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Level III The Behavioral Finance Perspective Summary Traditional Finance Behavioral Finance Investor behavior Traditional finance describes how investors should behave Behavioral finance tries to explain how investors actually behave Information Investors have perfect information and process information in an unbiased manner Bounded rationality; investors “satisfice” Cognitive and emotional biases Attitude to risk Investors are risk averse Reject all gambles with non-positive expected return Investors are not consistently risk averse People take gambles with non-positive expected return Utility Expected utility theory Prospect theory Markets Efficient market hypothesis Not entirely efficient; adaptive market hypothesis Portfolios Mean-variance optimized In layers to satisfy investor goals www.ift.world Traditional Finance and Expected Utility Theory Traditional finance assumes that individuals: • are perfectly rational, risk-averse and self-interested • have perfect information and update probability calculations using Bayes’ formula “REM will try to obtain the highest possible economic well-being or utility given budget constraints and the available information about opportunities, and he will base his choices only on the consideration of his own personal utility.” Expected utility theory • Indicates how people “should” make decisions • Objective is to make an optimal decision • Individuals maximize expected utility at given level of risk • Expected utility varies from person to person • Utility increases at a decreasing rate with increases in wealth “I have always followed a budget and have been a disciplined saver for decades Even in hard times when I had to reduce my usual discretionary spending, I always managed to save.” www.ift.world BF Perspectives: Attitude to Risk Individuals are not consistently risk averse; the level of risk individuals are willing to take depends on circumstances and level of wealth The curvature of the utility function can change People take low probability-high risk payoffs (lottery tickets, out-of-the-money options) while at the same time insure against low risks with low payoffs (flight insurance, earthquake insurance) Risk-seeking (convex) utility function for gains and a riskaverse (concave) utility function for losses Friedman-Savage double inflection utility function: a utility function that changes based on levels of wealth www.ift.world Prospect Theory Prospect theory is an alternative to expected utility theory and is based on how decisions are actually made • Assigns values to gains and losses (changes in wealth) rather than to absolute wealth • People often overweight low probability outcomes and underweight moderate/high probability outcomes – risk averse when there is a high probability of gains or a low probability of losses – risk seeking when there is a low probability of gains or a high probability of losses • Value function is based on deviations from a reference point – Concave for gains and convex for losses “When considering investments, I have always liked – Steeper for losses than for gains (loss aversion) using long option positions I like their risk/return Prospect theory explains why people simultaneously buy lottery tickets and insurance while investing money conservatively www.ift.world tradeoffs My personal estimates of the probability of gains seem to be higher than that implied by the market prices I am not sure how to explain that, but to me long options provide tremendous upside potential with little risk, given the low probability of limited losses.” Bounded Rationality People don’t necessarily optimize because the cost might be too high; also there are limitations to knowledge and cognitive capacity The bounded rationality theory recognizes that people are not fully rational when making decisions People satisfice (satisfy + suffice) • Outcomes might not be optimal but are likely to be adequate • Decisions are based on a limited set of important factors and/or heuristics: mental shortcuts; also called “rules of thumb” Examples: – A 60 years old invests 60% of his portfolio in fixed income based on the rule of thumb that the allocation to fixed income should equal ones age – Sticking with my existing asset management company because it meets my basic requirements – Curriculum Example 2: Depositing funds in a checking account at a bank down the street The bank is FDIC insured and offers a competitive rate – “When new information on a company becomes available, I adjust my expectations for that company’s stock based on past experiences with similar information.” • Downside: better alternatives might be missed www.ift.world Traditional and Behavioral Perspective on Market Behavior Traditional Behavioral Finance Markets are efficient Markets are not necessarily efficient; anomalies exist The price is right Example: “While I try to make decisions analytically, I believe the markets can be driven by the emotions of others So I have frequently used buy/sell signals when investing Also, my 20 years of experience with managers who actively trade on such information makes me think they are worth the fees they charge.” There is no free lunch Implications of adaptive market hypothesis (AMH): Risk premiums change over time Active management can add value by exploiting arbitrage opportunities Any particular investment strategy will not be successful on consistent basis Ability to adapt and innovate is critical for survival Survival is the essential objective www.ift.world Traditional and Behavioral Perspective on Portfolio Construction Traditional Portfolio Theory Behavioral Portfolio Theory (BPT) A rational economic individual: “Client exhibits a self-control bias by spending all of her current salary income and half her bonus income on current consumption, pursuing short term satisfaction to the detriment of long-term financial security.” uses self-control to pursue longterm goals rather than short-term satisfaction considers risk/return objectives and constraints uses the mean-variance optimization (MVO) framework considers difference sources of money/wealth to be fungible “A BPT investor maximizes expected wealth subject to a safety constraint As a result, the optimal portfolio of a BPT investor is a combination of bonds or riskless assets and highly speculative assets.” Mental accounting bias: different mental accounts based on source and/or use of money Portfolio is constructed in layers: current income, currently owned assets (partially spent on current consumption), present value of future income (very little spent on current consumption) www.ift.world Traditional versus Behavioral Portfolio Theory Examples “My clients like to match their goals with specific investment allocations or layers of their portfolio.” BPT Mental accounting “I follow a disciplined approach to investing When a stock has appreciated by 15 percent, I sell it Also, I sell a stock when its price has declined by 25 percent from my initial purchase price.” BPT Loss aversion, prospect theory “Overall, I have always been willing to take a small chance of losing up to percent of the portfolio annually I can accept any asset classes to meet my financial goals if this constraint is considered An acceptable portfolio will satisfy the following condition: Expected return – 1.6 × Expected standard deviation ≥ –8%.” Mean-variance optimization www.ift.world ...Traditional Finance Behavioral Finance Investor behavior Traditional finance describes how investors should behave Behavioral finance tries to explain how investors... BF Perspectives: Attitude to Risk Individuals are not consistently risk averse; the level of risk individuals are willing to take depends on circumstances and level of wealth The curvature of the. .. Traditional and Behavioral Perspective on Market Behavior Traditional Behavioral Finance Markets are efficient Markets are not necessarily efficient; anomalies exist The price is right Example: “While