Description
This is a presentation explaining Behavioral Finance, It introduces the concept.
Even apart from instability due to speculation, there is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rater than mathematical expectations , whether moral or hedonistic or economic. Keynes (1936)
Challenges to EMH
• Investors are not “fully rational”. They exhibit “biases” and use simple “heuristics” (rules of thumb) in making decisions.
• Empirical Evidence on investor behavior:
• investors fail to diversify. • investors trade actively (Odean). • Investors may sell winning stocks and hold onto losing stocks (Odean). • extrapolative and contrarian forecasts.
Prospect Theory
• Proposed by two psychologists: Daniel Kahneman and Amos Tversky. Gambles are evaluated relative to a reference point. Decision maker analyzes “gains” and “losses” differently. Incremental value of a loss is larger than that of a loss.
•
•
•
“the hurt of a $1000 loss is more painful than the benefit of a $1000 gain”
HEURISTICS-DRIVEN BIAS
• REPRESENTATIVENESS Suppose that a university is attempting to predict the grade point average (GPA) of some graduating students based upon their high school GPA levels. In the U.S., a student’s GPA lies in the interval [0, 4]. Below you will find some data, for undergraduates at Santa Clara University, based on students who entered the university in the years 1990, 1991, and 1992. During this period, the mean high school GPA of students who entered as freshmen and subsequently graduated was 3.44 (standard deviation was 0.36). The mean college GPA of those same students was 3.08 (standard deviation 0.40). Suppose that it is your task to predict the graduating college GPA of 3 undergraduate students, based solely on their high school GPA scores. The 3 high school GPAs are 2.2, 3.0, and 3.8. Write down your prediction below for the college GPAs of these students upon graduation.
• • •
Prediction of Graduation GPA of student with high school GPA of 2.2 = ______ Prediction of Graduation GPA of student with high school GPA of 3.0 = ______ Prediction of Graduation GPA of student with high school GPA of 3.8 = ______
Actual GPAs are close to the mean than predicted GPAs
High School GPA
Predicted College GPA
Actual College GPA
2.20 3.00
3.80
2.03 2.77
3.46
2.70 2.93
3.30
Effects of Representativeness
De Bondt and Thaler (1985) • Overly Pessimistic about past losers and overly optimistic about past winners • Gamblers fallacy If 5 tosses of a fair coin all turn out to be heads, what is the probability that 6th toss will be tails?
HEURISTICS-DRIVEN BIAS
• • OVER CONFIDENCE The Dow Jones Industrial Average closed 1999 at 11,497. As a price index, the Dow does not include reinvested dividends. If the Dow were redefined to reflect the reinvestment of all dividends since May 1896, when it commenced at a value of 40, what would its value have been at the end of 1999? In addition to writing down your best guess, also write down a low guess and a high guess so that you feel 90% confident that the true answer will lie between your low guess and your high guess. Best = ______ Low = ______ High = ______
•
FRAME DEPENDENCE
• LOSS AVERSION
• Suppose you face a choice between • A = a guaranteed loss of $745 • B = a 25% chance to lose nothing, 75% chance to lose $1000 • Which would you choose, the sure loss or the gamble?
Loss Aversion
• Manual of Stock Brokers (Leroy Gross 1982) Many clients, however will not sell anything at a loss. They don’t want to give up the hope of making money on a particular investment ,or perhaps they want to get even before they get out. The “get-evenitis” disease has probably wrought more destruction on investment portfolios than anything else….. Investors who accept losses can no longer prattle to their loved ones , “Honey, it’s only a paper loss. Just wait. It will come back
FRAME DEPENDENCE
• • CONCURRENT DECISIONS Sometimes people have to make a series of concurrent choices about sources of risk to which they will be simultaneously exposed. For example, they may use a single insurance agent for their homeowners’ policy, automobile insurance, life insurance, and personal liability coverage. This question simulates exposure to multiple sources of risk.
First Decision: Choose • • A = a guaranteed gain of $2400 B = 25% chance to win $10000, 75% chance to win nothing
Second Decision : Choose • • C = a guaranteed loss of $7500 D = 25% chance to lose nothing, 75% chance to lose $10000
FRAME DEPENDENCE
• HEDONIC EDITING This question concerns how your attitude to risk depends on other aspects of your financial situation. Imagine that you have just won $1,500 in one stylized lottery, and have the opportunity to participate in a second stylized lottery. The outcome of the second lottery is determined by the toss of a fair coin. If heads comes up, you win $450 in the second lottery. If tails comes up, you lose $450. Would you choose to participate in the second lottery? Yes (1) or no (2)?
Imagine that you have just lost $750 in one stylized lottery, but have the opportunity to participate in a second stylized lottery. The outcome of the second lottery is determined by the toss of a fair coin. If heads comes up, you win $225 in the second lottery. If tails comes up, you lose $225. Would you choose to participate in the second lottery? Yes (1) or no (2)?
Effects of frame dependence
Suppose that you are the only income earner in your family, and you have a good job guaranteed to give you your current (family) income every year for life. You are given the opportunity to take a new and equally good job, with an even chance it will double your (lifetime family) income and an even chance that it will cut your (lifetime family) income. Indicate exactly what the percentage cut x would be that would leave you indifferent between keeping your current job or taking the new job and facing 50-50 chance of doubling your income or cutting it by x percentage (Barsky et al. 1997)
Effects of Frame Dependence
• Departure from fundamental value
Rate 8 companies(based on portfolio game) on a scale from 0 (poor) to 10 (excellent) on eight attributes, along with your assessment about the company’s future stock return, level of risk, and future earnings.
• The 8 attributes are:
1. 2. 3. 4. 5. 6. 7. 8. quality of management; quality of products or services; innovativeness; value as a long-term investment; financial soundness; ability to attract, develop, and keep talented people; responsibility to the community and the environment; wise use of corporate assets;
In addition to your assessment of these attributes, record: • • Your expectation about the total return on the company’s stock over the next 12 months. Your perception of how risky the stock would be to hold for the next twelve months (on a scale of 0 to 10 with 0 being risk-free and 10 being extremely speculative); Your expectation about the total return on the company’s stock over the next 6 months.
•
•
• • •
Your expectation about the total return on the company’s stock over the next 3 years.
Your expectation about the company’s earnings (EPS) over the next 12 months; Your expectation about the company’s average earnings (EPS/yr) over the next 24 months; Your expectation about the annual average growth rate in the company’s earnings over the next 5 years, expressed as a percentage.
Behavioral Finance at JP Morgan
Investment Philosophy Irrational investor behavior/anomalies Exploited with disciplined approach
Risk Return Trade off 20 Year History
Focus on over confidence Loss Aversion
Implementation
• Portfolio selection
– Good valuation and news flow – Setting opposite what most people like doing
• Portfolio Construction
– Maximum exposure to value and momentum strategy
– Controlling other risk factors
Behavioral Finance Promise
• Behavioral Finance promises to make economic models better at explaining systematic (non-idiosyncratic) investor decisions, taking into consideration their emotions and cognitive errors and how these influence decision making. • Behavioral Finance is not a branch of standard finance; it is its replacement, offering a better model of humanity. • Create a long term advantage by understanding the role of investor psychology • Human flaws pointed out by the analysis of investor psychology are consistent and predictable, and that they offer investment opportunities.
doc_257022743.pptx
This is a presentation explaining Behavioral Finance, It introduces the concept.
Even apart from instability due to speculation, there is instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rater than mathematical expectations , whether moral or hedonistic or economic. Keynes (1936)
Challenges to EMH
• Investors are not “fully rational”. They exhibit “biases” and use simple “heuristics” (rules of thumb) in making decisions.
• Empirical Evidence on investor behavior:
• investors fail to diversify. • investors trade actively (Odean). • Investors may sell winning stocks and hold onto losing stocks (Odean). • extrapolative and contrarian forecasts.
Prospect Theory
• Proposed by two psychologists: Daniel Kahneman and Amos Tversky. Gambles are evaluated relative to a reference point. Decision maker analyzes “gains” and “losses” differently. Incremental value of a loss is larger than that of a loss.
•
•
•
“the hurt of a $1000 loss is more painful than the benefit of a $1000 gain”
HEURISTICS-DRIVEN BIAS
• REPRESENTATIVENESS Suppose that a university is attempting to predict the grade point average (GPA) of some graduating students based upon their high school GPA levels. In the U.S., a student’s GPA lies in the interval [0, 4]. Below you will find some data, for undergraduates at Santa Clara University, based on students who entered the university in the years 1990, 1991, and 1992. During this period, the mean high school GPA of students who entered as freshmen and subsequently graduated was 3.44 (standard deviation was 0.36). The mean college GPA of those same students was 3.08 (standard deviation 0.40). Suppose that it is your task to predict the graduating college GPA of 3 undergraduate students, based solely on their high school GPA scores. The 3 high school GPAs are 2.2, 3.0, and 3.8. Write down your prediction below for the college GPAs of these students upon graduation.
• • •
Prediction of Graduation GPA of student with high school GPA of 2.2 = ______ Prediction of Graduation GPA of student with high school GPA of 3.0 = ______ Prediction of Graduation GPA of student with high school GPA of 3.8 = ______
Actual GPAs are close to the mean than predicted GPAs
High School GPA
Predicted College GPA
Actual College GPA
2.20 3.00
3.80
2.03 2.77
3.46
2.70 2.93
3.30
Effects of Representativeness
De Bondt and Thaler (1985) • Overly Pessimistic about past losers and overly optimistic about past winners • Gamblers fallacy If 5 tosses of a fair coin all turn out to be heads, what is the probability that 6th toss will be tails?
HEURISTICS-DRIVEN BIAS
• • OVER CONFIDENCE The Dow Jones Industrial Average closed 1999 at 11,497. As a price index, the Dow does not include reinvested dividends. If the Dow were redefined to reflect the reinvestment of all dividends since May 1896, when it commenced at a value of 40, what would its value have been at the end of 1999? In addition to writing down your best guess, also write down a low guess and a high guess so that you feel 90% confident that the true answer will lie between your low guess and your high guess. Best = ______ Low = ______ High = ______
•
FRAME DEPENDENCE
• LOSS AVERSION
• Suppose you face a choice between • A = a guaranteed loss of $745 • B = a 25% chance to lose nothing, 75% chance to lose $1000 • Which would you choose, the sure loss or the gamble?
Loss Aversion
• Manual of Stock Brokers (Leroy Gross 1982) Many clients, however will not sell anything at a loss. They don’t want to give up the hope of making money on a particular investment ,or perhaps they want to get even before they get out. The “get-evenitis” disease has probably wrought more destruction on investment portfolios than anything else….. Investors who accept losses can no longer prattle to their loved ones , “Honey, it’s only a paper loss. Just wait. It will come back
FRAME DEPENDENCE
• • CONCURRENT DECISIONS Sometimes people have to make a series of concurrent choices about sources of risk to which they will be simultaneously exposed. For example, they may use a single insurance agent for their homeowners’ policy, automobile insurance, life insurance, and personal liability coverage. This question simulates exposure to multiple sources of risk.
First Decision: Choose • • A = a guaranteed gain of $2400 B = 25% chance to win $10000, 75% chance to win nothing
Second Decision : Choose • • C = a guaranteed loss of $7500 D = 25% chance to lose nothing, 75% chance to lose $10000
FRAME DEPENDENCE
• HEDONIC EDITING This question concerns how your attitude to risk depends on other aspects of your financial situation. Imagine that you have just won $1,500 in one stylized lottery, and have the opportunity to participate in a second stylized lottery. The outcome of the second lottery is determined by the toss of a fair coin. If heads comes up, you win $450 in the second lottery. If tails comes up, you lose $450. Would you choose to participate in the second lottery? Yes (1) or no (2)?
Imagine that you have just lost $750 in one stylized lottery, but have the opportunity to participate in a second stylized lottery. The outcome of the second lottery is determined by the toss of a fair coin. If heads comes up, you win $225 in the second lottery. If tails comes up, you lose $225. Would you choose to participate in the second lottery? Yes (1) or no (2)?
Effects of frame dependence
Suppose that you are the only income earner in your family, and you have a good job guaranteed to give you your current (family) income every year for life. You are given the opportunity to take a new and equally good job, with an even chance it will double your (lifetime family) income and an even chance that it will cut your (lifetime family) income. Indicate exactly what the percentage cut x would be that would leave you indifferent between keeping your current job or taking the new job and facing 50-50 chance of doubling your income or cutting it by x percentage (Barsky et al. 1997)
Effects of Frame Dependence
• Departure from fundamental value
Rate 8 companies(based on portfolio game) on a scale from 0 (poor) to 10 (excellent) on eight attributes, along with your assessment about the company’s future stock return, level of risk, and future earnings.
• The 8 attributes are:
1. 2. 3. 4. 5. 6. 7. 8. quality of management; quality of products or services; innovativeness; value as a long-term investment; financial soundness; ability to attract, develop, and keep talented people; responsibility to the community and the environment; wise use of corporate assets;
In addition to your assessment of these attributes, record: • • Your expectation about the total return on the company’s stock over the next 12 months. Your perception of how risky the stock would be to hold for the next twelve months (on a scale of 0 to 10 with 0 being risk-free and 10 being extremely speculative); Your expectation about the total return on the company’s stock over the next 6 months.
•
•
• • •
Your expectation about the total return on the company’s stock over the next 3 years.
Your expectation about the company’s earnings (EPS) over the next 12 months; Your expectation about the company’s average earnings (EPS/yr) over the next 24 months; Your expectation about the annual average growth rate in the company’s earnings over the next 5 years, expressed as a percentage.
Behavioral Finance at JP Morgan
Investment Philosophy Irrational investor behavior/anomalies Exploited with disciplined approach
Risk Return Trade off 20 Year History
Focus on over confidence Loss Aversion
Implementation
• Portfolio selection
– Good valuation and news flow – Setting opposite what most people like doing
• Portfolio Construction
– Maximum exposure to value and momentum strategy
– Controlling other risk factors
Behavioral Finance Promise
• Behavioral Finance promises to make economic models better at explaining systematic (non-idiosyncratic) investor decisions, taking into consideration their emotions and cognitive errors and how these influence decision making. • Behavioral Finance is not a branch of standard finance; it is its replacement, offering a better model of humanity. • Create a long term advantage by understanding the role of investor psychology • Human flaws pointed out by the analysis of investor psychology are consistent and predictable, and that they offer investment opportunities.
doc_257022743.pptx