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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

1 2

investors choose actively managed mutual

funds

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?

3 4

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.

colleagues.

Active portfolio managers think they can pick

winners. What is the probability that he is a lawyer?

5 6

1

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.

(stereotyping)

7 8

(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.

9 10

Loss Aversion and Framing Accounting

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).

11 12

2

Example of Framing and Mental

Accounting Other Behavioral Biases

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

individual failure to forecast correctly.

13 14

remorse about a decision that led to a bad Behavioral explanations suggest

outcome.

“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.

15 16

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.

feelings!!!

Difficult to correctly separate your abilities from

chance!

17 18

3

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.

B

$2,500

Or expected value of $4000 – 0.75*2000 =

$2,500.

19 20

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.

21 22

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.

23 24

4

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.

25 26

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.

27 28

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

29 30

5

Resolution

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.

31 32

Conclusion

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……

33

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