How do investors behave?

Classical View
Behavioral Finance „ Risk Averse
„ Incorporate all information into decision making
„ Optimizers, utility maximizers
„ “Rational” Investors
October. This is one of the particularly dangerous months to „ Markets are Efficient
speculate in stocks in. The others are July, January, September,
April November, May, March, June, December, August and Is the theory correct?
February. Are you a rational investor?
Mark Twain Pudd’nhead Wilson

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Problems... Behavioral Finance

Anomalies Investors are humans

„ investors choose actively managed mutual
funds
„ closed end funds sell at discount to net asset
value (NAV)
„ ‘arbitrage opportunities are left on the table’
Market deviates from perfect rational
behavior.
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Incorporate psychology into economic
decision making.
Systematic psychological biases will not
disappear in aggregate.
Hypothesis
„ Are anomalies found in financial markets because
people are not rational investors?

Overconfidence Example

„ 90% of automobile drivers in Sweden consider
themselves above average.
„ Nearly all people consider themselves above average
in their ability to get along with others.
„ When analysts say they are 70% sure a stock’s price
will rise, they are correct 51% of the time.
„ Active portfolio managers think they can pick
winners.
Consider 100 men, 70 are lawyers, 30 are
engineers. One is drawn randomly from this
sample.
Tim is a 30 year old man of high ability and
motivation. He is well liked by his
colleagues.
What is the probability that he is a lawyer?

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Representativeness Heuristic
How do people make probability based decisions?
Rational investors consider population
probabilities.
In general, people evaluate the probability of an
uncertain event by the degree to which the event is
representative or similar (in their mind) to the
population regardless of past probabilities.
(stereotyping)
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Example
Case 1: Which do you prefer?
(A) I give you $10,000 tomorrow for sure.
(B) With a 10% chance, I give you $100,000
tomorrow, otherwise nothing.
Case 2: Which do you prefer?
(A) You give me $10,000 tomorrow.
(B) With a 10% chance, you give me $100,000
tomorrow, otherwise nothing.
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Loss Aversion and Framing
Loss aversion suggests that decision making is
sensitive to how alternatives are framed.
People evaluate case 1 as a choice between gains,
and case 2 as a choice between losses.
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Results consistent with
Representativeness Heuristic
Stereotypes
„ e.g. tech stocks are winners
„ what about the individual firm characteristics?
„ Real estate is always a good investment
Loss Aversion and Framing
Experimental evidence shows that people
„ prefer riskfree gain (risk averse behavior)
„ prefer risky loss (risk seeking behavior)
Loss Aversion: People weigh losses more than
gains in their decision making.
People suffer more pain losing $10,000 than gain
pleasure in winning $10,000.
Example of Framing and Mental
Accounting
Investor 1 holds
„ 1000 shares of A, 1000 shares of B.
Investor 2 holds
„ 1000 shares in a mutual fund, each share of the mutual
fund corresponds to 1 share of A and 1 share of B.
They purchased their portfolios at the same time.
A was $5, B was $13. (Mutual fund was $18)
Currently both A and B are trading at $10.
(Mutual fund share = $20).
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Example of Framing and Mental
Accounting Other Behavioral Biases

If both investors were forced to liquidate Fads, Herding

their holdings, which one is likely to be „ the desire to conform and not deviate causes
more upset? people to herd.
What role do loss aversion and mental „ Analysts forecasts: the collective failure to

accounting play here? forecast correctly is not as costly as an

individual failure to forecast correctly.

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Regret, Prudence The Good News

remorse about a decision that led to a bad Behavioral explanations suggest
outcome.
“anomalies” are real, not mispricing.
tactic to reduce regret is to shift or share
responsibility. This suggests that they should last, not
alternatively, follow the “norm”: prudent investing disappear.
Institutions are reluctant to invest in small firms Why aren’t they arbitraged away?
and closed end funds.
small firm effect may be explained by lower
liquidity and hence higher returns due to lack of
institutional investors.
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The Bad News Framing Example

All humans suffer from psychological biases.
Evidence shows that both experts and novices
behave in the same way.
Even fund managers and analysts are not immune
from the biases.
You have been given a gift of $2,000.
„ In addition, choose between
„ (A) a sure gain of $500,
„ (B) a 25% chance of a gain of $2000, 75% $0.

Difficult to stomach investing counter to

feelings!!!
Difficult to correctly separate your abilities from
chance!

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Example 2 Solution
You have been given a gift of $4,000. A
„ In addition, choose between $2,500
„ (A) a sure loss of $1500
or expected value of 2000 + 0.25*2000 = $2,500.
„ (B) a75% chance of a loss of $2000, 25% $0.
B
$2,500
Or expected value of $4000 – 0.75*2000 =
$2,500.

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Endowment effects Switching strategies

People are reluctant to sell if they do not get
what they consider to be the ‘true value’ of
the asset.
If invested a lot of emotional energy in an
asset its value is considered to be higher
than it is actually worth.
Perceived value is not necessarily congruent
with actual value.
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When price falls to a certain level sell out
Buy back when raises to a certain level.
One of the best ways around to go
completely bankrupt. Fast….
Assumption is that you know that if price
rises it will keep on
And similarly with falling
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tulips In conclusion
The hot potato effect. People are greedy and over optimistic!
The profit of selling in a fast rising market
is not a true profit based on fundamentals
It is a hot potato ie you flick it onto
someone else before the prices start to fall.

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Gamblers Ruin
If the process is repeated indefinitely, the probability
Let two players each have a finite number that one of the two player will eventually lose all
of pennies pennies must be 100%. In fact, the chances and that
Now, flip one of the pennies (from either players one and two, respectively, will be rendered
player), with each player having 50% penniless are
probability of winning, and transfer a penny „ i.e., your chances of
going bankrupt are equal
from the loser to the winner. to the ratio of pennies
Now repeat the process until one player has your opponent starts out
with to the total number
all the pennies. of pennies.
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Ergo…
the player starting out with the smallest number of
pennies has the greatest chance of going bankrupt.
Even with equal odds, the longer you gamble, the
greater the chance that the player starting out with
the most pennies wins.
„ Since casinos have more pennies than their
individual patrons, this principle allows casinos to
always come out ahead in the long run.
„ And the common practice of playing games with
odds skewed in favour of the house makes this
outcome just that much quicker.
St Petersburg
Consider a game, first proposed by Daniel
Bernoulli , in which a player bets on how
many tosses of a coin will be needed before
it first turns up heads.
The player pays a fixed amount initially,
and then receives 2n dollars if the coin
comes up heads on the nth toss.

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so any finite amount of money can be
wagered and the player will still come out
ahead on average.
Variant doubling
Alternatively assume the player bets $2 that heads
will turn up on the first throw, $4 that heads will turn
up on the second throw (if it did not turn up on the
first), $8 that heads will turn up on the third throw,
etc. Then the expected payoff is

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 Resolution
It is misleading to consider the payoff without taking
into account the amount lost on previous bets, as can
be shown as follows.
At the time the player first wins (say, on the nth toss),
he/she will have lost
This means that the net gain for the player is
$2, no matter how many tosses it takes to
finally win.
As expected, the large payoff after a long run
of tails is exactly balanced by the large amount
that the player has to invest.

In this toss, however, he/she wins 2n dollars.

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Conclusion
When you put gamblers ruin together with
St Petersburg Paradox we see the issue for
financial markets.
Barings, Hunts, Tech stocks, NAB traders,
last few years etc
Whilst in theory if one plays long enough
one will eventually win the issue is
Does one have the capital to play as long as
is needed……
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