CHAPTER ELEVEN
BEHAVIORAL FINANCE
Practical Investment Management
Robert A. Strong
Outline
 Introduction
 Established Behaviors
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Representativeness Heuristic
Loss Aversion
Fear of Regret
Myopic Loss Aversion
Herding
Anchoring
Illusion of Control
Prospect Theory
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Outline
 Established Behaviors … continued
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Mental Accounting
Asset Segregation
Hindsight Bias
Overconfidence
Framing
Availability Heuristic
Illusion of Truth
Biased Expectations
Reference Dependence
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Outline
 Mistaken Statistics
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The Special Nature of Round Numbers
Extrapolation
Percentages vs. Numbers
Sample Size
Apparent Order
Regression to the Mean
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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.
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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
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Introduction
Behavioral finance research focuses on
 how investors make decisions to buy and
sell securities, and
 how they choose between alternatives.
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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.
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Representativeness Heuristic
Insert Table 11-1 here.
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Representativeness Heuristic
Insert Figure 11-1 here.
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Established Behaviors
Loss Aversion
 Investors do not like losses and often
engage in mental gymnastics to reduce
their psychological impact.
 Their tendency to sell a winning stock
rather than a losing stock is called the
disposition effect in some of the behavioral
finance literature.
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Established Behaviors
Fear of Regret
 Investors do not like to make mistakes.
 Rather than being unable to decide among
attractive alternatives, their focus is on the
negative: What if they pick the wrong
stock?
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Established Behaviors
Myopic Loss Aversion
 Investors have a tendency to 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.
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Established Behaviors
Herding
 Herding refers to the lemming-like behavior
of investors and analysts looking around,
seeing what each other is doing, and
heading in that direction.
 There may not have been safety in
numbers, but there probably was some
comfort in them.
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Established Behaviors
Anchoring
 Our decisions can be influenced by
extraneous information contained in the
problem statement.
 For example, investors tend to remember
the price they paid for a stock, and this
information influences their subsequent
decisions about what to do with it.
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Established Behaviors
Illusion of Control
 We like to pretend that we can
influence the resulting score by
varying the force with which we
throw a dice.
 Similarly, investors like to look at charts,
although charts are theoretically not
helpful in predicting the future prospects
for a stock.
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Established Behaviors
Prospect Theory
 Risk averse investors get increasing utility
from higher levels of wealth, but at a
decreasing rate.
 Research shows that while risk aversion
may accurately describe investor behavior
with gains, investors often show risk
seeking behavior when they face a loss.
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Prospect Theory
Insert Figure 11-2 here.
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Prospect Theory
Insert Figure 11-3 here.
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Prospect Theory
Insert Table 11-2 here.
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Established Behaviors
Mental Accounting
 Mental accounting refers to our tendency
to “put things in boxes” and track them
individually.
 For example, investors tend to differentiate
between dividend and capital dollars, and
between realized and unrealized gains.
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Established Behaviors
Asset Segregation
 Asset segregation refers to our tendency to
look at investment decisions individually
rather than as part of a group.
 The portfolio may be up handsomely for
the reporting period, but the investor will
still be concerned about the individual
holdings that did not perform well.
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Asset Segregation
Insert Table 11-3 here.
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Established Behaviors
Hindsight Bias
 Hindsight bias refers to our tendency to
remember positive outcomes and repress
negative outcomes.
 Investors remember when their pet trading
strategy turned up roses, but do not dwell
on the numerous times the strategy failed.
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Established Behaviors
Overconfidence
 Overconfidence refers to our tendency to
believe that certain things are more likely
than they really are.
 For example, most investors think they are
above-average stock pickers.
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Established Behaviors
Framing
 The concept of framing involves attempts
to overlay a situation with an implied sense
of gain or loss.
 It is easier to pay $3,400 for something that
you expected to cost $3,300 than it is to
pay $100 for something you expected to be
free.
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Established Behaviors
Availability Heuristic
 The availability heuristic is the contention
that things that are easier to remember are
thought to be more common.
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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.
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Established Behaviors
Biased Expectations
 Our prior experience causes us to
anticipate certain relationships or
characteristics that may not apply outside
our frame of reference.
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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.
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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.
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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.
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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.
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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, 3
more cases is not a cause for concern,
although a 30% increase is.
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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.
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Sample Size
Insert Table 11-4 here.
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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.
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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 do precisely this.
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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
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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