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Gayle Buff CFP, CFA Buff Capital Management 1 The Psychology of Investing.

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Presentation on theme: "Gayle Buff CFP, CFA Buff Capital Management 1 The Psychology of Investing."— Presentation transcript:

1 Gayle Buff CFP, CFA Buff Capital Management 1 The Psychology of Investing

2 Gayle Buff CFP, CFA Buff Capital Management 2 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.

3 Gayle Buff CFP, CFA Buff Capital Management 3 Introduction Behavioral finance looks at how people actually behave when faced with making a choice under risk. Two primary components of behavior: –Beliefs –Emotions

4 Gayle Buff CFP, CFA Buff Capital Management 4 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.

5 Gayle Buff CFP, CFA Buff Capital Management 5 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.

6 Gayle Buff CFP, CFA Buff Capital Management 6 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.

7 Gayle Buff CFP, CFA Buff Capital Management 7 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

8 Gayle Buff CFP, CFA Buff Capital Management 8 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.

9 Gayle Buff CFP, CFA Buff Capital Management 9 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.

10 Gayle Buff CFP, CFA Buff Capital Management 10 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

11 Gayle Buff CFP, CFA Buff Capital Management 11 Over- Confidence and Risk- Taking Are you a good driver? Compared with the drivers you encounter on the road, are you above- average, average or below- average? 82% of sampled college students rated themselves above average drivers. Studies show overconfident investors take more risk.

12 Gayle Buff CFP, CFA Buff Capital Management 12 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

13 Gayle Buff CFP, CFA Buff Capital Management 13 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

14 Gayle Buff CFP, CFA Buff Capital Management 14 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

15 Gayle Buff CFP, CFA Buff Capital Management 15 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.

16 Gayle Buff CFP, CFA Buff Capital Management 16 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.

17 Gayle Buff CFP, CFA Buff Capital Management 17 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.

18 Gayle Buff CFP, CFA Buff Capital Management 18 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...”

19 Gayle Buff CFP, CFA Buff Capital Management 19 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

20 Gayle Buff CFP, CFA Buff Capital Management 20 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?

21 Gayle Buff CFP, CFA Buff Capital Management 21 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.

22 Gayle Buff CFP, CFA Buff Capital Management 22 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.

23 Gayle Buff CFP, CFA Buff Capital Management 23 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, non- recoverable 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.

24 Gayle Buff CFP, CFA Buff Capital Management 24 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.

25 Gayle Buff CFP, CFA Buff Capital Management 25 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.

26 Gayle Buff CFP, CFA Buff Capital Management 26 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.

27 Gayle Buff CFP, CFA Buff Capital Management 27 Overcome Behaviors That Run Counter to Wealth Maximizing Policies “Three years of losses often turn investors with 30- year 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.

28 Gayle Buff CFP, CFA Buff Capital Management 28 Goal Approach Goal Avoidance Elation Disappointment Relief Anxiety _______________________________________________ Peterson, Richard L., Inside the Investor’s Brain: The Power of Mind Over Money Positive Progress Negative Progress

29 Gayle Buff CFP, CFA Buff Capital Management 29 Financial Decision  Anxiety (uncertainty) Personality Styles 1.Worried 2.Depressed 3.Impatient, wants to move on quickly 4.Outbursts, impulsive Risk Avoidance Risk Seeking _________________________________________________________

30 Gayle Buff CFP, CFA Buff Capital Management 30 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

31 Gayle Buff CFP, CFA Buff Capital Management 31 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

32 Gayle Buff CFP, CFA Buff Capital Management 32 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 Shefrin, Hersh, Beyond Greed and Fear, Boston, Harvard Business School Press, 2000

33 Gayle Buff CFP, CFA Buff Capital Management 33 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

34 Gayle Buff CFP, CFA Buff Capital Management 34 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

35 Gayle Buff CFP, CFA Buff Capital Management 35 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.

36 Gayle Buff CFP, CFA Buff Capital Management 36 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.

37 Gayle Buff CFP, CFA Buff Capital Management 37 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.

38 Gayle Buff CFP, CFA Buff Capital Management 38 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.

39 Gayle Buff CFP, CFA Buff Capital Management 39 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”.

40 Gayle Buff CFP, CFA Buff Capital Management 40 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).

41 Gayle Buff CFP, CFA Buff Capital Management 41 Presented by: Gayle H. Buff, MBA, CFP, CFA Buff Capital Management 111 Hyde Street Newton Highlands Massachusetts Tel: (617)


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