Behavioural Finance
Week 6
Monday: Investor Behavior + Guest
Wednesday: Behavior in Games
Chapter 9: Common Investment Mistakes
There are mutual funds who outperform the market, but this trend will happen roughly at
random and past performance will have little predictive power.
Index funds perform at the level of the overall market to which they are indexed, minus a
small (very low fees) operating fee.
Actively managed funds have higher expenses (frequent buying/selling leads to higher
brokerage cost) and therefore the returns are reduced.
Hedge funds provide wealthy individuals/institutional investors an alternative to traditional
vehicles (secrecy), hedge fund managers earn extremely high incomes (two and twenty: two
percent of total amount invested + 20 percent of investment gains). But… Evidence suggest
that this is not translated into superior performance.
Why do people still buy and continue to hold on such investments? Behavioral finance
Behavioral finance = Application of common judgment errors to the world of investment
(first negotiation, now financial decisions important) – How do biases affect individuals and
markets?
Investment decisions are affected by:
1) Overconfidence
Tendency to be excessively sure that you know in which direction the market is
headed or that you can pick the right fund in which to invest. This leads to more
active investing, which incurs high costs (transaction cost + difference between buy-
and-sell prices).
2) Optimism
After investing, people tend to be overly optimistic about future profitability and
maintain optimistic recollections of the past performance.
3) Denying random events and the regression to the mean
Past is not a good predictor of the future. Besides, people tend to deny that random
events are random and find patterns where none exists.
4) Anchoring, the status quo and procrastination
Investors procrastinate (uitstellen) on making allocation decisions while being overly
active in moving funds within a category, thus putting too much effort into less
important financial decisions and not enough effort into the far more vital ones (like
pension savings).
, 5) Prospect theory (selling winners and keeping losers)
Decision makers tend to compare outcomes to a reference point (initially paid price).
With gains, we are risk averse: tend to sell to guarantee the gain. With losses, risk
seeking take the risk holding on to the loser in hope of becoming a winner
regret minimization strategy (‘booking’ a loss and feeling regretful).
Following a long-term buy-and-hold strategy investing online is a better strategy than
through a full-service broker.
A key aspect of making more rational decisions is to identify clearly your final goal.
To predict which stocks will rise, investors need to know which stocks other investors think
will rise, just as those other investors are trying to do the same.
Strategy: Formulate an asset allocation plan, strive to achieve this in a low-cost manner,
invest on a regular basis.
Article 11: Are investors reluctant to realize their losses? (Odean, 1998)
Disposition effect = the tendency of investors to hold losing investments too long and sell
winning investments too soon.
Not motivated by a desire to rebalance portfolios or avoid higher trading costs of low-priced
stocks.
one implication of the prospect theory. Prospect theory = When faced with choices
involving simple two and three outcome lotteries, people behave as if maximizing an ‘S’-
shaped function – similar to standard utility function except that it is defined on gains and
losses rather than levels of wealth. Status quo (purchase price) as reference point.
Monday: Investor behavior + Guest lecture (Lecture 11)
How the Homo Economicus Invests (How it should be):
- Considers all investment opportunities
- Has rational expectations (on average, he/she is correct) about returns (risk return,
correlations between securities)
- Ignores past gains and past losses (totally irrelevant variables)
- Diversifies idiosyncratic risk adequately (only systematic risk is rewarded,
idiosyncratic risk is diversified away)
- Avoids costs: invests passively when (s)he has no inside info or superior trading skills
(only trade when beneficial)
- Evaluation horizon = investment horizon (thinks in terms of returns, these
distributions are associated with the investment horizon – invest for a year, annual
returns matter/invest for longer, distribution long horizon more important)
, Costly Behaviors of Investors
- Excessive Trading (Odean, 1999) – Tendency of people to trade to much
- Disposition Effect (Odean, 1998) – Decisions people make when people want to end
- Attention-Based Buying (Barber & Odean, 2008) – Role of attention
- Suboptimal diversification (Benartzi & Thaler, 2001) – Fail to properly diversify
Performance of Individual investors (retail investors):
Review paper by Barber & Odean (2013):
Many studies document that individual investors earn poor (long-run) returns even before
costs.
Compared returns of portfolio of individuals investors to the market. Clear conclusion:
Individual investors earn poor long-run returns. Not only low when you look at the bottom-
line results, but also if you control for cost. Make sense that more costs than a passive
index, still individual investors underperform the market.
Possible explanation underperformance before costs:
Info asymmetry – individual investors are at an informational disadvantage when trading
with institutional investors. Individual investors suffer from a lack of information than the
other investors in the market. When they trade with a better-informed counterparty, they
are selling at too low price and buying at too high price. Other party is only willing to trade
when it is beneficial and if they know better about the security, they win.
But why then do individual investors trade so much? If you know that you are behind,
others know more than you…
Excessive Trading
If a rational investor trades, he either…
- Has a surplus or shortage of liquidity (in need of cash)
- Wants to align risk preferences and portfolio risk (more or less risk)
- Rebalances his portfolio for optimal diversification
- Trades to realize tax losses, or (capital gain tax in US: losses can be subtracted from
tax invoice)
- Trades for a profit: However, expected return > transaction costs (costs associated
with selling/buying)
An overconfident investor (also) trades because he…
- Is mis calibrated about the precision of his information, or
- Optimistically believes he is a better-than-average trader/overconfident about his
ability to interpret information
Odean (1999)
Hypothesis: Due to overconfidence, investors trade too much: the securities investors buy
do not outperform those they sell by enough to cover trading costs
Data: Discount retail brokerage: data set (1987-93, 10.000 accounts)
Week 6
Monday: Investor Behavior + Guest
Wednesday: Behavior in Games
Chapter 9: Common Investment Mistakes
There are mutual funds who outperform the market, but this trend will happen roughly at
random and past performance will have little predictive power.
Index funds perform at the level of the overall market to which they are indexed, minus a
small (very low fees) operating fee.
Actively managed funds have higher expenses (frequent buying/selling leads to higher
brokerage cost) and therefore the returns are reduced.
Hedge funds provide wealthy individuals/institutional investors an alternative to traditional
vehicles (secrecy), hedge fund managers earn extremely high incomes (two and twenty: two
percent of total amount invested + 20 percent of investment gains). But… Evidence suggest
that this is not translated into superior performance.
Why do people still buy and continue to hold on such investments? Behavioral finance
Behavioral finance = Application of common judgment errors to the world of investment
(first negotiation, now financial decisions important) – How do biases affect individuals and
markets?
Investment decisions are affected by:
1) Overconfidence
Tendency to be excessively sure that you know in which direction the market is
headed or that you can pick the right fund in which to invest. This leads to more
active investing, which incurs high costs (transaction cost + difference between buy-
and-sell prices).
2) Optimism
After investing, people tend to be overly optimistic about future profitability and
maintain optimistic recollections of the past performance.
3) Denying random events and the regression to the mean
Past is not a good predictor of the future. Besides, people tend to deny that random
events are random and find patterns where none exists.
4) Anchoring, the status quo and procrastination
Investors procrastinate (uitstellen) on making allocation decisions while being overly
active in moving funds within a category, thus putting too much effort into less
important financial decisions and not enough effort into the far more vital ones (like
pension savings).
, 5) Prospect theory (selling winners and keeping losers)
Decision makers tend to compare outcomes to a reference point (initially paid price).
With gains, we are risk averse: tend to sell to guarantee the gain. With losses, risk
seeking take the risk holding on to the loser in hope of becoming a winner
regret minimization strategy (‘booking’ a loss and feeling regretful).
Following a long-term buy-and-hold strategy investing online is a better strategy than
through a full-service broker.
A key aspect of making more rational decisions is to identify clearly your final goal.
To predict which stocks will rise, investors need to know which stocks other investors think
will rise, just as those other investors are trying to do the same.
Strategy: Formulate an asset allocation plan, strive to achieve this in a low-cost manner,
invest on a regular basis.
Article 11: Are investors reluctant to realize their losses? (Odean, 1998)
Disposition effect = the tendency of investors to hold losing investments too long and sell
winning investments too soon.
Not motivated by a desire to rebalance portfolios or avoid higher trading costs of low-priced
stocks.
one implication of the prospect theory. Prospect theory = When faced with choices
involving simple two and three outcome lotteries, people behave as if maximizing an ‘S’-
shaped function – similar to standard utility function except that it is defined on gains and
losses rather than levels of wealth. Status quo (purchase price) as reference point.
Monday: Investor behavior + Guest lecture (Lecture 11)
How the Homo Economicus Invests (How it should be):
- Considers all investment opportunities
- Has rational expectations (on average, he/she is correct) about returns (risk return,
correlations between securities)
- Ignores past gains and past losses (totally irrelevant variables)
- Diversifies idiosyncratic risk adequately (only systematic risk is rewarded,
idiosyncratic risk is diversified away)
- Avoids costs: invests passively when (s)he has no inside info or superior trading skills
(only trade when beneficial)
- Evaluation horizon = investment horizon (thinks in terms of returns, these
distributions are associated with the investment horizon – invest for a year, annual
returns matter/invest for longer, distribution long horizon more important)
, Costly Behaviors of Investors
- Excessive Trading (Odean, 1999) – Tendency of people to trade to much
- Disposition Effect (Odean, 1998) – Decisions people make when people want to end
- Attention-Based Buying (Barber & Odean, 2008) – Role of attention
- Suboptimal diversification (Benartzi & Thaler, 2001) – Fail to properly diversify
Performance of Individual investors (retail investors):
Review paper by Barber & Odean (2013):
Many studies document that individual investors earn poor (long-run) returns even before
costs.
Compared returns of portfolio of individuals investors to the market. Clear conclusion:
Individual investors earn poor long-run returns. Not only low when you look at the bottom-
line results, but also if you control for cost. Make sense that more costs than a passive
index, still individual investors underperform the market.
Possible explanation underperformance before costs:
Info asymmetry – individual investors are at an informational disadvantage when trading
with institutional investors. Individual investors suffer from a lack of information than the
other investors in the market. When they trade with a better-informed counterparty, they
are selling at too low price and buying at too high price. Other party is only willing to trade
when it is beneficial and if they know better about the security, they win.
But why then do individual investors trade so much? If you know that you are behind,
others know more than you…
Excessive Trading
If a rational investor trades, he either…
- Has a surplus or shortage of liquidity (in need of cash)
- Wants to align risk preferences and portfolio risk (more or less risk)
- Rebalances his portfolio for optimal diversification
- Trades to realize tax losses, or (capital gain tax in US: losses can be subtracted from
tax invoice)
- Trades for a profit: However, expected return > transaction costs (costs associated
with selling/buying)
An overconfident investor (also) trades because he…
- Is mis calibrated about the precision of his information, or
- Optimistically believes he is a better-than-average trader/overconfident about his
ability to interpret information
Odean (1999)
Hypothesis: Due to overconfidence, investors trade too much: the securities investors buy
do not outperform those they sell by enough to cover trading costs
Data: Discount retail brokerage: data set (1987-93, 10.000 accounts)
