vishny (1994): The}

10% of firms with the highest average

growth rates are glamour firms, whereas the firms with the lowest sales growth are value firms.

 _{Glamour stocks earned an 11.4% compares}

to a return of 18.7% for the value stocks.

 _{Good companies do not always make good}

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Cognitive Dissonance:

 _{That is, people tend to ignore, reject or minimize}

any information that conflicts with a particular belief.

 _{They adjust the memory about the information and}

even change the recollection of the previous decision.

 _{Cognitive dissonance results in investors attempting}

to avoid or discount a conflicting belief and seeking out support for the preferred belief.

 _{Goetzmann and Peles (1997) measure the}

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Mood and optimism

 _{Psychologists can run experiments that}

influence moods and determine the

correlation between mood and behaviour.

 _{Linking mood and optimism to sunshine.}  _{Psychologists have documented how the}

sun affects people’s decisions.

 _{Researchers link a lack of sunlight to}

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Mood and optimism

 _{Kamstra, Kramer & Levi (2001) study seven}

stock market: Australia, Britain, Canada, Germany, New Zealand, Sweden, and the United States.

 _{They find that stock returns are lower}

during the fall when daylight decreases

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Mood and optimism

 _{Cloud cover in the city of a country’s}

major stock exchange is negatively correlated with daily stock index returns

 _{Stock market performance was}

simply worse on cloudy days. In New York City, there was a 24.8%

annualized return for all days

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Mood and optimism

 _{Mood affects the way investors analyze}

and make judgments (Nofsinger, 2002b)

 _{People in a good mood make more}

optimistic judgments than people in a bad mood.

 _{Being in a bad mood makes investors more}

critical.

 _{Bad moods call for more critical analysis in}

stock market judgments, whereas good moods cause decisions without the

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Mood and optimism

 _{For example, people tip a waitress or}

waiter 50% more on sunny days than on rainy days (Rind, 1996).

 _{Can the happy mood of a sunny day affect}

investors and the stock market?

 _{If the sunshine puts investors in a good}

mood, they will be more optimistic about future prospects.

 _{Therefore, investors are more likely to buy}

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Mood and Optimism

 _{Nofsinger (2002) claims that investors}

suffer from optimism bias.

 _{That is, investors can believe that nothing}

bad is likely to happen to their stock picks.

 _{Optimism affects investors in two ways.}  _{(1) optimistic investors tent to do less}

critical analysis in making their stock decisions.

 _{(2) optimists tend to ignore (or downplay)}

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Overconfidence

 _{Investors are usually overconfident about}

their abilities to complete difficult tasks successfully – such as picking winning stocks.

 _{They believe that their knowledge is more}

accurate than it really is and that

 _{Their forecasts are more precise than their}

experience should validate.

 _{Belsky and Gilovich (1999) refer to}

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Overconfidence

 _{Men seem more prone to overconfidence}

than women, particularly in male-dominated realms such as finance.

 _{Barber and Odean (2001) find that men}

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Overconfidence

 _{Several factors contribute to}

overconfidence such as

 _{The illusion of knowledge – having more}

information available.

 _{Increased levels of information do not}

necessary lead to greater knowledge

because many investors may not have the training, experience, or skill to interpret this information.

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Overconfidence

 _{Illusion of control}

 _{People often believe that they have}

influence over the outcome of uncontrollable events.

 _{Presson and Benassi (1996) show that the}

key attributes fostering the illusion of

control are choice, outcome sequence, task familiarity, information, and active

involvement.

 _{Online investors routinely experience these}

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Endowment Effect

 _{People often demand much more to sell an object}

than they would be willing to pay to buy it (Kahneman, Knetsch & Thaler, 1990, 1991).

 _{People have a tendency to hold the investments}

they already own.

 _{For example, Samuelson and Zeckhauser (1988)}

told students they just inherited a large sum of money.

 _{The students had the different investment choices}

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Endowment Effect

 _{The favored investment choice to hold was}

the type of investment they had inherited.

 _{That is, if the students inherited treasury}

bills, then they opted to hold them.

 _{If they inherited a high-risk company, they}

opted to hold that investment.

 _{Thus, the endowment effect had a greater}

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Reference Points and Anchoring

 _{Some investors fixate on specific stock prices.}

 _{The specific prices are called}_{reference points}_and

the fixation is called anchoring.

 _{Benartzi and Thaler (1995) argue that a reference}

point is the stock price that investors compare to the current stock price.

 _{The brain’s choice of a reference point is}

important because it determines whether the

investor feels the pleasure of obtaining a profit or the pain of experiencing a loss.

 _{One important reference point is the purchase}

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Status Quo Bias

 _{When faced with choices – do nothing}  _{When face with taking an action in an}

investor’s best interest, the status quo bias

influences the investor to do nothing.

 _{People prefer to hold the investments they}

already have.

 _{Changing an investment may imply that the}

previous purchase decision was a poor one.

 _{Tversky and Shafir (1992) realized that the}

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Law of Small Numbers

 _{People see patterns in data that are random}

and then make predictions about the future based on those perceived patterns.

 _{If a game is believed to be fair, like a roulette}

wheel, keno game, or state lottery, people cling to the idea that all the numbers in the game should come up the same number of times, on average ( Nofsinger, 2002a).

 _{The belief that some self-correcting process}

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Two categories: How investors think and how investors feel.



_{How investors feel:}

_{A common adage}

on Wall Street is that markets are

motivated by two emotions: greed

and fear. Although these emotions

affect investors, other strong

emotions such as hope, pride, and

regret also influence decisions.

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Disposition Effect

 _{Shefrin and Statman (1985) show that avoiding}

regret and seeking pride also have an effect on investors’ decisions.

 _{Specifically, they show that fearing regret and}

seeking pride cause investors to be predisposed to

selling winners too early and holding onto losers too long.

 _{They call this the disposition effect.}

 _{These emotions consequently result in selling}

good-performing stocks and keeping poor-performing stocks.

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Disposition Effect

 _{Unfortunately, some evidence shows that the}

good-performing stocks that investors sell tend to continue to do well, whereas the

losers that investor hold continue performing poorly.

 _{Odean finds that when investors sell winner,}

the sale represents 23% of the total gains of the investor’s portfolio but a loser being sold represents only 15% of the unrealised losses.

 _{On average, investors are 50% more likely to}

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Attachment Bias

 _{When investors become emotionally attached to a}

stock, they also fail to recognize bad news about the company and consequently hold the stock too long.

 _{For example, many current employees and}

retirees get attached to the company for which they work or have worked. As a consequence, they continue to hold too large a proportion of their portfolios in that company’s stock. The fact that some Enron employees exclusively held

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Attachment Bias

 _{Attachment bias, causes investors to}

become emotionally attached to a security.

 _{This attachment causes them to focus on}

good traits and deeds and to discount or ignore bad traits or deeds.

 _{Investors frequently get attached to a}

stock. Although attachment bias has the potentially positive effect of discouraging trading with its concomitant tax and

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Changing Risk Preference

_{Emotions are particularly strong after large}

gains and losses (Thaler & Johnson, 1990).

_{When an investor is on a winning streak,}

greed affects ensuing decisions. Having made some large gains, many investors may feel

like they are playing with the house’s money.

_{Gamblers tend to treat winnings as if the}

money did not belong to them.

_{Specifically, the feeling of betting with}

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Overcoming psychological biases

 _{Belsky and Gilovich (1999) contend that no easy}

fixes exist for many of the psychological biases that affect investors.

 _{Merely learning about cognitive and emotional}

weaknesses does not eliminate them.

 _{Two key difficulties exist to overcoming}

psychological biased that result in common investor mistakes.

 _{First, although these mistakes often cost investors}

money, each psychological habit may have a flip side that is beneficial.

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Overcoming psychological biases

1. Understand psychological

biases

2. Indentify Investment

Objectives and Constraints

3. Develop Quantitative

Investment Criteria

4. Diversify Investments

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