Practice investment management pim3 ch11
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CHAPTER ELEVEN
BEHAVIORAL FINANCE
Practical Investment Management
Robert A. Strong
Outline
Introduction
Established Behaviors
Representativeness Heuristic
Loss Aversion
Fear of Regret
Myopic Loss Aversion
Herding
Anchoring
Illusion of Control
Prospect Theory
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Outline
Established Behaviors … continued
Mental Accounting
Asset Segregation
Hindsight Bias
Overconfidence
Framing
Availability Heuristic
Illusion of Truth
Biased Expectations
Reference Dependence
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Outline
Mistaken Statistics
The Special Nature of Round Numbers
Extrapolation
Percentages vs. Numbers
Sample Size
Apparent Order
Regression to the Mean
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Introduction
There are three sub fields to modern
financial research.
Theoretical finance is the study of logical
relationships among assets.
Empirical finance deals with the study of
data in order to infer relationships.
Behavioral finance integrates psychology
into the investment process.
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Introduction
“Financial economists have been aware for a
long time that in laboratory settings,
humans often make systematic mistakes
and choices that cannot be explained by
traditional models of choice under
uncertainty.”
– Paul Pfleiderer
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Introduction
Behavioral finance research focuses on
how investors make decisions to buy and
sell securities, and
how they choose between alternatives.
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Established Behaviors
Representativeness Heuristic
The representativeness heuristic takes one
characteristic of a company and extends it
to other aspects of the firm.
In particular, many investors believe a wellrun company represents a good
investment.
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Representativeness Heuristic
Insert Table 11-1 here.
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Representativeness Heuristic
Insert Figure 11-1 here.
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Established Behaviors
Loss Aversion
Investors do not like losses and often
engage in mental gymnastics to reduce
their psychological impact.
Their tendency to sell a winning stock
rather than a losing stock is called the
disposition effect in some of the behavioral
finance literature.
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Established Behaviors
Fear of Regret
Investors do not like to make mistakes.
Rather than being unable to decide among
attractive alternatives, their focus is on the
negative: What if they pick the wrong
stock?
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Established Behaviors
Myopic Loss Aversion
Investors have a tendency to assign too
much importance to routine daily
fluctuations in the market.
Abandoning a long-term investment
program because of normal market
behavior is sub optimal behavior.
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Established Behaviors
Herding
Herding refers to the lemming-like behavior
of investors and analysts looking around,
seeing what each other is doing, and
heading in that direction.
There may not have been safety in
numbers, but there probably was some
comfort in them.
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Established Behaviors
Anchoring
Our decisions can be influenced by
extraneous information contained in the
problem statement.
For example, investors tend to remember
the price they paid for a stock, and this
information influences their subsequent
decisions about what to do with it.
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Established Behaviors
Illusion of Control
We like to pretend that we can
influence the resulting score by
varying the force with which we
throw a dice.
Similarly, investors like to look at charts,
although charts are theoretically not helpful
in predicting the future prospects for a
stock.
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Established Behaviors
Prospect Theory
Risk averse investors get increasing utility
from higher levels of wealth, but at a
decreasing rate.
Research shows that while risk aversion
may accurately describe investor behavior
with gains, investors often show risk
seeking behavior when they face a loss.
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Prospect Theory
Insert Figure 11-2 here.
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Prospect Theory
Insert Figure 11-3 here.
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Prospect Theory
Insert Table 11-2 here.
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Established Behaviors
Mental Accounting
Mental accounting refers to our tendency to
“put things in boxes” and track them
individually.
For example, investors tend to differentiate
between dividend and capital dollars, and
between realized and unrealized gains.
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Established Behaviors
Asset Segregation
Asset segregation refers to our tendency to
look at investment decisions individually
rather than as part of a group.
The portfolio may be up handsomely for the
reporting period, but the investor will still
be concerned about the individual holdings
that did not perform well.
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Asset Segregation
Insert Table 11-3 here.
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Established Behaviors
Hindsight Bias
Hindsight bias refers to our tendency to
remember positive outcomes and repress
negative outcomes.
Investors remember when their pet trading
strategy turned up roses, but do not dwell
on the numerous times the strategy failed.
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Established Behaviors
Overconfidence
Overconfidence refers to our tendency to
believe that certain things are more likely
than they really are.
For example, most investors think they are
above-average stock pickers.
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