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The secret lives of investors: Lessons from behavioral finance Presenter Name Job Title INVESTMENT PRODUCTS: NOT FDIC INSURED NOT BANK GUARANTEE MAY LOSE.

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Presentation on theme: "The secret lives of investors: Lessons from behavioral finance Presenter Name Job Title INVESTMENT PRODUCTS: NOT FDIC INSURED NOT BANK GUARANTEE MAY LOSE."— Presentation transcript:

1 The secret lives of investors: Lessons from behavioral finance Presenter Name Job Title INVESTMENT PRODUCTS: NOT FDIC INSURED NOT BANK GUARANTEE MAY LOSE VALUE 0

2 Important information This material is provided on an informational basis only and should not be construed as a solicitation for any specific Legg Mason product or service. All discussion of behavioral finance, and market psychology reflects general principles and does not represent a recommendation for specific action. All investments involve risk including loss of principal amount invested. There is no guarantee that investment objectives will be achieved. Investors should carefully consider their objective, risk tolerance and time horizon before investing. 1

3 Learning Objectives Provide information on how to help investors recognize why they can easily make irrational investment decisions because of emotions, misperceptions and errors in logic and discuss various options to help avoid them. Outline key differences between various emotions, misperceptions and errors of logic Provide details of various kinds of client emotions, misperceptions and errors in logic (using examples). Gain a deeper understanding of the role of the financial advisor.

4 Agenda Are you a rational investor? What is behavioral finance? Noise vs. signal: the quest for meaning Common mistakes by investors: examples from behavioral finance -When emotions take over -When perception is deception -When logic isn’t enough Staying on track: lessons for investors 3

5 Are you a rational investor? 1 This chart is for illustrative purposes only and does not represent actual performance, past or future, of any investment. Past performance is no guarantee of future results. Please note S&P 500 (please see slide number 24 for a definition), and Barclays U.S. Aggregate Bond (please see below for a definition), performance does not reflect the deduction of any fees and expenses. Indexes are unmanaged and one cannot invest directly in an index. Source: DALBAR Quantitative Analysis of Investor Behavior DALBAR uses industry cash flow reports from the Investment Company Institute (ICI), to calculate the figure for the “Average equity fund investor” and “Average fixed income investor” categories. The figures are based on the ICI’s reports for the “stock fund” and “fixed income” categories, which represents flows and performance for U.S. mutual fund assets. “Average equity fund investor, and ”Average fixed income fund investor” and as defined by DALBAR, refers to the universe of all mutual fund investors whose actions and financial results are restated to represent a single investor. This approach allows the entire universe of mutual fund investors to be used as the statistical sample, ensuring ultimate reliability. “Average equity fund investor” and “Average fixed income fund investor” returns are calculated by the DALBAR Quantitative Analysis of Investor Behavior (QAIB) Report. QAIB calculates investor returns as the change in assets after excluding sales, redemptions and changes. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated: total investor return rate for the period and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for the period. The Barclays U.S. Aggregate Index is a broad-based bond index comprised of government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity.www.dalbarinc.comwww.ici.org 4

6 Behavioral finance defined Emotional: when decisions made based on feelings rather than logic Perceptual: when information is misunderstood or taken out of context. Intellectual: when the wrong mental process leads to faulty judgments. Behavioral finance draws on finance, psychology and sociology to explain these common investor mistakes: 5 Source: Legg Mason, 2013.

7 Noise vs. Signal: The quest for meaning “The market is strong!” “The market is weak!” “Profits are down!” “Profits are up!” “Consumer sentiment is down!” “Consumer sentiment is up!” Everybody’s got an opinion… Cable TV The daily paper The Internet Talk radio Financial magazines Financial newspapers Friends Family Your dry cleaner 6

8 Choice Overload… Too much choice equals confusion 2 “When Choice is Demotivating: Can One Desire Too Much of a Good Thing?,” by S.S. Iyengar and M. Lepper, M., Journal of Personality and Social Psychology, 79, , “How Much Choice is Too Much?: Contributions to 401(k) Retirement Plans,” by S.S. Iyengar, W. Jiang, and G. Huberman, Pension Research Council of the Wharton School of the University of Pennsylvania (2003). Please note that the figures cited in the above chart are estimates based on the illustrations provided in the research. Researchers conducted a study on 401(k) accounts showed the more investment options, the less participation in the 401(k) plan 2 7

9 Overconfidence: “I’m on a roll” Loss aversion: “No regrets” Thrill seeking: “I want to shake things up” Fear: the most dangerous emotion of all When emotions take over: Decisions made on feelings 8

10 Source: Legg Mason, This image is for illustrative purposes only. When emotions take over: Riding an emotional rollercoaster 9

11 When emotions take over: Overconfidence: ‘I’m on a roll’ Too many people confuse access to financial information with having the expertise of an investment professional Overconfidence can lead to: understating the price swings of a security taking excessive risks 10

12 When emotions take over: Overconfidence: the behavioral view How would you rate your automobile driving skills:  Above average?  Below average? 11

13 When emotions take over: Overconfidence: the behavioral view 3 “Are we all less risky and more skillful than our fellow drivers?”, by Ola Swenson, Acta Psychologica, Volume 47, Issue 2, February 1981, pp In one study, 93% rated themselves above average… …far more than is actually possible! 3 12

14 When emotions take over: Loss aversion: “no regrets” The tendency to avoid accepting the reality of losing money *“A Conversation With Daniel Kahneman; On Profit, Loss and the Mysteries of the Mind, “ by Erica Goode, November 5, 2002, The New York Times. Consider this wager: We flip a coin. If heads, you lose $100; if tails, you win $100. Do you take the bet? Loss aversion research shows people look for a potential gain at least TWICE as large as the potential loss in order to accept this gamble* 13

15 Consequences: Do nothing and miss good opportunities Take imprudent risks to make up a loss Holding onto a “loser” too long When emotions take over: Loss aversion: “no regrets” 14

16 When emotions take over: Loss aversion: regret minimization Security A’s price rose to $30 before falling to $15 Source: Legg Mason, This graphical depiction is hypothetical and for illustrative purposes only. Which investor is less likely to sell?  Investor #1  Investor #2 15

17 When emotions take over: Loss aversion: regret minimization Investor #2 Would regret the loss if he sells… …doing nothing lets him avoid the reality of losing money Source: Legg Mason, This graphical depiction is hypothetical and for illustrative purposes only. 16

18 When emotions take over: Thrill seeking: “I want to shake things up” T-Type individuals: easily bored, tremendous appetite for excitement who seek out daring experiences T-Types are prone to take risky positions with the goal of quickly turning a profit Consequences: Taking on too much risk Making too many trades 17

19 When emotions take over: Fear: the most dangerous emotion Why? It has immediate effects on our physical bodies that affect our thinking Increased heart rate Shallow breathing Goosebumps The dangers for investors Panic selling Investment “paralysis” The best defense Make a plan for adversity and follow it, not your emotions 18

20 When perception is deception: Decisions based on misinformation Anchoring Hindsight bias Prejudice Framing Pattern recognition 19

21 When perception is deception: What do you see? Source: Legg Mason, This graphical depiction is hypothetical and for illustrative purposes only. 20

22 When perception is deception: Anchoring: “stuck on you” Investment A 15.3% average annualized return Manager tenure 10 years Standard deviation* 19% Lower-ranked investment Investment B 11.9% average annualized return Manager tenure 10 years Standard deviation* of 6% Highly-ranked investment This depiction is hypothetical and for illustrative purposes only. *Standard deviation measures the risk or volatility of an investment’s return over a particular time period; the greater the number, the greater the risk. 21

23 When perception is deception: Hindsight bias: “I could have predicted that!” Inclination to see past events as more predictable than they actually were — the “Monday Morning Quarterback” phenomenon Seeing the past through “rose-colored” pair of glasses Consequences: Believing that you’re smart when you were only lucky 22

24 Perception based on limited experiences Can hinder our acceptance or denial of the truth “I once owned a small-cap value investment and it was a stinker…I’ll never buy one of those again.” “My father got burned in the bond market…there’s no way I’ll ever buy fixed income.” “I only purchase investments that are within the top quartile.” When perception is deception: Prejudice: “I know what I know” 23

25 The manner in which a choice has been presented Becomes evident in what is known as the “money illusion” Excitement about a 10 percent raise when the rate of inflation is 12 percent rather than with a 5 percent raise when the rate of inflation is at 3 percent. Examples of Framing Half-empty vs. Half-full 50% chance of success vs. 50% chance of failure $3 a day vs. $1,095 a year When perception is deception: Framing: “It’s not what you say, but how you say it” 24

26 Source: FactSet. Past performance is no guarantee of future results. The charts provided is for illustrative purposes only and represents unmanaged indices in which investors cannot directly invest. The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S. Please note an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charge. S&P 500 performance 12/31/05 to 12/31/12 When perception is deception: Pattern recognition: ‘I see, therefore I think’ 25

27 When logic isn’t enough: Decisions based on faulty judgment Mental accounting Heuristics 26

28 Source: Legg Mason, A CD is a debt instrument issued by a bank that usually pays an interest rate set by competitive forces in the marketplace. CDs are FDIC-insured up to $100,000, offer a fixed rate of return, but may be subject to fluctuating rates and early withdrawal penalties. *Illustration based on research from “Toward A Positive Theory of Consumer Choice,“ by Richard H. Thaler, Journal of Economic Behavior and Organization, Vol. 1: pp When logic isn’t enough: Mental accounting: ‘everything is in its place’ 27

29 When logic isn’t enough: Heuristics: ‘You can’t compare apples to oranges’ *There are special considerations associated with investing in emerging markets, including risks related to currency fluctuations and adverse social and political developments. Furthermore, the securities markets of emerging markets countries are substantially smaller, less developed, less liquid and more volatile than securities markets of the U.S. and more developed countries. Heuristics are simple rules that people use to make decisions when facing complex problems or incomplete information. For instance, many people tend to believe in “the more expensive the beverage the better it tastes.” Would you use the same criteria to select an emerging market investment* as a U.S. “blue-chip” stock? Or do you consider other criteria? 28

30 Staying on track: lessons for investors Lesson 1: Work with a trusted financial advisor Lesson 2: Identify your goals, your time horizon and your tolerance for risk Lesson 3: Don’t let emotions drive your decisions Lesson 4: Focus on building wealth instead of reducing losses Lesson 5: Understand your perceptions Lesson 6: Avoid “mental accounting” 29

31 “When I let go of what I am, I become what I might be” ― Lao Tzu 30

32 CPE Program Refund Policy For more information regarding administrative policies such as complaints, cancellation, and refunds, please contact Kerry Ryan, CE Credits Program Administrator at (203)

33 Visit us:Follow us on Twitter: © 2013 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc. FN INVESTMENT PRODUCTS: NOT FDIC INSURED NOT BANK GUARANTEE MAY LOSE VALUE All discussions of behavioral finance and market psychology reflects general principles and does not represent a recommendation for specific action. All investments involve risk, including loss of principal amount invested. There is no guarantee that investment objectives will be achieved. Investors should carefully consider their objective, risk tolerance and time horizon before investing. 32


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