Investment Analysis and Portfolio Management Behavioral finance What often triggers our decisions to buy and to sell Why we refrain from selling loss-making investments How you should look at an investment position to find out whether to keep it, buy some more or sell it Cognitive biases, emotions 22.11.2018

Buying and Selling Decisions We tend to buy and sell based on past returns. Hence: We buy an asset because it has been performimng well recently. We exit a position because we have made a decent return. We refrain from exiting loss-making investments. 22.11.2018

Price Data: Nokia 22.11.2018

When to buy? When to sell? Assume you bought 1000 shares at 30 EUR in 1999. Probably because you looked at the past performance of the stock. In 2000, the stock goes up to 60 EUR. Would you keep the stock or sell it? Why? 22.11.2018

When to sell? 22.11.2018

When to sell? The right question to ask? Remember, you bought 100 shares at 30 EUR. The stock goes up to 60… and then drops to 20 EUR. Would you sell the position? (Yes/No) Why? What about asking the following question: If I had 20,000 EUR today, would I purchase 1000 shares? If you answer ‘yes’, then…. If you answer ‘no’, then …. 22.11.2018

Nokia’s Long time average P/E was 24. 22.11.2018

What happened later 22.11.2018

Conclusions We should focus more on Fundamentals (or fair value) than past returns. Look at company and sector valuations Review the investment decision in the light of the company’s strategy A tip for focusing more on Fundamentals: Forget the purchase price of your investments! 22.11.2018

Rational Decision Making: Get information, process info (valuation, measurement of dependency between assets, etc.) then make a decision (pick a security) 22.11.2018

Actually what happens… 22.11.2018

Experiment 22.11.2018

Experiment 22.11.2018

Lessons from this simple experiment The way you perceive things is influenced by other things (e.g. the outer circles). Our brain is bad at perceiving absolute values. It’s all relative. By knowing this, you can consciously adjust for the difference. But this doesn’t necessarily change your actual perception. 22.11.2018

Experiment 22.11.2018

Experiment 22.11.2018

Learning outcomes The brain is constantly filling in missing information It makes many assumptions about our environment in order to reconstruct it from the limited information it receives When these assumptions are wrong, errors in judgement arise 22.11.2018

Basic steps in investment 1. Definition of investment universe 2. Construction of the optimal investment strategy 3. Adjustment and rebalancing over time We face cognitive biases in these stages 22.11.2018

Biases when chosing which assets to look at Availability biases: Home bias: over-investment in local companies Recency bias: Overweight recent information From a very large set of (financial) information, we only select a subset to make decisions This subset selection is influenced by availability biases (home bias and recency bias) 22.11.2018

Biases when processing financial information Anchoring bias: when we are asked to estimate something, we tend to be influenced by other (unrelated) numbers we recently encountered Confirmation bias: we tend to look for information that confirms our bliefs and ignore information that contradicts them 22.11.2018

Biases when processing financial information Overconfidence bias: A simple question: ‘Do you think that you are an above average driver?’ 93% of American drivers said they were ….. Overconfidence comes in different forms: Overestimate your actual performance, Effect: Overestimating the expected return Overestimate where you rank among your peers, Being overly sure about your beliefs. Effect: Underestimating the risk of your portfolio 22.11.2018

Biases when rebalancing portfolio Endowment biase (status-quo): People tend to value highly their holdings Fear of regret effect: People have a tendency to Sell their winning positions too early, Hold onto their losing positions for too long. 22.11.2018

The basic steps in investment – Wrap up 1. Definition of the investment universe Don’t rely solely on readily available data, Do some extensive research 2. Construction of the optimal investment strategy Look for information that contradicts your current beliefs and forecast 3. Adjustment and rebalancing over time Stick to your original and carefully designed strategy Your buy and sell orders should be dictated by this strategy only. 22.11.2018

A continuous improvement tool Keep a log of: Your transactions (and non-transactions) The motives behind each of them The information set you used to reach your decision This way, you will be aware of your cognitive biases and be able to adjust them. 22.11.2018

Rational decisions and future wealth Being perfectly rational does not necessarily guarentee that you will maximize the returns of your investment strategy But the (stock) market is closely tied to the fundamentals of the economy. Being rational helps in ensuring that these will be the real drivers behind your investment decisions. 22.11.2018

Emotions and decision making Emotions constantly influence our decisions. People who have experienced financial crises (and lost money) are more risk averse later in their life. People trade to increase personal wealth, to satisfy gambling-related thrills and to increase own status and value. For increasing personal wealth identify and eliminate the latter two motives from your decision process. For triggering emotions and providing status and value develop a strategy that won’t hurt you financially in the long term. 22.11.2018

Some advice Don’t act impulsively, invest when you are calm and well informed. Learn to recognize your emotions Don’t look at your stocks every day Portfolios with frequent transactions tend to do worse than portfolios with few transactions You can trade virtually for fun Never mix your investment portfolio with your fun portfolio Treat your fun portfolio like you would any other hobby. 22.11.2018