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 South-Western / Thomson Learning © 2004 11 - Outline Established Behaviors … continued Mental Accounting Asset Segregation Hindsight Bias Overconfidence Framing Availability Heuristic Illusion of Truth Biased Expectations Reference Dependence South-Western / Thomson Learning © 2004 11 - Outline Mistaken Statistics The Special Nature of Round Numbers Extrapolation Percentages vs Numbers Sample Size Apparent Order Regression to the Mean South-Western / Thomson Learning © 2004 11 - 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 South-Western / Thomson Learning © 2004 11 - 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 South-Western / Thomson Learning © 2004 11 - Introduction Behavioral finance research focuses on how investors make decisions to buy and sell securities, and how they choose between alternatives South-Western / Thomson Learning © 2004 11 - 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 South-Western / Thomson Learning © 2004 11 - Representativeness Heuristic Insert Table 11-1 here South-Western / Thomson Learning © 2004 11 - Representativeness Heuristic Insert Figure 11-1 here South-Western / Thomson Learning © 2004 11 - 10 Established Behaviors Availability Heuristic The availability heuristic is the contention that things that are easier to remember are thought to be more common South-Western / Thomson Learning © 2004 11 - 27 Established Behaviors Illusion of Truth People tend to believe things that are easier to understand more readily than things that are more complicated Most investors prefer a low PE ratio, since they prefer to buy low-priced stocks with high earnings South-Western / Thomson Learning © 2004 11 - 28 Established Behaviors Biased Expectations Our prior experience causes us to anticipate certain relationships or characteristics that may not apply outside our frame of reference South-Western / Thomson Learning © 2004 11 - 29 Established Behaviors Reference Dependence Suppose you demand $75,000 in salary for the next year Your boss offers you $60,000 and if things go to arbitration, $50,000 People currently earning $60,000 tend to accept the offer, while people currently earning $75,000 tend to take the gamble and go to arbitration South-Western / Thomson Learning © 2004 11 - 30 Mistaken Statistics There are some other tendencies that may have a behavioral influence on asset values These involve “innumeracy” or a misunderstanding of the likeliness of an event or series of events South-Western / Thomson Learning © 2004 11 - 31 Mistaken Statistics The Special Nature of Round Numbers Given a giant lottery wheel with numbers from one to one thousand, many of us would find a random outcome like 287 to be more reasonable than the “unusual” outcome of 1,000 Similarly, investors tend to make disproportionate use of round numbers when placing stop or limit orders South-Western / Thomson Learning © 2004 11 - 32 Mistaken Statistics Extrapolation We have a tendency to assume that the past will repeat itself and to give too much weight to recent experience A belief that recent occurrences influence the next outcome in a sequence of independent events is known as the gambler’s fallacy South-Western / Thomson Learning © 2004 11 - 33 Mistaken Statistics Percentages vs Numbers Suppose the incidence of a particular disease rose from 10 in a million to 13 in a million We would likely find that to many people, more cases is not a cause for concern, although a 30% increase is South-Western / Thomson Learning © 2004 11 - 34 Mistaken Statistics Sample Size There are many instances where people draw incorrect inferences from statistical data The probability of a given person winning the lottery twice is very remote However, the probability of someone winning twice is actually reasonably good South-Western / Thomson Learning © 2004 11 - 35 Sample Size Insert Table 11-4 here South-Western / Thomson Learning © 2004 11 - 36 Mistaken Statistics Apparent Order A single occurrence of an unlikely event becomes much more likely as the sample size increases However, many people will find a run of six consecutive numbers in a daily state lottery extremely unlikely South-Western / Thomson Learning © 2004 11 - 37 Mistaken Statistics Regression to the Mean The regression to the mean concept states that given a series of random, independent data observations, an unusual occurrence tends to be followed by a more ordinary event Hence, chasing last year’s winning mutual fund is likely to be a losing strategy, although many investors precisely this South-Western / Thomson Learning © 2004 11 - 38 Review Introduction Established Behaviors Representativeness Heuristic Loss Aversion Fear of Regret Myopic Loss Aversion Herding Anchoring Illusion of Control Prospect Theory South-Western / Thomson Learning © 2004 11 - 39 Review Established Behaviors … continued Mental Accounting Asset Segregation Hindsight Bias Overconfidence Framing Availability Heuristic Illusion of Truth Biased Expectations Reference Dependence South-Western / Thomson Learning © 2004 11 - 40 Review Mistaken Statistics The Special Nature of Round Numbers Extrapolation Percentages vs Numbers Sample Size Apparent Order Regression to the Mean South-Western / Thomson Learning © 2004 11 - 41 ... study of data in order to infer relationships Behavioral finance integrates psychology into the investment process South-Western / Thomson Learning © 2004 11 - Introduction “Financial economists... aspects of the firm In particular, many investors believe a wellrun company represents a good investment South-Western / Thomson Learning © 2004 11 - Representativeness Heuristic Insert Table... 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 South-Western / Thomson