behavioural finance and financial planning Flashcards
The field of behavioural finance looks at how
a variety of mental biases and decision-making errors affect financial decisions. It relates to the psychology that underlies and drives financial decision-making behaviour.
Although traditional economic theory assumes that individuals and investors always act rationally, which usually means with the aim of maximising some interpretation of expected utility, experimental and actual evidence suggests that this may not always be entirely the case.
Much of the work to date has concentrated on the impact on prices in capital markets (indeed, some “contrarian” investment funds are run on the basis of taking advantage of errors made by other investors).
contrarian fund is one that
Atends to take the opposite view to the rest of the market – ie it will tend to buy shares when most people in the market are recommending sell and vice versa. For example, it might sell shares when the market is “high” or rising on the basis that the market tends to overreact to positive news and so is likely to be overvalued.
In investment consultancy, behavioural arguments
can be applied to trustees and used to justify proposed investment management structures.
In practice, the management of an investment portfolio in accordance with an investment objective will require both:
an investment strategy
a choice of investment management structure.
Once these have been determined, the implementation of the chosen investment strategy will then require the selection of the individual investments and investment managers.
If it is recognised that the trustees responsible for the direction of investment policy are subject to the types of mental bias identified by behavioural finance,
then the recommended investment management structure may be chosen to reflect those biases.
if capital markets are indeed influenced by behavioural factors, then
those investors who recognise this may be able to exploit this knowledge to the disadvantage of investors who don’t.
Common themes found in research on behavioural finance include:
anchoring and adjustment prospect theory framing (and question wording) myopic loss aversion estimating probabilities overconfidence mental accounting the effect of options.
Anchoring and adjustment
Anchoring is a term used to explain how people will produce estimates. They start with an initial idea of the answer (“the anchor”). They then adjust away from this initial anchor to arrive at their final judgement.
Thus, people base perceptions on past experience or “expert” opinion, which they amend to allow for evident differences to the current conditions. The effects of anchoring are pervasive and robust and are extremely difficult to ignore, even when people are aware of the effect and aware that the anchor is ridiculous. The effect of anchoring and adjustment grows with the size of the difference between the anchor value – the original estimate provided – and the pre-anchor estimate – the mean estimate people make before being exposed to an explicit anchor. In other words, the bigger this difference, the greater the influence of the anchor value on the post-anchor estimate. The effects of anchoring are pervasive and robust and are extremely difficult to ignore, even when people are aware of the effect and aware that the anchor is ridiculous. Even patently ridiculous anchor values have been shown to influence post- anchor estimates.
Prospect theory is a theory of
how people make decisions when faced with risk and uncertainty. It replaces the conventional risk-averse / risk-seeking decreasing marginal utility theory based on total wealth with a concept of value defined in terms of gains and losses relative to a reference point. This generates utility curves with a point of inflexion at the chosen reference point.
Prospect theory attempts to explain why people may make asymmetric choices when faced with similar possible gains and losses.
evidence suggests that rather than being risk-averse, people may actually become risk-seeking when facing losses. prospect theory assumes that:
value is based on gains and losses relative to some reference point
people are typically risk-averse when considering gains relative to the reference
point and risk-seeking when considering losses relative to the reference point.
Prospect theory suggests that
the decision made depends on how a problem is presented or “framed”, ie whether the available choices are presented as gains or losses relative to the chosen reference point. If the alternative choices are presented as possible gains, then the value function is concave, reflecting the risk-averse nature of individuals. Conversely if they are presented as possible losses, then the value function is convex reflecting the risk-seeking nature of individuals. So, the value function will be as shown on the diagram above.
The way a choice is presented (“framed”)
particularly, the wording of a question in terms of gains and losses, can have an enormous impact on the answer given or the decision made. Changes in the way a question is framed of only a word or two can have a profound effect. In the same way, “structured response” questions are found to convey an implicit range of acceptable answers.
Myopic loss aversion is:
This is similar to prospect theory, but considers repeated choices rather than a single “gamble”. It may therefore be relevant when considering investment choices, which can often be thought of as a series of repeated gambles. For example, if an investor reviews and possibly changes its investment strategy on an annual basis, then the investment strategy decision can be thought of as a series of repeated one-year gambles.
Research suggests that investors are less “risk-averse” when faced with a multi- period series of “gambles”, and that the frequency of choice / length of reporting period will also be influential.
As its name suggests, myopic loss aversion relates to investors’ aversion to short-term losses. The basic idea is that investors have been shown to be less “risk-averse” when faced with a repeated series of “gambles” than when faced with a single gamble. Thus, if the investor recognises that the investment strategy decision is in fact a series of repeated short-term gambles and consequently takes a long-term view when determining strategy, then they are likely to be less risk-averse than if they instead consider only the immediate short-term gamble and so take too short-term a view. In this latter case, they will tend to focus more on the short-term risk of loss than is necessarily in their best interests, the consequence being that their resulting portfolio ends up being overweight in less risky assets.
In addition, the extent of investors’ short-sightedness may be influenced by the frequency with which they review their investment choices and/or the length of the reporting period. For example, a pension fund that has to report its financial position every year may be more averse to very short-term investment losses than one that has to report only every three years.
What might be the consequence on its investment strategy of requiring a pension fund to report its financial position annually rather than triennially?
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investors’ estimates OF PROBABILITIES may be influenced by a number of biases.
Dislike of “negative” events – the “valence” of an outcome (the degree to which it is considered as negative or positive) has an enormous influence on the probability estimates of its likely occurrence.
In particular, experiments suggest that individuals are prone to underestimate the probability that a negative event may occur.
Representative heuristics – people find more probable that which they find easier to imagine. As the amount of detail increases, its apparent likelihood may increase (although the true probability can only decrease steadily).
As the amount of detail increases, the more specific (less generalised) the event becomes and the less probable the occurrence of such a specific event must become.
Availability – people are influenced by the ease with which something can be brought to mind. This can lead to biased judgements when examples of one event are inherently more difficult to imagine than examples of another.
An example here concerns the incidences of deaths due to car crashes and cancer. When asked to estimate the relative numbers of deaths due to each, people tend to overestimate the numbers of deaths due to car crashes perhaps because they receive more publicity and are easier to imagine.
Overconfidence
People tend to overestimate their own abilities, knowledge and skills. For example, if you ask 100 people if they are better than average drivers, then you might not be surprised if more than 50% of them reply “yes”!
Moreover, studies show that the discrepancy between accuracy and overconfidence increases (in all but the simplest tasks) as the respondent is more knowledgeable! (Accuracy increases to a modest degree but confidence increases to a much larger degree. ) If this is true then it may not be wise to pass the Subject F105 exam!
Overconfidence could therefore be a potentially serious problem in fields such as investment where most of the participants are likely to be highly knowledgeable. Moreover, the available evidence suggests that
even when people are aware that they are overconfident they remain so, due to:
Hindsight bias – events that happen will be thought of as having been predictable prior to the event; events that do not happen will be thought of as having been unlikely prior to the event.
A possible example of the first type of event was the dot. com crash that followed the dot. com bubble of 1999/2000. A possible example of the second type of event is when an underdog is heavily beaten in a sporting event. Although supporters may have had high hopes of an upset prior to the event, after the event a heavy defeat will always have seemed inevitable.
Confirmation bias – people will tend to look for evidence that confirms their point of view (and will tend to dismiss evidence that does not justify it).
For example, failing an exam might reinforce an existing preconception that the exam system is a lottery – even if the real reason for failure was a lack of preparation. In contrast, passing an exam might reinforce a view of the exam system as a lottery, even if it was in fact due reward for months of long, hard study!
