FIN3102/FIN3702

Investment Analysis & Portfolio Management

Lecture 5: Behavioral Finance

Dr. YUE Ling

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Learning Outcomes
1. Behavioral critique
2. Irrationalities of investors
• 2.1 Information processing errors
• 2.2 Behavioral biases
3. Limits to arbitrage
4. Behavioral biases in DC pension plans

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 Behavioral critique

Example

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Market emotions cycle

Source: Howard Marks “Mastering the Market Cycle”
https://www.stlouistrust.com/wp‐content/uploads/2018/12/Late‐Cycle‐Investing_image‐2.png 4
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Nobel Prizes (Economic Sciences, 2013)

• “There is no way to predict the price of stocks and bonds over the next few days
or weeks. But it is quite possible to foresee the broad course of these prices over
longer periods, such as the next three to five years. ”
• Two approaches to interpret these findings:
• Rational investors: Investors respond rationally to uncertainty in prices. High future
returns are viewed as compensation for holding risky assets during unusually risky
times. (EMH)
• Behavioral finance: Investors depart from rational behavior, as there are behavioral
biases, institutional restrictions (e.g., borrowing limits), etc. (this lecture)

Source: 
https://www.nobelprize.
org/prizes/economic‐
sciences/2013/press‐
release/ 6
 Behavioral critique

Behavioral Critique
• 1st leg: Irrationalities of investors – two broad categories:
• Information processing errors: investors do not always process information
correctly
• Behavioral biases: investors often make inconsistent or systematically
suboptimal decisions

• 2nd leg: Limits to arbitrage:

• The existence of irrational investors would not by itself be sufficient to render
capital markets inefficient.
• In practice the actions of arbitrageurs are limited and therefore insufficient to
force prices to match intrinsic value.
• If behaviorists are correct about limits to arbitrage activity, then the absence of
profit opportunities does not necessarily imply that markets are efficient.

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Learning Outcomes
1. Behavioral critique
2. Irrationalities of investors
• 2.1 Information processing errors
• 2.2 Behavioral biases
3. Limits to arbitrage
4. Behavioral biases in DC pension plans

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 Irrationalities of investors

2.1 Information processing errors

• Errors in information processing can lead investors to misestimate the true
probabilities of possible events or associated rates of return.

• Examples:
• Overconfidence
• Limited attention
• Conservatism
• Representativeness bias
• Anchoring

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 Irrationalities of investors

Information processing errors (cont’d)

• Overconfidence
• People tend to overestimate the precision of their beliefs or forecasts, and they
tend to overestimate their abilities.
• E.g., men (in particular, single men) trade far more actively than women (Barber
and Odean, 2001) and trading activity is highly predictive of poor investment
performance (Barber and Odean, 2000).

• Limited attention
• Rely on rules of thumb or intuitive decision-making procedures
• Overreaction to salient or attention-grabbing news
• E.g., high P/E firms tend to be poor investments; IPO stocks underperform
similar-size firms.
• Underreaction to less salient information
• E.g., high current accruals (which artificially inflate reported earnings) will
be a predictor of poor future returns.
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 Irrationalities of investors

Information processing errors (cont’d)

• Conservatism
• Investors are too slow (too conservative) in updating their beliefs in response to
new evidence. Prices will fully reflect new information only gradually.
• E.g., momentum in stock market returns.

• Representativeness bias
• Individual are adept at discerning patterns and are overly prone to believe that
these patterns are likely to characterize an entire population. They therefore
infer a pattern too quickly based on a small sample and extrapolate apparent
trends too far into the future.
• E.g., momentum and reversal anomalies;
• E.g., stocks with the best recent performance suffer reversals surrounding
management earnings forecasts or actual earning announcements.

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 Irrationalities of investors

Information processing errors (cont’d)

• Anchoring
• An arbitrarily chosen reference point (anchor) will significantly influence value
estimates, and value estimates will be insufficiently adjusted away from the
reference point toward the true value of the object of estimation (Slovic &
Lichtenstein, 1971).
• E.g., Northcraft and Neale (1987) studied the anchoring effect in the real estate
market. They randomly divided participants into different groups. The same
property was shown to each group separately and every participant submitted
his/her appraisal price afterwards. Everything else equal, different groups
received different listing prices for the same property. The results are as below:

Listing price Appraisal price Appraisal price

(amateurs) (experts)
$119,900
$149,900

Source: Northcraft, G. B., & Neale, M. A. (1987). Experts, amateurs, and real estate: An anchoring‐and‐adjustment perspective on 
property pricing decisions. Organizational behavior and human decision processes, 39(1), 84‐97. 13
 Irrationalities of investors

2.2 Behavioral biases

• Even if information processing were perfect, individuals would tend to make less-
than-fully-rational decisions (risk-return trade-offs) using that information.

• Examples:
• Framing
• Mental accounting
• Regret avoidance
• Affect and feelings
• Prospect theory
• Disposition effect

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 Irrationalities of investors

Behavioral biases (cont’d)

• Framing wording has a psychological effect on people

• Decisions seem to be affected by how choices are framed. Individuals may act
risk averse in terms of gains but risk seeking in terms of losses.

• Mental accounting
• A specific form of framing.
• People segregate certain decisions, e.g., an investor may take a lot of risk with
one investment account but establish a very conservative position with another
account that is dedicated to her child’s education.

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 Irrationalities of investors

Behavioral biases (cont’d)

• Regret avoidance
• Individuals who make decisions that turn out badly have more regret (blame
themselves more) when that decision was more unconventional.
• E.g., buying a blue-chip portfolio that turns down is not as painful as
experiencing the same losses on an unknown start-up firm.
• E.g., regret avoidance is consistent with both the size and book-to-market effects
(De Bondt and Thaler, 1987).

• Affect and feelings

• Affect is a feeling of “good” or “bad” that consumers may attach to a potential
purchase or investors to a stock.
• E.g., stocks ranked high in Fortune’s survey of most admired companies (i.e.,
with high affect) tend to have lower average risk-adjusted returns than the least
admired firms (Statman, Fisher, and Anginer, 2008).

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 Irrationalities of investors

Behavioral biases (cont’d)

• Prospect theory
(Kahneman and Tversky, 1979)

Loss aversion: Much bigger drop in utility (or  Symmetric in utility (or value or satisfaction) 

value or satisfaction) while losing compared to  while gaining compared to losing the same 
the gain of the same amount. amount of $$.
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 Irrationalities of investors

Behavioral biases (cont’d)

• Disposition effect
• Individual investors tend to hold losers too long and sell winners too soon
(Odean, 1998).
• The disposition effect is one implication of extending Kahneman and Tversky’s
(1979) prospect theory to investments.

Source: Odean, T. (1998). Are investors reluctant to realize their losses?. The Journal of finance, 53(5), 1775‐1798. 19
 FIN3102/3702

Learning Outcomes
1. Behavioral critique
2. Irrationalities of investors
• 2.1 Information processing errors
• 2.2 Behavioral biases
3. Limits to arbitrage
4. Behavioral biases in DC pension plans

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 Limits to arbitrage

Limits to arbitrage
• In EMH world, arbitrageurs eliminate mispricing gaps rapidly and efficiently.
• For example, if the Ford stock price is $15, while the fundamental value is $20,
rational traders will see this as an opportunity and will buy the security as a
bargain.
• So a buying pressure will be introduced by the underpricing of Ford stock. The
buying pressure will bring the stock price back to the true value.

• In practice, several factors limit the ability to profit from mispricing…

• Fundamental risk
• Implementation costs
• Model risk

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 Limits to arbitrage

Limits to arbitrage (cont’d)

• In practice, several factors limit the ability to profit from mispricing…
• Fundamental risk
• John M. Keynes: “The market can stay irrational longer than you can stay
solvent.”
• Arbitrage has its own risks. The market can deviate from the true value further
away before it converges back.
• E.g., a mutual fund manager may lose clients (or even his/her job!) if short-term
performance is poor.
• Implementation costs
• Commissions, bid-ask spread
• Exploiting overpricing can be particularly difficult. The cost to initiate and
maintain short positions can fluctuate dramatically.
• Many pension or mutual fund managers face strict limits to short securities.
• Model risk
• Perhaps you are using a faulty model to value the security, and the price is
actually right.
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Alternative explanations for “anomalies”

• Market anomalies may mean that there are unobserved risks in efficient markets.
Alternatively, they can be explained by behavioral finance.

• (1) Irrationalities of investors:

• The underreaction-overreaction puzzle (momentum and reversal) can be
explained by behavioral biases, such as conservatism (the price drift is due to
investors’ slow reaction to the news) or representativeness bias (the price drift is
due to the excessive extrapolation of recent performance and the reversal is
correction in the long run).
• The value puzzle can be explained by representativeness bias (the
underperformance of glamour stocks is caused by the inappropriate rosy picture
about its future growth potential) or regret aversion (glamour stocks are more
well-known and invested by more people).

• (2) Limits to arbitrage:

• In general, anomalies are stronger or only present when there are significant
costs to implement arbitrage (e.g., short sale constraints).

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Possible investment strategy from behavioral finance

Sample Strategy: Fusion Investing
• The integration of two elements of investment valuation: fundamental value and
investor sentiment
• During some periods, investor sentiment is rather muted and noise traders are
inactive, so that fundamental valuation dominates market returns.
• In other periods, when investor sentiment is strong, noise traders are very active and
market returns are more heavily impacted by investor sentiments.

• An example: http://www.bloomberg.com/news/videos/2015-01-06/psys-sons-tech-
company-gangnam-style-bounce

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 FIN3102/3702

Learning Outcomes
1. Behavioral critique
2. Irrationalities of investors
• 2.1 Information processing errors
• 2.2 Behavioral biases
3. Limits to arbitrage
4. Behavioral biases in DC pension plans

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 Behavioral biases in DC pension plans

Behavioral biases in DC pension plans

• A defined contribution (DC) plan is a type of retirement plan in which the employer,
employee or both make contributions on a regular basis.
• Individual accounts are set up for participants and benefits are based on the amounts
credited to these accounts plus any investment earnings on the money in the account.
In DC plans, future benefits fluctuate on the basis of investment earnings.
• E.g., 401(k) in the U.S., CPF in Singapore.

• Some behavioral biases in DC pension plans:

• Representativeness
• Familiarity
• Endorsement effect
• Naïve diversification
• Inertia / Power of defaults

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 Behavioral biases in DC pension plans

Representativeness
• Over-extrapolate past events into the future. Employees tend to allocate more 401(k)
money in their employer company stock when the stock past performance is better.
• However, worker’s higher allocation to his employer company stock results in lower
future return (Benartzi, 2001).

Benartzi, S., 2001. Excessive extrapolation and the allocation of 401 (k) accounts to company stock. The Journal of Finance, 56(5), pp.1747‐1764. 28
 Behavioral biases in DC pension plans

Familiarity
• Misinterpret casual knowledge of an investment as a reduction in the risk of that
investment. In other words, the perceived risk of an investment is lower when the
perceived familiarity of an investment is higher.
• E.g., workers invest more than optimal allocation in their own company stock.
• Investing in company stock of own employer is very risky and the outcomes can
be either win-win or lose-lose.

• Background risk: when making financial choices, need to consider your TOTAL
portfolio of assets and liabilities, considering all accounts, tax effects, financial and
non-financial assets, human capital, etc..
• E.g., a public sector worker with a fixed salary should invest more in risky
assets than an individual who owns their own business.
• E.g., insurers of homes in Singapore should probably not invest in Singapore
real estate. exacerbate risk

• Information advantage vs. Background risk

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 Behavioral biases in DC pension plans

Endorsement effect
• When firms can provide choice of pension plan structure (e.g., type of investment
options available, whether firm contributes company stock or cash in the U.S. 401(k)
plan), participants may interpret the firm’s choice as providing suggestions to worker
as to how to invest.

• Suppose a U.S. firm provides matching contributions to the workers DC pension

plans. Would a worker of the firm invest more or less of his contributions in his
firm’s stock, if the employer matches in company stock as opposed to matching in
cash (which then can be invested how the worker wishes)?
• Portfolio diversification: less
• Endorsement effect: more

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 Behavioral biases in DC pension plans

Naïve diversification
• “1/n” investing
• Participants are influenced simply by the composition of investment choices, even if some
of the choices are duplicative.

• Two hypothetical sets of options:

• Option 1: 4 bond funds and 2 stock funds
• Option 2: 2 bond funds and 4 stock funds
• Suppose all bond funds are duplicative and all stock funds are duplicative. What
would be the average percent of assets in equity?
• Rational: same % regardless of Option 1 or 2 is given
• Naïve diversification: 33% if given Option 1, 67% if given Option 2.

• A study of 401(k) plans in the U.S. shows a strong positive relationship between the share
of investment options provided to employees in a particular asset class (i.e., company
stock, equities, fixed income, and balanced funds) and the share of their portfolios
invested in that asset class.
• Brown, J.R., Liang, N. and Weisbenner, S., 2007. Individual account investment options and portfolio choice:
Behavioral lessons from 401 (k) plans. Journal of public Economics, 91(10), pp.1992-2013.
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 Behavioral biases in DC pension plans

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Source: Brown, J.R., Liang, N. and Weisbenner, S., 2007. Individual account investment options and portfolio choice: Behavioral lessons from 401 (k) plans.
Journal of public Economics, 91(10), pp.1992-2013.
 Behavioral biases in DC pension plans

Inertia / Power of defaults

• People are reluctant to change and generally do not undo default.
• It’s important to make a sound portfolio decision at the start.

• Participation by enrollment status of pension plans:

• The default is out unless sign up;
• The default is in unless sign out.
• Switching from default-out/opt-in to default-in/opt-out increases participation in
the 401(k) plan by almost 50% (Madrian and Shea, 2001) and the highest
increase is for the lower-income people (Utkus and Young, 2014).

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 Behavioral biases in DC pension plans

Automatic enrollment increases participation in the 401(k) plan

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Source: Scott Weisbenner (2016).
 Behavioral biases in DC pension plans

CPF Investment Scheme (CPFIS)

• The CPF Investment Scheme (CPFIS) provides members with the option to invest
their CPF savings in various instruments such as insurance products, unit trusts, fixed
deposits, bonds and shares. Please refer to the following information if you are
interested to have your product/investment services included under the CPFIS.

• Lists of instruments allowed by CPFIS:

https://www.cpf.gov.sg/members/bptopics/bp-topics/cpfis

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Summary
1. Behavioral critique
2. Irrationalities of investors
• 2.1 Information processing errors
• 2.2 Behavioral biases
3. Limits to arbitrage
4. Behavioral biases in DC pension plans

• Readings: BKM Chapter 12.

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