Topic 9: Behavioural Finance &n Individual Investors Flashcards
Define Behavioural Finance
–Behavioural finance is the formal study of the role of emotions rather than rationality (e.g. fear, greed, ability to manipulate & mislead, ramping stock prices etc.)
–Traditional finance has only modelled rationality in aggregate, does not demand it at individual level in reality
Behavioural Finance:
What are the implications for asset pricing?
Asset pricing implications
–Saw CAPM, assumptions of rationality
–People are not rational
–Does this impact asset prices in aggregate? Who knows
Behavioural Finance:
What are the implications for PWM?
•PWM implications
–We know clients are not rational
–Don’t care about the aggregate but individuals
–Need to protect clients from themselves, how make decisions
–Use behavioural insights to get clients to do what in their best interests (and your?), make sure not subject to biases
Evolutionary biases
- brain programmed to leap to conclusions to save time
–Bias to optimism as likely want to have more
–Brain learns patterns for speed of recognition (i.e. that is a lion over there)
–Mental short cuts (e.g. stick to with what know unless compelling evidence to change as takes valuable time)
Dangers of shortcuts
- Retail investors “follow the herd”, sell funds at exact wrong time as all else are (Frazzini & Lamont)
–Trade too often and so underperform due to overconfidence (Odean). Perhaps also “availability”of reports of winners…
–Worst is selling after a crash
Availability Bias; (problem / solution)
–Estimates of future probabilities not rational, overweighted by recently available evidence –Examples: •currently overstate equities risk, usually understate it •More news on successful active managers increases probability estimates of achieving alpha –Solution: make sure you and your clients aware of all evidence, long histories etc.
Overconfidence bias (problem / solution)
–All think above average
–The harder the task and the longer we go without definitive feedback, the more confident we get (Griffin & Tversky)
–Attribute success in 1 field to ability in all
Solution:
•Be humble in the face of uncertainty, the market and the record of active management
•Be aware of taxes and costs to reduce likelihood will trade
•Be aware of abilities of PWM managers/brokers in context of wider finance industry skill set
•Calm clients down, stop them trading
•If in doubt, do nothing!
Anchoring Bias (problem / solution)
–We use available information for decisions, even if not relevant (see in exams) –E.G: number of countries in UN
Solution:
•Be aware of all information floating around in decision sphere
•Be careful how frame questions (e.g. in selling annuities, it is insurance, not a bet on dying)
•Ask lots of questions of clients and listen actively to be sure no anchoring going on: –Only sell above $X because that what paid –Why do they want a 20% return?
Confirmation bias/conservatism (problem / solution)
–We focus information which supports our existing beliefs, ignore other
–Waleed Aly’s on “conservatives”: a conservative likes the status quo, and will defend a new status quo after a period of time even if he initially rejected it Solution:
•Read opposite views, even if annoying
•Be sure clients are listening to all you say, not just the bits they like
•If need an investment to go up (e.g. leverage), be especially careful –hope is not an investment strategy
•Aim for “dialogue”with opposing views
Hindsight bias (problem / solution)
–After an event (e.g. GFC) the drivers were always “obvious”
–Gives us a false sense of control and ability to predict future
Solution:
•Keep good records of decisions and why made
•Keep very good records of bad decisions
•Maintain polite contempt for forecasters
Mental accounting bias (problem / solution)
–We break down decisions into digestible chunks
–We do not consider all our assets as a portfolio:
•Save up for a holiday while have a mortgage •Credit card debt & undrawn mortgage facility •Punting money vs. super fund
Solution:
•Frame things in terms of mental accounts while ensuring makes sense at the macro level
•Core & satellite approach to indulge their punter passions in a safe way
•Clearly set out analysis, but then put in terms they can understand, into buckets: Welch article
Fairness bias (problem / solution)
–“The Golden Rule” seems inbuilt
–Albeit what is “fair” can be in the eye of the beholder
Solution:
•Appeals to fairness on fees
–Amount of work do, risk take, what other clients pay (i.e. the market)
–Levels of service, access to products, quality of staff etc.
•Never infringe as wont be forgiven (“market” pricing when market dislocation (e.g. flood))
Disposition bias (problem / solution)
–Hold losers, sell winners
–Pain of regret
•Recognition loser won’t recover
•Would hate to see profit go so sell
Solution:
•Use tax arguments to sell losers
•Only sell if good reason, not because gone up
•Disciplined rebalancing program is a nice compromise
Home bias (problem / solution)
–All around the world, people over exposed to domestic assets, forfeiting diversification benefits
–Can be liability hedging, tax and “sleep at night” arguments, but these do not fully explain
Solution:
•Explain diversification, with illustration of lack of diversification (e.g. Argentina, Zimbabwe, who is next?)
•Accept there will be a bias and try to minimise as best can. Arguably less of an issue now major markets more integrated
