Behavioral Finance and Psychology of Investing

• Chapter 8 is about Behavioral Finance and Psychology of Investing
• It focuses on understanding how reasoning errors influence investor decisions and market prices

Behavioral Finance Definition

• Behavioral Finance research tries to understand and explain how reasoning errors influence investor decisions and market prices
• Cognitive psychology is the study of how people, including investors, think, reason, and make decisions
• Reasoning errors are often called cognitive errors
• Cognitive errors made by investors can cause market inefficiencies

Market efficiency

• For a market to become inefficient, many investors must make irrational investment decisions
• The collective irrationality of investors can lead to either an overly optimistic or pessimistic market situation
• The situation cannot be corrected via arbitrage by rational, well-capitalized investors
• Whether these conditions can be absent is debated among financial market researchers

Prospect Theory

• Prospect Theory provides an alternative to classical, rational economic decision-making
• Investors are more distressed by prospective losses than they are happy about prospective gains
• A typical investor considers the pain of a $1 loss to be twice as impactful as the pleasure received from the gain of $1
• Investors respond differently to identical situations depending on how that situation is presented
• People focus on changes in wealth versus levels of wealth

Note on investor biases

• Predictions of prospect theory help to describe the many psychological biases of investors
• Human investor's biases into two groups: Cognitive and Behavioral
• Cognitive Errors can be lessened by investors
• Belief Preservation Biases: How stubborn is the investor?
• Information Processing Biases: How do investors deal with new information?
• Behavioral Biases are quite difficult for investors to lessen

Investor Behavior Consistent with Prospect Theory Predictions

• Prospect theory identifies three major judgment errors: Frame Dependence, House Money Effect and Loss Aversion

Frame Dependence

• If an investment problem is presented in two different ways but are really equivalent, investors often make inconsistent choices
• How a problem is described, or framed, affects choices
• The two scenarios shown are actually identical where you end up with $1,500 for sure if you pick option A
• You end up with a 50-50 chance of either $1,000 or $2,000 if you pick option B
• You should pick the same option in both scenarios
• The framing of the question causes people to answer the questions differently

Mental accounting

• Mental accounting involves segmenting money into mental "buckets"
• Regular income can be viewed and spent differently than bonuses
• Retirement account investments are handles prudently but taking wild risks with a separate stock account

The House Money Effect

• Gamblers in Las Vegas casinos are more likely to take risks with money they won from the casino, also known as, "house money"
• Gamblers are less upset with losing house money than with losing their initial gambling money
• Money is separated into your very precious money earned through hard work, sweat, and sacrifice and Your less precious windfall money -- this is irrational
• Any dollar amount buys the same amount of goods and services
• Buying power is the same for both "your money" and for "house money"
• You are only guilty of playing with "house money" when giving back "paper profits"
• Losing original investment money and losing investment gains is irrelevant.
• Important lesson - There are no paper profits, all your money is yours
• You should not separate your money into bundles labeled "my money" and "house money."

Loss Aversion and Anchoring

• Loss Aversion: A reluctance to sell investments after they have fallen in value, also known as "breakeven" or "disposition" effect
• If you suffer from loss aversion, you will think that if you can somehow "get even," you will be able to sell the stock
• If you suffer from loss aversion, it is sometimes said that you have "get-evenitis."
• Symptoms include a difficulty selling a stock at a price lower than its purchase price
• Selling stock at a loss makes it seem like the purchasing of the stock in the first place was the wrong decision
• Anchoring: Associating a stock with its purchase price and fixating on that reference price.
• The market determines the worth of shares, not purchase price
• A raging case of loss aversion comes when Fama Enterprises, Inc. shares were a good buy at $40, so they must be a steal at $20
• Nicholas Leeson caused the collapse of the 233-year-old Barings Bank and this was due to Get-evenitis

Overconfidence: Error in Investor Judgment

• A serious error in judgment is to be overconfident
• The majority of people consider themselves better than average drivers
• Overconfidence affects investment decisions
• Investors tend to invest too heavily in shares of the company they work for
• Loyalty can be disastrously bad financially because earning power or income, and retirement nest-egg also depends on this company
• Avoiding diversification is also an example of investing too heavily in the stocks of local companies

Overconfidence and Trading Frequency

• Overconfidence results in too much trading and causes lower returns
• Average households earned an annual return of 16.4 percent while frequent traders return 11.4 percent
• Excessive trading is hazardous to your wealth
• Men trade about 50 percent more than women
• Researchers show that both men and women reduce their portfolio returns when they trade excessively
• Portfolio returns for men are 94 basis points lower than portfolio returns for women, and for single men, 144 basis points lower than for single women
• Men invest in riskier positions

What is a Diversified Portfolio to the Everyday Investor

• Most investors have a poor understanding of what constitutes a well-diversified portfolio
• The average number of stocks in a household portfolio is about four, and the median is about three
• The lack of diversification is the source of your surprise
• If there are many stocks, about half the individual stock returns outperform the market average
• Half the investors will beat the market with only one stock in their account

The Illusion of Knowledge

• One aspect of overconfidence stems from a belief that information you hold is superior
• Overconfidence leads to the belief that you can make more informed judgments
• In the aftermath of the 2009 General Motors bankruptcy, GM's management said the existing shares were worthless but these existing shares continued to trade at a positive value and this was driven by investors with an illusion of knowledge

The Snakebite Effect

• The snakebite effect refers to the unwillingness of investors to take a risk following a loss
• This is sometimes considered opposite from overconfidence
• This leads to less money to be liquidated from mutual funds following some significant market declines
• In other market declines, less money than “normal” tends to flow toward mutual funds

Misperceiving Randomness and Overreacting to Chance Events

• Cognitive psychologists discovered the human mind is a pattern-seeking device
• Humans conclude that there are causal factors or patterns at work behind sequences of events
• The representativeness heuristic: Concluding that there are causal factors at work behind random sequences
• The human mind is made to see a pattern in flipping a coin 20 times, when there isn't one

The Hot-Hand Fallacy

• Assuming that if a player has made two shots in a row, they will make the next one as well
• When asked, basketball fans think LeBron has a "hot hand" when players do not deviate much from their long-run shooting averages
• It is an illusion that basketball players are either “hot” or “cold"
• In reality, randomness often appears in clusters
• Clustering Illusion: Belief that random events that occur in clusters are not really random
• If a fair coin is flipped 20 times, there is about a 50 percent chance of flipping four heads in a row, you do not have a hot hand
• It is universal that past performance is no guarantee of future results but investers chase past returns

The Gambler's Fallacy

• Assuming that a departure from what occurs on average will be corrected in the short run
• Because an event has not happened recently, it has become "overdue" and is more likely to occur
• The odds on a US Roulette table never change:
• There is an 18 in 38 chance for a red number to hit
• There is an 18 in 38 chance for a black number to hit
• Suffer from the Gambler's Fallacy if you think that it is more likely for a black number to hit after a series of red numbers have hit

Heuristics

• Investors try to pick stocks that suit investment goals, but there is abundant of financial information available
• Investors use rules of thumb, also known as heuristics, to make decisions
• It simplifies decision-making process and they define the sets of critia
• Investors often choose inappropriate criteria

Herding

• Fish move together in both a quick and pronounced manner and this behavior is often called herding, a common among investors
• Stock analysts exhibit herding behavior in their earnings forecasts and stock ratings
• Where one analyst goes, others follow which comes from the fear of being left behind and a preservation behavior

Overcoming Bias

• Behavioral finance proponents generally claim most investor biases are coded in our DNA - we are born with them
• Knowing about potential biases can help overcome them and by understanding what errors you could make, you are less likely to make them

Sentiment-Based Risk and Limits to Arbitrage

• The efficient markets hypothesis (EMH) does not require every investor to be rational
• EMH just requires some smart, well-financed investors who are prepared to buy and sell to take advantage of marketplace mispricing
• Limits to Arbitrage is when certain circumstances make it impossible for rational, well-capitalized traders to correct mispricing in a short time period
• Strategies to eliminate mispricings are often risky, costly, or restricted
  • Firm-Specific Risk : unanticipated bad news drives GM's stock price lower after believing the stock price is too low
  • Noise Trader Risk :Someone whose trades aren't based on info
  • Implementation Costs: transaction costs such as bid-ask spreads, brokerage commissions, and margin interest

Technical Analysis

• Technical analysis differs significantly from fundamental analysis and differs techniques
• Technical analysts essentially search for bullish and bearish signals about stock prices or market direction
• Technical analysis is used at the present time because past security prices can easily fit into a wide variety of technical systems
• Technicians are continuously tinkering and find methods that fit past prices (back testing)

Market Sentiment Index

• The prevailing mood among investors about the future outlook for an individual security or for the market
• Market sentimentalists believe investors will follow the "consensus"
• One way to measure market sentiment is to ask investors whether they think the market is going up or down.
• Calculated number of bearish investors, number of bullish investors
• MSI = Number of Bearish Investors / (Number of Bullish Investors + Number of Bearish Investors)
• The MSI has a maximum value of 1.00, which occurs when every investor you ask is bearish on the market
• The MSI has a minimum value of 0.00, when every investor is bullish on the market
• Handy when using the MSI- "When the MSI is high, it is time to buy; when the MSI is low, it is time to go."
• There is no guide investors as to what level of the MSI is "high," and what level is "low.”

Dow Theory

• The Dow theory is a method to interpret and signal changes in the stock market direction
• Dates back to the turn of the 20th century and named after Charles Dow who co-founded the Dow Jones Co.
• Dow theory identifies:
  • A primary direction or trend,
  • A secondary reaction or trend,
  • Daily fluctuations known as noise, and has no real importance (The Trend is your Friend...)
• Dow theory is less popular today and underlies more contemporary approaches to technical analysis

Elliott Waves

• Invented in the 1930's by Ralph Nelson Elliott as a Dow Theorist
• Elliott's theory was that repeating stock price patterns, or waves, collectively expressed investor sentiment
• By using sophisticated "wave counting" techniques, a wave theorist could forecast market turns accurately
• The structure involves an eight-wave repeating sequence in which the first five waves are impulse waves

Support and Resistance Levels

• Support level: a price or level below which a stock or the market as a whole is unlikely to go
• Resistance level: a price or level above which a stock or the market as a whole is unlikely to rise
• Support and resistance levels are "psychological barriers."
• Bargain hunters and profit takers trade within these barriers
• A "breakout" occurs when a stock (or the market) passes through either a support or a resistance level

Technical indicators

• Markets diary details statistics about trading, such as issues traded, advances, declines, unchanged, new highs, new low, adv volume, decl volume, total volume, closing tick and closing arms
• The "advance/decline line" shows, the cumulative difference between advancing and declining issues.
• "Closing tick" is the difference between the number of shares that closed on an uptick and those that closed on a downtick.
• Closing Arms” or “trin” (trading index) is the ratio of average trading volume in declining issues to average trading volume in advancing issues

Relative Strength

• Determines the performance of one investment compared with another
• Technical indicators are used to determine the overall performance of stocks A vs Stock B

Charting

• Technical analysts rely heavily on charts showing recent market prices
• Technical analysis is sometimes called "charting and chartists and are often called chartists,
• Chartists study graphs (or charts) of past market prices (or other information)
• Chartists try to identify particular patterns known as chart formations in order to signal the direction of future prices
• The diagrams include open high low close charts, price channels, head and shoulders and moving averages
• Common technical indicators used are Fibonacci Numbers and hemline theory