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How do investors behave?

Classical View
Behavioral Finance „ Risk Averse
„ Incorporate all information into decision making
„ Optimizers, utility maximizers
„ “Rational” Investors
October. This is one of the particularly dangerous months to „ Markets are Efficient
speculate in stocks in. The others are July, January, September,
April November, May, March, June, December, August and Is the theory correct?
February. Are you a rational investor?
Mark Twain Pudd’nhead Wilson

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Problems... Behavioral Finance

Anomalies Investors are humans

„ investors choose actively managed mutual
Incorporate psychology into economic
decision making.
„ closed end funds sell at discount to net asset
value (NAV) Systematic psychological biases will not
„ ‘arbitrage opportunities are left on the table’ disappear in aggregate.
Market deviates from perfect rational Hypothesis
behavior. „ Are anomalies found in financial markets because
people are not rational investors?
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Overconfidence Example

„ 90% of automobile drivers in Sweden consider Consider 100 men, 70 are lawyers, 30 are
themselves above average. engineers. One is drawn randomly from this
„ Nearly all people consider themselves above average sample.
in their ability to get along with others.
Tim is a 30 year old man of high ability and
„ When analysts say they are 70% sure a stock’s price
motivation. He is well liked by his
will rise, they are correct 51% of the time.
„ Active portfolio managers think they can pick
winners. What is the probability that he is a lawyer?

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Results consistent with
Representativeness Heuristic Representativeness Heuristic
How do people make probability based decisions? Stereotypes
Rational investors consider population „ e.g. tech stocks are winners
probabilities. „ what about the individual firm characteristics?
In general, people evaluate the probability of an „ Real estate is always a good investment
uncertain event by the degree to which the event is
representative or similar (in their mind) to the
population regardless of past probabilities.

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Example Loss Aversion and Framing

Case 1: Which do you prefer? Experimental evidence shows that people

(A) I give you $10,000 tomorrow for sure. „ prefer riskfree gain (risk averse behavior)
(B) With a 10% chance, I give you $100,000 „ prefer risky loss (risk seeking behavior)
tomorrow, otherwise nothing.
Loss Aversion: People weigh losses more than
gains in their decision making.
Case 2: Which do you prefer?
People suffer more pain losing $10,000 than gain
(A) You give me $10,000 tomorrow.
pleasure in winning $10,000.
(B) With a 10% chance, you give me $100,000
tomorrow, otherwise nothing.
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Example of Framing and Mental

Loss Aversion and Framing Accounting

Loss aversion suggests that decision making is Investor 1 holds

sensitive to how alternatives are framed. „ 1000 shares of A, 1000 shares of B.
People evaluate case 1 as a choice between gains, Investor 2 holds
and case 2 as a choice between losses. „ 1000 shares in a mutual fund, each share of the mutual
fund corresponds to 1 share of A and 1 share of B.
They purchased their portfolios at the same time.
A was $5, B was $13. (Mutual fund was $18)
Currently both A and B are trading at $10.
(Mutual fund share = $20).

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Example of Framing and Mental
Accounting Other Behavioral Biases

If both investors were forced to liquidate Fads, Herding

their holdings, which one is likely to be „ the desire to conform and not deviate causes
more upset? people to herd.
What role do loss aversion and mental „ Analysts forecasts: the collective failure to

accounting play here? forecast correctly is not as costly as an

individual failure to forecast correctly.

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Regret, Prudence The Good News

remorse about a decision that led to a bad Behavioral explanations suggest
“anomalies” are real, not mispricing.
tactic to reduce regret is to shift or share
responsibility. This suggests that they should last, not
alternatively, follow the “norm”: prudent investing disappear.
Institutions are reluctant to invest in small firms Why aren’t they arbitraged away?
and closed end funds.
small firm effect may be explained by lower
liquidity and hence higher returns due to lack of
institutional investors.
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The Bad News Framing Example

All humans suffer from psychological biases. You have been given a gift of $2,000.
Evidence shows that both experts and novices „ In addition, choose between
behave in the same way.
„ (A) a sure gain of $500,
Even fund managers and analysts are not immune
from the biases. „ (B) a 25% chance of a gain of $2000, 75% $0.

Difficult to stomach investing counter to

Difficult to correctly separate your abilities from

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Example 2 Solution
You have been given a gift of $4,000. A
„ In addition, choose between $2,500
„ (A) a sure loss of $1500
or expected value of 2000 + 0.25*2000 = $2,500.
„ (B) a75% chance of a loss of $2000, 25% $0.
Or expected value of $4000 – 0.75*2000 =

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Endowment effects Switching strategies

People are reluctant to sell if they do not get When price falls to a certain level sell out
what they consider to be the ‘true value’ of Buy back when raises to a certain level.
the asset. One of the best ways around to go
If invested a lot of emotional energy in an completely bankrupt. Fast….
asset its value is considered to be higher Assumption is that you know that if price
than it is actually worth. rises it will keep on
Perceived value is not necessarily congruent And similarly with falling
with actual value.
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tulips In conclusion
The hot potato effect. People are greedy and over optimistic!
The profit of selling in a fast rising market
is not a true profit based on fundamentals
It is a hot potato ie you flick it onto
someone else before the prices start to fall.

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Gamblers Ruin
If the process is repeated indefinitely, the probability
Let two players each have a finite number that one of the two player will eventually lose all
of pennies pennies must be 100%. In fact, the chances and that
Now, flip one of the pennies (from either players one and two, respectively, will be rendered
player), with each player having 50% penniless are
probability of winning, and transfer a penny „ i.e., your chances of
going bankrupt are equal
from the loser to the winner. to the ratio of pennies
Now repeat the process until one player has your opponent starts out
with to the total number
all the pennies. of pennies.
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Ergo… St Petersburg
the player starting out with the smallest number of Consider a game, first proposed by Daniel
pennies has the greatest chance of going bankrupt.
Even with equal odds, the longer you gamble, the Bernoulli , in which a player bets on how
greater the chance that the player starting out with many tosses of a coin will be needed before
the most pennies wins. it first turns up heads.
„ Since casinos have more pennies than their
individual patrons, this principle allows casinos to The player pays a fixed amount initially,
always come out ahead in the long run.
„ And the common practice of playing games with
and then receives 2n dollars if the coin
odds skewed in favour of the house makes this comes up heads on the nth toss.
outcome just that much quicker.

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Variant doubling
Alternatively assume the player bets $2 that heads
will turn up on the first throw, $4 that heads will turn
so any finite amount of money can be
up on the second throw (if it did not turn up on the
wagered and the player will still come out first), $8 that heads will turn up on the third throw,
ahead on average. etc. Then the expected payoff is

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It is misleading to consider the payoff without taking This means that the net gain for the player is
into account the amount lost on previous bets, as can
be shown as follows. $2, no matter how many tosses it takes to
At the time the player first wins (say, on the nth toss), finally win.
he/she will have lost As expected, the large payoff after a long run
of tails is exactly balanced by the large amount
that the player has to invest.

In this toss, however, he/she wins 2n dollars.

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When you put gamblers ruin together with
St Petersburg Paradox we see the issue for
financial markets.
Barings, Hunts, Tech stocks, NAB traders,
last few years etc
Whilst in theory if one plays long enough
one will eventually win the issue is
Does one have the capital to play as long as
is needed……