The Psychology of Investing
Gayle Buff CFP, CFA
Capital Management
Buff
1
Overview
•
This presentation presents a framework for enhancing our knowledge of how
investors process information and make decisions in the face of uncertainty. Current
studies from behavioral finance research are crisply and concisely reviewed with
the intent of deepening our understanding of how each of our own psychologies
informs decision-making.
•
We, as private wealth practitioners, therefore, have a unique opportunity to add
considerable value to our client relationships when we understand what clients
think and feel. Often beliefs and emotions, referenced in the behavioral literature
by the term “psychological biases”, obstruct reason and result in a less than optimal
solution, which, all too often, is not consistent with a policy of preserving and
maximizing client wealth.
•
And finally, we will explore ways that may help us and help our clients to discipline
our hearts, quell our fears and greed, engage our heads, and call upon our
dispassionate faculties.
Gayle Buff CFP, CFA
Capital Management
Buff
2
Introduction
• Behavioral finance looks at how people
actually behave when faced with making a
choice under risk.
• Two primary components of behavior:
– Beliefs
– Emotions
Gayle Buff CFP, CFA
Capital Management
Buff
3
Sources of Cognitive Error
Prospect Theory and Loss Aversion: Investors
value gains/losses using S shaped Function.
Two important insights:
1. Twice the gain or loss is not twice as good or
twice as bad—each a little more good and a
little more bad.
2. Function is steeper for losses than gains:
losses hurt more than gains give pleasure.
Gayle Buff CFP, CFA
Capital Management
Buff
4
Sources of Cognitive Error
Bounded Rationality: rational model verses real
life
• Herbert Simon challenged models of rational
decision making with the notion of “bounded
rationality.”
• People make decisions under the constraints of
limited knowledge, resources and time.
• Traditional economic theory assumes people
have perfect information and unlimited time.
Gayle Buff CFP, CFA
Capital Management
Buff
5
Sources of Cognitive Error
Heuristic Simplification: Do we commit errors
because we rely on rules of thumb, based on what
worked in the last situation, and extrapolate the rules
to a new, but similar situation, instead of a more
detailed analysis?
• Trade-offs: We can act quickly, based on past
experience, and we don’t need to re-examine all the
inputs in the decision.
• But devising simple rules can result in less
thoroughness, missing new information that may not
fit the rules, and choosing unwisely.
Gayle Buff CFP, CFA
Capital Management
Buff
6
Sources of Cognitive Error
• Representativeness Heuristic
• Tom is 31 years old, well-dressed, outspoken, and
very bright. He majored in political science. As a
student he was editor of the campus newspaper for
social action and deeply involved with local activist
community groups.
• Tom is most likely:
1. Landscaper
2. Teacher and is running for political office
Gayle Buff CFP, CFA
Capital Management
Buff
7
Role of Emotions
Emotional States: often overcome reason when
making decisions involving risk.
• Psychologists and economists have found that
unrelated feelings and emotions can affect
decisions.
• Mood affects decision making: happy or sad
affect predictions about the future.
Gayle Buff CFP, CFA
Capital Management
Buff
8
Role of Emotions
• Emotions drive complex decisions: financial
decisions are complex and include risk and
uncertainty.
• Optimistic mood trap: investors believe that
nothing bad is likely to happen to their stock.
Gayle Buff CFP, CFA
Capital Management
Buff
9
Role of Emotions
• Emotions bias judgment
• Less critical analysis in making stock
decisions
• Ignore or downplay negative information
• Extreme optimism underlie price bubbles
• Pessimistic investors tend to be more
analytical
Gayle Buff CFP, CFA
Capital Management
Buff
10
Over- Confidence and Risk- Taking
Are you a good driver? Compared with the drivers
you encounter on the road, are you aboveaverage, average or below- average?
82% of sampled college students rated themselves
above average drivers.
Studies show overconfident investors take more risk.
Gayle Buff CFP, CFA
Capital Management
Buff
11
Over- Confidence and Risk- Taking
Behaviorists Barber and Odean found a negative
correlation between risk and return in
overconfident investors.
Factors contributing to over-confidence:
• control –ownership conferred more control
than less familiar, not owned stock
• knowledge – belief that information increases
knowledge and improves performance
Gayle Buff CFP, CFA
Capital Management
Buff
12
Over- Confidence and Risk- Taking
Key attributes that foster illusion of control:
1. Choice –confers ownership interest
2. Outcome sequence – early positive returns reinforce
investor skill
3. Task familiarity – the devil that you know appears
less threatening
4. Information – knowledge imparts certainty
5. Active involvement – high participation enhance
control
6. Past Successes – confirmation you are a genius
Gayle Buff CFP, CFA
Capital Management
Buff
13
Over- Confidence and Risk- Taking
• Over-confident behavior undermines clients
goals to preserve and grow their wealth
• Trades too much—costly and lowers
investment return
• Assumes too much risk –invests in high beta,
smaller company stock
• Too little diversification – holds too few stocks
Gayle Buff CFP, CFA
Capital Management
Buff
14
The Disposition Effect
– Hersh Shefrin ,Meir Statman: investors are
predisposed to selling winners too early and riding
losers too long.
– Researchers conclude that on average, we are 50%
more likely to sell a winner than a loser.
– Selling for a gain validates our good decision for
the original purchase and confers a sense of pride
when the profit is locked in.
– Conversely, selling at a loss means recognizing
your decision to purchase was bad.
Gayle Buff CFP, CFA
Capital Management
Buff
15
Pain of Regret
• Prospect Theory and Loss Aversion
Revisited:
• Recall that Prospect Theory tells us how bad we feel
when faced with a loss –so bad, in fact, that we feel
compelled to do anything to avoid the pain of regret.
The realization that one has a losing position drives
us to gamble and even take on greater risk, to avoid
feeling pain…whatever it takes so as not to feel bad.
Pain of regret is associated with feeling personally
responsible for the loss.
Gayle Buff CFP, CFA
Capital Management
Buff
16
Reference Point
The reference point determines whether a
position is a winner or loser.
Stock example:
• Tom bought Stock in ABC Company for $50 a share two years ago. The
stock sells for $75 today and at the end of last year it was valued at $100 a
share.
• If Tom sells the stock today does he have a gain or loss?
• Tom believes he has a loss because his reference point moved from $50 a
share, his purchase price, to $100 a share, the year- end value.
• Behavioral researchers say that we like to use the 52 week high price as our
reference point in calculating potential gain or loss.
Gayle Buff CFP, CFA
Capital Management
Buff
17
Pain of Regret and Reference Point
Boston Housing Market: Reported in Boston Globe July 26, 2006
• For month of June, 2006, home sales in
Massachusetts dropped 16.6% but house prices fell
just 1 %.
• “…Massachusetts real estate agents are increasingly
discouraged by unwillingness among clients with
properties on the market to lower their listing prices
to spark more sales...”
Gayle Buff CFP, CFA
Capital Management
Buff
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Pain of Regret and Reference Point
• “Many sellers, particularly empty-nesters with no urgency to
sell, are holding out for a high price to help them realize the
80% price appreciation that occurred in the market between
2000 – 2005.”
“ In order for sales to begin to edge up, sellers are going to have
to face reality and adjust their pricing accordingly…they have
to take the longer view of what the house is worth instead of
looking back two years.”
David Wluka, President of the Massachusetts Realtors Association as quoted in the Boston Globe
Gayle Buff CFP, CFA
Capital Management
Buff
19
Mental Budgeting
Two Rules or simple heuristics people rely upon when
managing household finances:
Rule One: Use budget to track and control spending—
create a separate budget for each account
Rule Two: Pay as you go—match the cost of an item to
the benefit received to determine the pay period
•
•
•
Ignores diversification and asset allocation benefits that
could accrue if accounts were more integrated.
Researchers found that people postpone payment for new
purchases like a washer and dryer but would prepay
vacations.
Why?
Gayle Buff CFP, CFA
Capital Management
Buff
20
Mental Budgeting
• To prepay or finance depends on the amount of
pleasure expected by the purchase and the
aversion to debt when the good or service is
consumed quickly.
• Financing a vacation is undesirable because
the long term cost (financing even for six
months) on a short term benefit (say a week)
mismatches cost to benefit.
Gayle Buff CFP, CFA
Capital Management
Buff
21
Mental Budgeting
Sometimes decision rules predisposes someone to
choose more costly option. When given the choice
between two financing options (longer than and same
term of purchase), people pick the one that more
closely resembles the term of the purchase and ignore
the cost of the loan, even when they may have
received a better rate on the longer term financing
option, and paid off the loan sooner, thereby
effectively matching term to purchase.
Gayle Buff CFP, CFA
Capital Management
Buff
22
Sunk Cost Effect
Traditional economic theory says people consider
present and future costs and benefits. Past costs
should not be a factor.
But…people routinely consider past, nonrecoverable costs when making decisions about
the future.
Once an investment in money, time, or effort has
been made, people find it very difficult to walk
away.
Gayle Buff CFP, CFA
Capital Management
Buff
23
Sunk Cost and Mental Accounts
Factors that Play Role in Sunk Cost:
1- Size of sunk cost—larger, less likely to
walk.
2 - Pain of closing mental account—closing an
account without offsetting benefit decreases
over time.
Gayle Buff CFP, CFA
Capital Management
Buff
24
Sunk Cost and Mental Accounts
Example:
• You purchased tickets a year ago for $60 to
attend concert. On the day of event, there is a
major snowstorm creating some hardship
getting there. You decide not to attend.
• Same scenario, but you purchased tickets three
weeks earlier. You decide to attend the concert.
Gayle Buff CFP, CFA
Capital Management
Buff
25
Wealth Effects
• Lose benefit of portfolio optimization when accounts viewed
separately.
• Incur monetary costs to facilitate mental budgeting process.
• When payments are accelerated (prepay) lose the benefit of
time value of money.
• Not using wealth maximizing strategies like tax swap strategy
because it may compound aversion to selling losers.
Gayle Buff CFP, CFA
Capital Management
Buff
26
Overcome Behaviors That Run
Counter to Wealth Maximizing
Policies
“Three years of losses often turn investors with 30year horizons into investors with 3-year
horizons; they want out.”
Kenneth Fisher and Mier Statman
Summary
Understand the role of emotions in your own and your
clients' decisions.
Use Investment Policy Statement as long-run guide.
On-going client education.
Gayle Buff CFP, CFA
Capital Management
Buff
27
Goal Approach Goal Avoidance
Positive
Elation
Relief
Progress
_______________________________________________
Negative
Disappointment
Anxiety
Progress
Peterson, Richard L., Inside the Investor’s Brain: The Power of Mind Over Money
Gayle Buff CFP, CFA
Capital Management
Buff
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Financial Decision  Anxiety
(uncertainty)
Personality Styles
1. Worried
2. Depressed
Risk Avoidance
_________________________________________________________
3. Impatient, wants to
move on quickly
4. Outbursts, impulsive
Risk Seeking
Gayle Buff CFP, CFA
Capital Management
Buff
29
For Further Information
I.
Role of Complexity Theory and Adaptive Systems
•
Strogatz, Steven, SYNC: The Emerging Science
of Spontaneous Order, New York, Hyperion,
2003
Taleb, Nassim Nicholas, Fooled by Randomness,
New York, TEXERE LLC, 2001
Taleb, Nassim Nicholas, The Black Swan: The
Impact of the Highly Improbable, New York,
Random House, 2007
•
•
Gayle Buff CFP, CFA
Capital Management
Buff
30
For Further Information
II. Behavioral Finance and Investor Psychology
• Gigerenzer, Gerd Adaptive Thinking:
Rationality in the Real World, Oxford
University Press, New York 2000
• Kahneman, Daniel and Amos Tversky,
Choices, Values and Frames, Russell Sage
Foundation, Cambridge University Press, 2000
Gayle Buff CFP, CFA
Capital Management
Buff
31
For Further Information
• Peterson, Richard L., Inside the Investor’s
Brain: The Power of Mind Over Money, John Wiley &
Sons Inc., NJ 2007
• Plous, Scott, The Psychology of Judgment
and Decision Making, McGraw-Hill Series in
Social Psychology, McGraw-Hill, Inc. 1993
• Shefrin, Hersh, Beyond Greed and Fear,
Boston, Harvard Business School Press, 2000
Gayle Buff CFP, CFA
Capital Management
Buff
32
For Further Information
III. Intersection of Theory and Practice
• Bookstaber, Richard, Markets, Hedge Funds,
and the Perils of Financial Innovation: A
Demon of Our Own Design, John Wiley & Sons, NJ
2007
• Hughes Jr., James E., Family Wealth:
Keeping It in the Family - How Family
Members and Their Advisors Preserve Human,
Intellectual, and Financial Assets for Generations,
Bloomberg Press, New York 2004
Gayle Buff CFP, CFA
Capital Management
Buff
33
For Further Information
• Maubussin, Michael J., More Than You
Know: Finding Financial Wisdom in
Unconventional Places, Columbia Univ.
Press, NY 2006
• Swensen, David F., Unconventional Success:
A Fundamental Approach to Personal
Investment, New York, Free Press, 2005
Gayle Buff CFP, CFA
Capital Management
Buff
34
Closing Thoughts
Though I have titled this talk “The Psychology
of Investing” it occurs to me the “Art of
Investing” might be as descriptive and perhaps
more useful.
Gayle Buff CFP, CFA
Capital Management
Buff
35
Closing Thoughts
To be successful as an investor, we must appreciate,
understand, and accept the unpredictability and
seeming randomness of both our own psychologies
and the challenging marketplace. At the same time,
we must strive to discipline our hearts, quell our fears
and greed, engage our heads, and call upon our
dispassionate faculties – all with an eye to coming as
close as we possibly can to “predicting” the behavior
of a dynamically evolving system whose recurring
patterns and repetitions will begin to surface once we
can see them more clearly, the view no longer
obstructed by our drive to beat the market.
Gayle Buff CFP, CFA
Capital Management
Buff
36
Closing Thoughts
In our world is there really one set of rules or
guidance to offer that would be failsafe?
Our world -- a dynamic, multilayered,
interdependent universe, where hour to hour
we respond to subtle, and not so subtle, shifts
in our own physical states, how tired or how
hungry, that inform and are informed by our
emotions, as we continuously interact with
markets and our clients.
Gayle Buff CFP, CFA
Capital Management
Buff
37
Closing Thoughts
The processes by which we make decisions rely on
our own internal interplay and on what others around
us do. And, we must be mindful of our biases, and
how our personalities affect the decisions we make.
Often, uncertainty leads us to grab at rules to steady
us. People have rules to limit choice and deal with
uncertainty. We always take the same route to work,
stop at the same gas station, and order the same item
off the menu at the same restaurant.
Gayle Buff CFP, CFA
Capital Management
Buff
38
Closing Thoughts
Let me close with two more thoughts on common errors
investors make with regard to holding onto to losses too long
and selling gains too soon. In the first situation, you must
learn to forgive yourself again and again. You have made a
past mistake, like a sunk cost, it is done, over.
In the second instance, sellers let go too soon. Sellers must
tolerate the anxiety that comes from the uncertainty of their
winning situation continuing – take the money and go home, a
bad rule, often prevails. We might want to reframe the
winner’s stance to “hang in there”.
Gayle Buff CFP, CFA
Capital Management
Buff
39
Closing Thoughts
And so I have searched for a way to leave all of you
with some guidance that may not always prove
failsafe but I hope will be helpful nonetheless:
Know and appreciate your own psychology and don’t
hold on for too long even though you are hoping that
things will change (the losing position) but do hold
on even though you are afraid that they will change
(the winning position).
Gayle Buff CFP, CFA
Capital Management
Buff
40
Presented by:
Gayle H. Buff, MBA, CFP, CFA
Buff Capital Management
111 Hyde Street
Newton Highlands
Massachusetts 02461
gayle@buffcapital.com
Tel: (617) 641-2377
Gayle Buff CFP, CFA
Capital Management
Buff
41