Making Better Investment DecisionsThrough the Insights of Behavioural Finance

Steve Foerster

Investment Innovation ConferenceDecember 1, 2010

• If the principles of behavioural finance were better understood portfolio performance might be improved

• Contrasting the assumptions and implications of traditional versus behavioural finance can help identify how many investment decisions are actually made

• Understanding these principles can identify some investment-related biases and lead to improved decision making

What Can We Learn From Behavioural Finance and Investor Psychology?

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Traditional Finance and Rationality

• Traditional finance assume investors are rational:1. When investors receive new information, they update

their beliefs correctly2. Given their beliefs, investors make choices that are

consistent with expected utility maximization

• When investors are rational and there are no market frictions: market price = intrinsic value

• Implication for investors (if true): Buy & hold an index fund

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Are Investors Rational? Newton’s Reflection on the South Sea Bubble

“I can calculate the motion of heavenly bodies,but not the madness of people.”

Sir Isaac Newton (1642-1727)

Sir Isaac Newton(Wikipedia)

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“Stock prices have reached what looks like a permanent high plateau.”

Irving Fisher, Yale Economist, Autumn 1929

Are Investors Rational?1929, Pre Stock Market Crash

Irving Fisher(Wikipedia)

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Are Investors Rational?Alan Greenspan Bubble Musings

“How do we know when irrational exuberance has unduly escalated asset values, which then become

subject to unexpected and prolonged contractions?”"The Challenge of Central Banking in a Democratic Society“

Alan Greenspan, Federal Reserve Board ChairmanDecember 5, 1996

Alan Greenspan(Wikipedia)

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Are Investors Rational?Dot-com Bubble 2000: My $10,000 Cap

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Behavioural Finance Overview*

• Behavioural finance argues that in order to understand many empirical findings in finance, we need to rely on models in which some investors are not fully rational (i.e., they violate principles #1 and #2 on previous slide)

• Key implication:market price does not always equal intrinsic value

*See: “A Survey of Behavioral Finance” by Nicholas Barberis and Richard Thaler, 2003, in G.M. Constanides, M. Harris, and R.M. Stulz, editors, Handbook of the Economics of Finance volume 1, pp 1053-1128;The Psychology of Investing by John Nofsinger, 2008, Pearson Prentice Hall;Behavioral Corporate Finance: Decisions that Create Value by Hersh Shefrin, 2007, McGraw-Hill Irwin

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Behavioural Finance Building Blocks

• Limits to arbitrage:– It is difficult for rational traders to correct the mispricing

by irrational traders

• Psychology:– Describes the kinds of deviations from rationality we

might expect to see due to:• Biases• Heuristics• Framing Effects

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Limits to Arbitrage

• Behavioural finance argues that even when a security is mispriced, strategies to correct the mispricing can be both risky and costly

“prices are right” “no free lunch”

but...

“no free lunch” “prices are right”

...i.e., “no free lunch” can be true in an inefficient market

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Limits to Arbitrage: Pick-a-Number Game

• Choose a number between 1 and 100• The winner will be the person whose choice is closest to two-

thirds of the average entry• Example: 5 entries: 10, 20, 30, 40, 50 avg=30, x 2/3 =20

…and the winner is…!!!

• Key Messages:– The desire to win limits smart players from behaving in a

way that brings the average entry close to the intrinsic value– Playing skilfully requires understanding others’ errors– The best course of action is different if others make errors

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Investor Psychology Overview

• If irrational traders cause deviations from fundamental values, what is the form of irrationality?

• Reliance on experimental evidence of psychologists:• Biases: predisposition toward error• Heuristics: rules of thumb• Framing Effects: manner and setting of decisions

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Excessive Optimism Bias

• Unrealistic rosy views

• Overestimation of how frequently favourable outcomes will be experienced

• Underestimation of how frequently unfavourable outcomes will be experienced

• Example: Stocks “priced for perfection” (e.g., early-2000: stocks trading at P/Es > 100x)

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Overconfidence Bias

• Overconfidence in judgments: thinking one has more knowledge and ability than is actually the case; overly convinced your view is correct

• Example 1: “Are you a good driver? Compared to other drivers you encounter are you above average, average, or below average?” 82% above average!

• Example 2: Survey of 3,000 new business owners: “What are the chances of your success?... Of other similar businesses?” 70% versus 39%!

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Confirmation Bias

• Ignore information that is counter to the current viewpoint

• One only hears what they want to hear

• Spend too much time searching for reasons to support views and not enough time searching for reasons why the current view may be wrong

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Representativeness Heuristic

• Example (Nofsinger 2008): “Mary is quiet, studious, and concerned with social issues. While an undergraduate at Berkeley, she majored in English literature and environmental studies. Given this information, indicate which of the followingthree cases is most probable.

a) Mary is a librarian.b) Mary is a librarian and a member of the Sierra Club.c) Mary works in the banking industry.”

• Investment implication: Don’t confuse a “good company” with a “good investment”

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Framing Effect: Prospect Theory(Kahneman & Tversky)

•Investors feel good (bad) with gains (losses) but not “linear”•Asymmetry: function is steeper for losses•Reference point is key: often segregate gains vs losses

GainsLosses

Utility

-$x +$y

-X

+X

Reference point

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Framing Effect: Loss Aversion

• Example: A coin toss leads to an equal chance you will lose $100 or win some other amount. What is the minimum potential gain for which you would agree to the bet?

GainsLosses

Utility

-$100 +$??

-X

+X

Reference point

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Framing Effect: Loss Aversion (cont’d)

• Losses loom larger than similar sized gains (e.g., 2.5x)

• Can lead investors to behave in a risk-averse manner and often to treat repeated risks in the same manner as one-time risks, thereby being too conservatively

• Investment implication: Disposition effect sell winners too soon and hold losses too long

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Foerster Research – “Double Then Nothing:Why Individual Stock Investments Disappoint”

• Assume investors are either irrational “positive feedback traders” or rational “fundamentalists”

• Which investors do better and which are disappointed?

• Comparison of recent past performance with subsequent performance:• Whether stock price has doubled in 4-years or less in

screening period• Compare with subsequent 4-year test period

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“Double Then Nothing” Results

• Just over half have doubled in the screening period; average out-performance of 10.1%

• Only one-quarter double in the subsequent 4-year test period; average underperformance of 3.6%

• Stocks that did not double in the screening period are more likely to double in the test period

• Future stock returns are predictable: negatively related to past returns as well as the speed of past price increases

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Overall and Past Double/Non-Double

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Past Double (Speed of Doubling)/Non-Double

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• Past performance doesn’t guarantee future returns

• Investors tend to overreact and in particular to stocks that have recently doubled in value

• Stock return predictability may be based on simple information readily available to most investors: avoid investing in stocks that have recently doubled in value (especially if you have an investment horizon of 1-4 years)

Research Conclusions and Implications

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Investor Psychology Implications:Making Better Investment Decisions

• Work to “de-bias”– Understand why you are investing– View decision-making as widely as possible– Set investment criteria based on sound research– Diversify– Accept losses and treat sunk costs as sunk– Think long-term

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