Behavioral Finance Lecture Notes PDF

Introduction Participation and asset allocation Behavior of individual investor Principles of Finance Lecture 17: Introduction to Behavioral Finance (Barber and Odean (2013) & Campbell (2006)) Rikke Sejer Nielsen...

Introduction Participation and asset allocation Behavior of individual investor Principles of Finance Lecture 17: Introduction to Behavioral Finance (Barber and Odean (2013) & Campbell (2006)) Rikke Sejer Nielsen 1 / 19  Introduction Participation and asset allocation Behavior of individual investor Introduction Until now: The role of information in financial markets related to Asset pricing: Market efficiency To what degree, prices reflect all available relevant information Corporate finance: ▶ Asymmetric information and signalling ▶ Asymmetric information and agency theory ⇒ We assumed that individuals are rational decision makers w. standard preferences. BUT, BUT, BUT,... ▶ Human beings are more complex compared to standard theory ▶ Do individuals/ households behave rationally? ▶ Are individuals able to process all available information correctly? ▶ Are the behavior of individuals based on information of other individuals’ behavior (social networks)? 2 / 19  Introduction Participation and asset allocation Behavior of individual investor Introduction Now: How is the individuals’/households’ financial decisions related to how they process the available information. ⇒ Behavioral Finance: An area of study focused on how psychology of human beings affects individuals’/households’ financial decisions (behavior). 3 / 19  Introduction Participation and asset allocation Behavior of individual investor Introduction Our focus here: Behavioral finance in relation to Household Finance Financial decisions of households/individuals about ▶ Asset side: Savings, retirement savings, real estate investments, and portfolio choice. ▶ Liability side: credit card debt, mortgage choice and student loans. Examples: Investor behavior and financial planning. ▶ How do households consume and save over the life cycle? ▶ Do households save enough for retirement? ▶ Do households borrow too much? ▶ Do households participate in the stock market and thereby benefit from the equity risk premium? ▶ Investment biases (irrational behavior) But behavioral finance also relates to corporate finance: How individuals/households use financial instruments to attain their objectives. asset pricing: Individuals’/Households’ asset demands affect asset prices (mainly impact from wealthy and risk-tolerant households). 4 / 19  Introduction Participation and asset allocation Behavior of individual investor Household Finance Financial decisions of households/individuals: Complex compared to standard theory ▶ Human being are complex ⇒ Psychological factors affect decision making ▶ Special features of financial problems of households ∗ Plan over a life-time (long and finite horizons), ∗ Nontradable assets (e.g. human capital), ∗ Hold illiquid assets (e.g. housing), ∗ Borrowing constraints, ∗ Complex taxation. ⇒ Needs to account for nonstandard preferences, role of asymmetric information, behavioral biases, and social networks. ⇒ Empirical and theoretical research works together to understand underlying mechanisms in household decision making 5 / 19  Introduction Participation and asset allocation Behavior of individual investor Positive vs. Normative research Positive research: Households actual/observed behavior Requires high qualitative data Normative research: Ideal behavior of households Requires significant extensions of textbook financial theory ⇒ Actual and ideal behavior coincide (typical economic assumption) e.g. use nonstandard behavioral models of preferences to account for loss aversion, mental accounting, etc. ⇒ Actual and ideal behavior do not coincide Households take suboptimal/irrational financial decisions that are harmful to their wealth (e.g. investment mistake/biases) due to complexity of financial planning problem and financial products. 6 / 19  Introduction Participation and asset allocation Behavior of individual investor Participation and asset allocation Question: How households allocate their assets? 1 Household participation in asset markets 2 Fraction of their assets allocated to each asset category 8 / 19  Introduction Participation and asset allocation Behavior of individual investor Wealth distribution, 2001 Figure: The U.S. wealth distribution. The cross-sectional distribution of total assets, financial assets, and net worth in the 2001 Survey of Consumer Finances. (Figure 1 from Campbell, J. Y. (2006). Household finance. The Journal of Finance 61 (4), 1553 - 1604.) 9 / 19  Introduction Participation and asset allocation Behavior of individual investor Participation rate, 2001 Figure: Participation rates by asset class. The cross-sectional distribution of asset class participation rates in the 2001 Survey of Consumer Finances. (Figure 2 from Campbell, J. Y. (2006). Household finance. The Journal of Finance 61 (4), 1553 - 1604.) 10 / 19  Introduction Participation and asset allocation Behavior of individual investor Household portfolios, 2001 Figure: Asset class shares in household portfolios. The share of each asset class in the aggregate portfolio of households at each point in the wealth distribution, in the 2001 Survey of Consumer Finances. (Figure 3 from Campbell, J. Y. (2006). Household finance. The Journal of Finance 61 (4), 1553 - 1604.) 11 / 19  Introduction Participation and asset allocation Behavior of individual investor Stock market participation puzzle Stock market participation puzzle: Many households own no equity (do not participation in the stock market) and allocate their financial wealth to safer assets. Standard theory: positive equity premium, so households should hold some equity. Potential explanations: Unawareness of stocks, Nonstandard preferences and Fixed cost, ▶ Time and money spent on stock market investments ▶ Psychological factors against stock market investments ⇒ Entry costs or ongoing participation costs, Private business risk 12 / 19  Introduction Participation and asset allocation Behavior of individual investor Behavior of individual investor Questions: 1 How do household construct their portfolio? 2 How do investors behave (e.g. trading tendencies)? 3 How do households perform on the stock market? 14 / 19  Introduction Participation and asset allocation Behavior of individual investor Behavior of individual investor - Empirical evidence Avg. individual investor underperforms the market in the long run. Stock market: zero-sum game → If investor A beats the market, another investor must underperform. Performance varies a lot across individuals Investment skill ▶ Predict investment skills by past performance, ∗ i.e. an investor performing better in past period ⇒ higher investment skills ⇒ Higher skilled investors outperform those with lower skills Cognitive abilities, ▶ Predict cognitive ability using demographic variables such as education, age and social networks ⇒ Smarter investors outperform others Location, ▶ Individual investors tend to hold stocks for which they hold an informational advantage, ⇒ Outperform more diversified portfolios due to informational advantage. ▶ Informational advantage more pronounced for local stocks (home bias), ⇒ Underperform due to failure to Diversification. and gender. ⇒ Women perform better than men. 15 / 19  Introduction Participation and asset allocation Behavior of individual investor Explanations for under-performance I Asymmetric information ▶ Investor realize that they have informational disadvantage when trading ⇒ Only trade when forced to, e.g. ∗ Buy stocks to save ∗ Sell stocks to consume ∗ Trade to rebalance portfolio ⇒ Underperform due to non-speculative trading Overconfidence, ▶ The belief that one knows more than one actually does. ▶ Classical theoretical models incl. overconfidence predicts that investors will trade too much ▶ Men more overconfident ⇒ men trade more than women, ⇒ Underperform due to excessive trading 16 / 19  Introduction Participation and asset allocation Behavior of individual investor Explanations for under-performance II Sensation seeking ▶ Trading is entertainment ▶ Appealing to people seeking the sensation ⇒ Underperform due to excessive trading Failure to Diversification ▶ Households own few stocks ▶ Familiarity - Home bias ▶ Households invest heavily in employer stocks (U.S.) ⇒ Underperform due to underdiversification of portfolios. 17 / 19  Introduction Participation and asset allocation Behavior of individual investor Investment mistakes Disposition effect ▶ Selling Winners and Holding Losers Attention ▶ Investors have limited amount of attention to devote to investment decisions. ∗ Too little attention ⇒ delayed reaction ∗ Too much attention ⇒ overreaction 18 / 19  Introduction Participation and asset allocation Behavior of individual investor References Barber and Odean (2013) Campbell (2006) 19 / 19