Strictly Private & Confidential
Applied
Applied Behavioural
Behavioural Finance:
Finance:
Insights
Insights into
into irrational
irrational minds
minds and
and market
market
James Montier: Global Equity Strategy
1
“The brain is my second favourite organ”
Woody Allen
“The market can stay irrational, longer than you can stay solvent”
JMK
“There is nothing so dangerous as the pursuit of a rational investment policy in an irrational world”
JMK
“Economists are people who look at reality, and wonder whether it would work in theory”
Ronald Reagan
2
Taxonomy
Taxonomyofofbiases
biases
Biases
Self Deception
(Limits to learning)
Heuristic Simplification
(Information processing errors)
Social Interaction
Overoptimism
Illusion of control
Illusion of knowledge
Representativeness
Emotion/Affect
Imitation
Overconfidence
Framing
Mood
Contaigon
Self Attribution bias
Catergorization
Self control
(Hyperbolic discounting)
Herding
Confirmation bias
Anchoring/Salience
Ambiguity aversion
Casacades
Hindsight bias
Availability bias
Regret theory
Cue Competition
Cognitive dissonance
Loss aversion/Prospect theory
Global Strategy Unit
2
3
The
Thebias
biasblind
blindspot:
spot:Everyone
Everyoneelse,
else,not
notme
me
8
Cognitive
dissonance
Biased
assimilation
Halo effect
Fundamental
attribution
error
Reactive
devaluation
Self serving
3
Global Strategy Unit
Self interest
4
Self
Average American
7
6
5
4
Dual
Dualprocessing
processingtheories
theoriesofofthought
thought
System One/ X- system
Intuitive
System Two C- System
Reflective
Process Characteristics
Automatic
Controlled
Effortless
Effortful
Associative
Deductive
Rapid, parallel
Slow,serial
Process opaque
Self aware
Skilled action
Rule application
Content on which processes act
Global Strategy Unit
Affective
Neutral
Causal propensities
Statistics
Concrete, specific
Abstract
Prototypes
Sets
4
5
Neuropsychology
Neuropsychologyofofdual
dualprocessing
processing (Liberman)
(Liberman)
X X-system
X C-system
X Amygdala
X Anterior cingulate cortex
X Basal ganglia
X Prefrontal cortex
X Lateral temporal cortex
X Medial temporal lobe
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5
6
Klein’s
Klein’sfactors
factorsfor
forNDM
NDM(X-system)
(X-system)
X System X is more likely when:
X The problem is ill-structured & complex
X Information is incomplete, ambiguous and changing
X Goals are ill defined, shifting and competing
X Stress is high (time constraints and/or high stakes)
X Decisions involve multiple participants
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7
X-system
X-systemcan
candominate
dominate
3.1
Masters
3
2.9
2.8
Class B players
2.7
2.6
2.5
1
2
Blitz (6 sec per move)
Global Strategy Unit
Standard (2.25 mins per move)
7
8
Affect
Affect
The rational model
X Perceptions -> attitudes
X I like this person because I think she is smart and honest
X I like this company because it is low risk and high return
The affect model
X Attitude -> perceptions
X Because like this person, I think she is smart and honest
X Because I like this company, it is low risk and high return
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9
Biased
Biasedassimilation:
assimilation:When
Whenattitudes
attitudesdrive
driveperceptions
perceptions
2
1.5
Studies supporting death penalty
Studies opposing death penalty
1
0.5
0
-0.5
-1
-1.5
-2
-2.5
Participants pro death penalty
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Participants anti death penalty
9
10
Panda
Pandaand
andaffect
affect
24
22
Pictures
20
18
16
14
12
Dots
10
1 Panda
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4 Panda
10
11
The
Thedark
darkside
sideofofemotion
emotion
90
80
70
60
50
40
30
20
10
0
No invest
Target patients
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Invest and lost
Norm al players
Invest and won
Patient controls
11
12
No
Nosign
signofoflearning
learning
90
85
80
75
70
65
60
55
50
45
40
1st 5
Target patients
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2nd 5
3rd 5
Normals
4th 5
Patient controls
12
13
Self
Self deception
deception or
or perception
perception isis reality
reality
14
Self
Selfdeception
deception
Over-optimism
X People tend to exaggerate their own abilities
X Illusion of control
X Illusion of knowledge
Over-confidence
X People are surprised more often than they expect. Not well calibrated.
X Confidence intervals around a forecast which should yield 2% error,
actually get a 30-40% error
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15
Overconfidence
Overconfidence
100
90
80
70
Weather men
60
50
40
30
Doctors
20
10
0
0
10
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20
30
40
50
60
70
80
90
100
15
16
Overconfidence
Overconfidenceand
andinvestment
investment
1
0.9
0.8
0.7
Lay people
0.6
0.5
0.4
P rofessionals
0.3
0.2
0.1
0.55
Global Strategy Unit
0.65
0.75
0.85
0.95
1
16
17
Overconfidence
Overconfidencedriven
drivenby
bythe
theillusion
illusionofofknowledge
knowledge
Laypeople
8.0
Professionals
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
Previous
Other knowledge
month's results
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Intuition
Guessing
17
18
Does
Doesmore
moreinformation
informationimprove
improveyour
youraccuracy?
accuracy?
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19
The
Thewalk
walkdown
downtotobeatable
beatableearnings:
earnings:
average
averagescale
scaleofofforecast
forecasterror
erroratatthe
theearnings
earningslevel
level––US
US(%,
(%,1986-2000)
1986-2000)
20
Forecast Error
15
10
5
0
-23 -22 -21 -20 -19 -18 -17 -16 -15 -14 -13 -12 -11 -10
-5
-9
-8
-7
-6
-5
-4
-3
-2
-1
0
Months
Source: DrKW Macro research and IBES
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20
Trading
Tradingisishazardous
hazardoustotoyour
yourwealth
wealth
30
Turnover
Net return
20
10
0
1
2
3
5
High turnover
Low Turnover
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20
21
Should
Shouldtraders
tradersbe
bewomen?
women?
100
80
All Women
60
All Men
Single
Women
Single
Men
0
40
-2
20
-4
0
-6
All Women
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All Men
Single
Women
Single
Men
-8
21
22
Bubble
Bubbleechoes
echoesininthe
thelaboratory
laboratory
10
Once experienced
9
Mixture of twice experienced and novice players
(Ratio of 4/7)
8
7
Novices
6
5
4
3
Fundamental value
2
1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Source: Ackert and Church
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23
Keynes’s
Keynes’sbeauty
beautycontest
contestand
andinvestment
investmentprofessionals
professionals
10
9
Over 1000 players
Average number picked 26
2/3rds: 17
Average level of thinking 1.6 steps
8
7
6
5
4
3
2
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100
95
90
85
80
75
70
65
60
55
50
45
40
35
30
25
20
15
10
5
0
0
1
23
24
Self
Selfdeception
deception
E
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K
4
7
24
25
Self
Selfattribution
attributionbias
bias
X Good outcomes are a testament to your skill, bad outcomes are sheer bad
luck.
X How often do you say that’s just a blip?
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26
Hindsight
Hindsightbias
bias
X It is a common observation that events in the past appear simple,
comprehensible, and predictable in comparison to events in the future.
Everyone has had the experience of believing that they knew all along the
outcome of a football game, a political election or a business investment. The
hindsight bias is the tendency for people with outcome knowledge to believe
falsely that they would have predicted the reported outcome of an event. After
learning of the occurrence of an event, people tend to exaggerate the extent to
which they had foreseen the likelihood of its occurrence.
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27
Psychological
Psychological Foundations
Foundations
II. Heuristic Simplification
Or
There is no such thing as context free decision making
28
Heuristic
HeuristicSimplification
Simplification
X Conservatism Bias
X Hard to give up a view once it has formed. Leads to:
X Anchoring and slow adjustment
X Depends upon saliency of the anchor
X i.e. analysts will change their views from their forecasts slowly
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29
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Jan-03
Jan-02
Jan-01
-4
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
Jan-89
8
Jan-88
Jan-87
Jan-86
Analysts
Analystslag
lagreality
reality
12
10
Earnings
6
4
2
0
-2
Forecasts
-6
-8
29
30
The
TheFed
Fedmodel
model
1.70
1.70
1.60
1.60
1.50
1.50
1.40
1.40
1.30
1.30
1.20
1.20
1.10
1.10
1.00
1.00
0.90
0.90
0.80
0.80
0.70
0.70
0.60
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
0.60
Source: Thomson Financial Datastream
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31
Equities
Equitiesvs.
vs.bonds
bondsininthe
theUS:
US:the
theFed
Fedmodel
modelsince
sincethe
the1950s
1950s
3.0
2.5
2.0
1.5
1.0
0.5
Apr-04
Apr-01
Apr-98
Apr-95
Apr-92
Apr-89
Apr-86
Apr-83
Apr-80
Apr-77
Apr-74
Apr-71
Apr-68
Apr-65
Apr-62
Apr-59
Apr-56
Apr-53
0.0
Source: DrKW Macro research
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32
Simple
Simplemaths
mathsleads
leadstotoanchoring
anchoring
X 8*7*6*5*4*3*2*1 = median answer 2250
X 1*2*3*4*5*6*7*8 = median answer 512
X Actual answer = 40,320
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Estate
Estateagents
agentsand
andanchoring
anchoring
160,000
150,000
140,000
130,000
120,000
110,000
100,000
90,000
80,000
1
2
Given
Listing Price
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Appraisal value
Lowest acceptable offer
33
34
Anchoring
Anchoringand
andvaluation
valuation
4
60
Low SS No.
High SS No.
50
Ratio
3.5
3
40
2.5
30
2
1.5
20
1
10
0.5
0
0
Cordless
mouse
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Cordless
keyboard
Average
Wine
Rare Wine
Design
book
Belgian
Chocolates
34
35
Cheap?
Cheap?Surely
Surelysome
somemistake
mistake--US
US
Various valuation measures (x)
Trailing reported PE
Operating PE
Forward operating PE
PB
PC
Graham and Dodd PE
Hussman PE
Trend PE
Current level
1997-2004
Longrun*
21.1
17.5
15.6
3.0
13.0
27.5
19.3
22.0
29.0
22.5
19.7
4.0
14.9
37.0
23.5
29.0
14.0
14.9
12.5
2.4
9.2
16.4
11.0
13.9
Source: DrKW Macro research
* the term long run refers to the longest run of data we have which varies from starting in the 1870s to starting in the mid 1980s. All long
run measures end at the end of 1996, effectively stripping out the bubble years.
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36
Psychological
Psychologicalfoundations
foundations
X Linda is 31, single, outspoken and
very bright. She majored in
philosophy. As a student she was
deeply concerned with issues
surrounding equality and
discrimination.
X Is it more likely that Linda is
X Works in a bank
X Works in a bank and is active in
the feminist movement
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37
Psychological
PsychologicalFoundations
Foundations
Representativeness Heuristic
X Aka law of small numbers – belief that random samples of a population
will resemble each other and the population more closely than statistical
sampling theory would predict.
X Which is more likely HTHTTH or HHHTTT?
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38
Earnings
Earningsgrowth
growthas
asrepresentativeness
representativeness
40.0
35.0
Trailing 5 year
Forward 5 year
Actual 1
Actual 3
Actual 5
30.0
25.0
20.0
15.0
10.0
5.0
0.0
Q1
Q2
Q3
Q4
Q5
Source:
Montier,
and Chan
Source:
Montier,
& Chan
et al et al
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39
Great
Greatstories
stories≠≠Great
Greatinvestments
investments
18
16
14
12
10
8
6
4
2
0
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Glamour (1)
Glamour (2)
Value (9)
Value (10)
39
40
Under-reaction
Under-reactionand
andOver-reaction
Over-reaction
X Information is judged in two dimensions – strength and weight
X Letter of reference – judged by strength i.e. number of appealing traits
X Weight is neglected. i.e. who wrote it
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41
Over-reaction
Over-reactionand
andUnder-reaction
Under-reaction::Information
Informationanalysis
analysis
Weight
Low
Low
Underreaction
Strength
High
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High
Overreaction
41
42
Analysis
Analysisofofover-reaction
over-reactionand
andunder-reaction
under-reaction
Under-reaction
Over-reaction
X Dividend omissions, initiations
X IPOs, SEOs
X Earnings surprises
X High earnings growth
X Analyst recommendations
X Cap ex.
X Z-scores
X Buybacks on growth stocks
X Buybacks on value stocks
X Quarterly earnings announcements
X Goodwill write-offs
X Valuations
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43
Bias
BiasofofJudgement
Judgement
X Availability Bias
X Which is a more likely cause of death in the US – being killed by a
lightening strike or as a result of a shark attack?
X Shark attacks receive more publicity, they are easier to imagine (thanks to
Jaws). However, the chance of dying from a lightening strike are 30x
greater than chances of being killed by a shark.
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Narrow
NarrowFraming
Framing
X Context sensitivity. Aka frame
dependence or mental accounting.
X We can’t see through how things are
actually framed.
X Separate funds for separate
purposes – holiday money, house
keeping
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45
When
Whenisisaabuyback
buybacknot
notaabuy
buyback?
back?
announced,
announced,actual
actualand
andnet
netshare
sharebuy-backs
buy-backsininthe
theUS
US
350,000
300,000
Announced
250,000
200,000
150,000
Completed
100,000
50,000
Net
0
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
-50,000
Source: DrKW Macro research
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46
Repurchases
Repurchases&&their
theirimpact:
impact:
dividend,
dividend,repurchase
repurchase&&total
totalyield
yieldfor
forthe
theS&P500
S&P500(%)
(%)
6.00
5.00
4.00
3.00
Total yield
2.00
Dividend yield
1.00
Net repurchase yield
0.00
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
-1.00
Source: DrKW Macro research
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47
Prospect
ProspectTheory
Theory
4
2
X People value changes not states.
Rational man tries to maximise the
utility of wealth.
X Real people worry far more about
gains and losses than levels.
0
-20
-15
-10
-5
-2
0
5
10
15
20
-4
-6
-8
-10
-12
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48
Stock
Stockbroker
brokerSample
Sample
25
20
15
10
5
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00
10
00
10
00
50
0
32
0
20
1
15
0
11
0
10
1
10
0
50
0
48
49
Prospect
Prospecttheory
theory
• Leads to
• Endowment effect
• Status quo bias
• Disposition effect
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50
Endowment
Endowmenteffect/Status
effect/Statusquo
quobias
bias
8
Sellers
Choosers
Buyers
7
6
5
4
3
2
1
0
1
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3
50
51
US
USmutual
mutualfund
fundmanagers
managersand
andthe
thedisposition
dispositioneffect
effect(1980-2002)
(1980-2002)
25
Proportion of losses realized
Proportion of gains realized
20
15
10
5
0
Low return
2
3
4
High
All
return
Source: Frazzini (2004)
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52
Top
Toptips
tipsfor
forbetter
betterdecision
decisionmaking
making
X This applies to me, you and everyone else
X You know less than you think you do
X Be less certain in your views, aim for timid forecast and bold choices
X Don’t get hung up on one technique tool, approach or view – flexibility and
pragmatism are the order of the day
X Listen to those who don’t agree with you
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53
Top
Toptips
tipsfor
forbetter
betterdecisions
decisions
X You didn’t know it all along, you just think you did
X Forget relative valuation, forget market prices, work out what the stock is worth
(Use reverse DCFs)
X Don’t take information at face value, think carefully about how it was presented
to you
X Don’t confuse good firms with good investments, or good earnings growth with
good returns
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54
Top
Toptips
tipsfor
forbetter
betterdecisions
decisions
X Vivid, easy to recall events are less likely than you think they are, subtle
causes are underestimated
X Try to focus on facts, not stories
X Sell your losers and ride your winners
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Beating
Beatingthe
thebiases
biases
X Being aware of the biases is not enough. It is just an important first step.
X Need to create a framework that incorporates mental best practice. Easier said
than done. Mental bad habits are persistent.
X The good news, we continue to create new brain cells throughout our lives.
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56
Strictly Private & Confidential
Applied
Applied Behavioural
Behavioural Finance:
Finance:
Are
Are two
two heads
heads better
better than
than one?
one?
The
The psychology
psychology ofof group
group decisions
decisions
James Montier: Global Equity Strategy
57
“Madness is a rare thing in individuals – but in groups...it is the rule”
Friedrich Nietzsche
“To associate with other like-minded people in small, purposeful groups is for the great majority of
men and women a source of profound psychological satisfaction..”
Aldous Huxley
“Deliver us from committees”
Robert Frost
“Committees are groups of people who keep minutes but waste hours”
Berle Milton
“A committee is an animal with four back legs”
John le Carre
“A committee is a group of the unwilling, chosen from the unfit, to do the unnecessary “
Unknown
58
Types
Typesofofgroups
groups
¾Statistical groups = large number of people asked for an answer, take the mean.
¾Deliberative groups = discussion is necessary
¾Evidence suggests that statistical groups outperform deliberative groups and
individuals
¾E.g. when judging the number of beans in a jar, the group average is almost always
better than the vast majority of the individual members. In one such experiment, a
group of 56 students was asked about a jar containing 850 beans; the group estimate
was 871, a better guess than all but one of the students
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59
Statistical
Statisticalgroups
groups
¾ Only work when:
¾ People are unaffected by others’ decisions (errors are uncorrelated)
¾ Probability of being correct must be independent of the probability of
everyone else being correct
¾ The participants must be unaffected by their own vote possibly being
decisive
¾ When participants have some idea of the answer.
¾ Anchors are avoided
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Deliberative
Deliberativegroups
groups
¾ Such groups seem to amplify:
¾ Representativeness
¾ Framing
¾ Overconfidence (simple repetition of views leads to people having greater
confidence)
¾ Anchoring
¾ Availability
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The
Theestablishment
establishmentofofnorms
norms(Sherif
(Sherif1936)
1936)
8
7
1
2
3
6
5
4
3
2
1
0
Alone
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Session 2
Session 3
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62
Conformity
Conformity(Asch
(Asch1955)
1955)
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¾ On 12 of the 18 rounds, confederates unanimously agreed on a wrong answer
¾ ¾ of participants agreed with the confederates in at least one round. Half
agreed in 6 or more rounds. Only 25% resisted in all rounds!
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Does
Doesgroup
groupsize
sizematter?
matter? (%
(%conforming
conformingtotowrong
wronganswers)
answers)
35
30
25
20
15
10
5
0
1
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3
4
15
64
65
Herding
Herdingwhen
whenuncertain
uncertain––Baron
Baronetetalal
4
3.5
Low uncertainity
High uncertainty
3
2.5
2
1.5
1
0.5
0
Unimportant
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Important
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66
Sharing
Sharinginformation
information(Stasser
(Stasseretetalal1989)
1989)
80
70
60
Shared
Unshared
50
40
30
20
10
0
Unstructured
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Structured
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67
Why
Whyare
arewe
weso
sobad
badatatsharing
sharinginformation?
information?
¾ Shared information is more likely to be discussed and repeated and this will
influence the individuals in the group, and hence influence the group’s eventual
outcome.
¾ Social pressure
¾ Cascades
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Social
Socialpressure
pressure::Those
Thosewho
whoconform
conformare
arerewarded
rewarded(Wittenbaum
(Wittenbaumetetalal1999)
1999)
7
6.8
Self
Others
6.6
6.4
6.2
6
5.8
5.6
5.4
5.2
5
Shared
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Unshared
68
69
Cascades
Cascades
Cascade creation: Actual pot used B
Player
1
2
3
4
5
6
Private
signal
a
a
b
b
b
b
Decision
A
A
A
A
A
A
Source: Anderson and Holt (2004)
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Group
Grouppolarisation
polarisation
• Group polarization is the tendency for members of a group to end up in a more
extreme position in line with their original beliefs after talking to one another.
The increased confidence in view mentioned earlier, begins to create feedback
into the extremity of view, generally creating a loop of increased confidence in
more and more extreme views
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Groupthink
Groupthink
¾ A tendency to examine too few alternatives
¾ A lack of critical assessment on each other’s ideas
¾ A lack of contingency plans
¾ Poor decisions are often rationalized
¾ Illusion of group invulnerability and shared morality
¾ True feelings and beliefs are suppressed
¾ Illusion of unanimity is maintained
¾ Mind guards are appointed to protect the group from negative information
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Solutions
Solutions
¾ Secret ballots
¾ Devil’s advocates
¾ Authentic dissent
¾ Respect for other group members
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Beware
Bewareofofauthority
authority––Milgram
Milgramexperiments
experiments
Global Strategy Unit
73
74
Bandura’s
Bandura’sdriving
drivingforces
forces––turning
turninggood
goodpeople
peoplebad
bad
• Moral justification
• Euphemistic labelling
• Advantageous comparison
• Displacement of responsibility
• Diffusion of responsibility
• Disregard or distortion of consequences
• Dehumanisation
Global Strategy Unit
74
75
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© Dresdner Kleinwort Wasserstein Securities Limited 2004
DRESDNER KLEINWORT WASSERSTEIN RESEARCH – RECOMMENDATION DEFINITION
(Except as otherwise noted, expected performance over next 12 months)
Buy
10% or greater increase in share price
Reduce
5-10% decrease in share price
Add
5-10% increase in share price
Sell
10% or more decrease in share price
Hold
+5%/-5% variation in share price
Distribution of DrKW equity recommendations as of 1 Apr 2004
All covered companies
Buy/Add
337
53%
Companies where a DrKW company has provided
investment banking services (in the last 12 months)
55
57%
Hold
188
30%
31
32%
Sell/Reduce
108
17%
11
11%
Total
633
97
Source: DrKW
Global Strategy Unit
75
76