6 Behavioral Finance Cont’ Behavioral Finance is a reflection to extremes we see in Efficient Market Theory or in Mathematical Finance.It is not just Behavioral Psychology applied to finance but also includes more broad social aspects which are not related to anything fundamental.Stocks Market PriceStocks Dividends
9 Over Confidence What is the weight of Status of Liberty -in Tons- ? Population of Turkey ?Size of Sahara Desert -Sq meter- ?
10 Over Confidence What is the weight of Status of Liberty -in Tons- ?
11 Over Confidence What is the weight of Status of Liberty -in Tons- ? Population of Turkey ?73,914,260
12 Over Confidence What is the weight of Status of Liberty -in Tons- ? Population of Turkey ?73,914,260Size of Sahara Desert -Sq meter- ?3.5 Million Sq meter
13 Prospect TheoryIn year 1979 Daniel Kahneman & Amos Tversky published there article about Prospect Theory as a psychologically realistic alternative to Expected Utility Theory.There is a discontinuity in slope which means we value losses more than we value gains given an equal probability for both. In contrary to EUF, here we are always at the reference point exaggerate in our minds the importance of deviations from where we are. This is not rational! So losses tend to dominate so you don’t want to take the bet.Expected Utility FunctionValue Function
14 The Weighting Function Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory: Given these two prospects Which one you choose?ProbabilityGain25%$300020%$4000
15 The Weighting Function Cont’ Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory:Given these two prospectsWhich one you choose?Most people would choose the 20% & $4000ProbabilityGain25%$300020%$4000
16 The Weighting Function Cont’ What if you have Which one you choose ?ProbabilityGain100%$300080%$4000
17 The Weighting Function Cont’ What if you haveWhich one you choose ?Most people would choose the 100% & $3000 because we prefer certainty. This contradict with the EUF theory.ProbabilityGain100%$300080%$4000
18 The Weighting Function Cont’ Kahneman & Tversky said we weight probabilities in our minds in a distortion way. They stated that we emotionally minimize the differences between probabilities if they are close.
19 JP MorganJ.P. Morgan Chase & Co. is one of the oldest financial services firms in the world. It has operations in 60 countries. It is a leader in financial services with assets of $2 trillion.J.P Morgan manages clients’ assets through three key business units:Private BankHigh net worth individual (26 counties)Private Client Services (PCS)Client with < $ 25M in AssetsAsset ManagementDeveloping financial products for retail and institutional investorsJPM was the seventh largest asset management company in the world in 2005
20 Behavioral Finance at JP Morgan They emphasis on two behavioral Biases:Over confidenceJPM funds systematically overweight value stocks, means that our investment behavior is changed. We are forced to focus on out of fashion stocks that we wouldn’t naturally have bothered with and that means that we cannot fall into the same overconfidence trap.Loss AversionOur approach requires a systematic tilt to momentum, forcing us to run our winners and cut our losers. It also forces our investors to re-evaluate stocks which have done well for a long time but are now starting to disappoint
21 Behavioral Finance Implementation The implementation of the BF investment philosophy had three parts:Stock selectionA quantitative stock selection model is used to rank stocks based on behavioral characteristicsPortfolio constructionPortfolio construction involved maximizing exposure to stocks with value and momentum, while controlling other risk exposures, such as overall risk, sector exposuresExecution.In our portfolios, stocks are systematically combined in such a way as to produce a barbell portfolio which is cheaper than the market and has better momentum than the market - a kind of “super-stock.”
22 JPM Branded BF Fund Intrepid Funds Intrepid AmericaIntrepid GrowthIntrepid ValueIntrepid Multi CapThey Capitalize on the emotions that often cause people to make poor investment decisionsTheir performance had been impressiveExample: Intrepid Value was ranked first of 400 funds since its release in 2003