Practice investment management pim3 ch11

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