Behavioral Finance
Ashish Mali
Josh Cavers
Ian Herle
Lindsey Polishuk
AGENDA
1.
2.
3.
4.
Standard and
Behavioral
Finance
Biases
Rational Choice
QUIZ
Standard Finance
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Investors are rational
Markets are efficient
Investors should design their portfolios
according to the rules of Mean-Variance
portfolio theory
Expected returns are a function of risk and
risk alone
What is behavioral finance?

Describes the behavior of investors and
managers; it describes outcomes of
interactions between investors and
managers in financial and capital markets

Doesn’t follow four parts of standard finance
Behavioral finance
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Investors are not rational, they are normal
Markets are not efficient
Investors design portfolios according to the
rules of Behavioral Portfolio Theory
Expected returns are determined by more
than risk. “Behavioral Asset Pricing Theory”
Normal?

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Cognitive biases and emotions come into
play
E.g. not realizing loses because it brings pain
and regret
“I’ll kick myself if I sell for $1 those dotcom
shares I bought for $100. maybe I should
wait to see if the stock recovers.”
Market Efficiency

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Stocks are always equal to its intrinsic value
You can not “beat the market”
Much evidence that stock prices regularly
deviate from price
E.g. crash in 1987
Behavioral Portfolio Theory

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People build portfolios like layered pyramids
Each layer represents a specific goal
Your risk aversion depends on the specific
goal
Behavioral Asset Pricing Theory
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Stocks with desirable characteristics have
lower expected returns
Market capitalization and price to book ratio
are added to beta to get expected returns
Social responsibility?
Cognitive Biases

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Identify biases affecting investors
Consultants duty to educate investors
Scientific knowledge is key
Availability Bias

Weigh decisions on recent information
–

Stock market
–

Lottery winners
Winners vs. losers
Retain perspective
–
Long-term focus
Winners vs. Losers
Anchoring Bias
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Attach to a reference point
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Stock market
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Relevance
New & novel concepts
Short-term volatility
Company fundamentals
Use an array of perspectives
Confirmation Bias
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Preconceived opinion
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Hot stock tip
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–
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Emphasize favorable information
Seek information to prove true
Avoid red flags
Look for a sober opinion
Hindsight Bias
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The outcome was predictable
–
–
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Resulting incorrect oversimplifications
The .com bubble
Causes overconfidence
Overconfidence
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Fund managers & individuals
Overconfident manager
–
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Confident manager
–

More trades and lower yields
Less trades and higher yields
Ongoing battle to beat the market
–
Investment techniques require constant
refinement
Mental Accounting
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Investors separate money
–
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Subjective criteria
Creates different functions for asset groups
Paying debt vs. savings
Varying values associated with assets
Money is fungible
Rational Choice & Framing of Decision
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Decision Theory
Perception of Situation
Normative Rules
Invariance
Imagine that you face the following pair of concurrent decisions
1):
A.
B.
a sure gain of $240
25% chance to gain $1000 & 75% chance
to gain nothing
2):
A.
B.
a sure loss of $750
75% chance to lose $1000 and 25%
chance to lose nothing
Framing Outcomes
1) Assume yourself richer by $300 than you
are today. You have to choose between:
A. a sure gain of $100
B. 50% chance to gain $200 and 50% chance
to gain nothing
2) $500 richer than today
A. a sure loss of $100
B. 50% chance to lose nothing and 50% to
lose $200
Rational Choice

Assumptions in economics occur when
certainty in market is present
What Money Type Are You?
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Our decisions about money are often driven
by psychological factors over which we have
little conscious control
Personality tests help to recognize which
errors are commonly made – and to use this
knowledge to prevent them
So, which type are you?
Mostly A’s
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You’re an Artisan
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Good instincts will prevail
You are a “trust your gut” kind of person, who enjoys the
thrill of investing
Very comfortable at taking risks
Tend to lack interest in long-term planning and discipline
Advice from the experts
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–
Use your confidence
But don’t indulge every whim
Mostly B’s
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You’re an Idealist
–
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Money just isn’t the top priority
More concerned with assisting others and improving society
rather than building personal wealth
Your lack of interest in money matters can be a failure to
reach any financial goals - that is, if you have set any
Advice from the experts
–
–
Put your investing on autopilot
Have your cause and money too
Mostly C’s
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You’re a Guardian
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Discipline is key to security
Greater emphasis is on financial security
You are disciplined, patient, organized, and cautious
Prefer fixed-income investments to relatively volatile
equities
Advice from the experts
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–
Deploy your discipline
Conquer your timidity
Mostly D’s
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You’re a Rational
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Cool reason conquers all
You enjoy problem solving, fact finding, and have
an interest in science and technology
You tend to stay calm in tense situations
Advice from the experts
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Feed your taste for systematic thinking
Remember: The market isn’t always rational
QUESTIONS