Investments: Analysis and Behavior Chapter 8- Psychology and the Stock Market

Learning Objectives  Find out about the new field of behavioral finance.  Understand how mental shortcuts impact investment decisions.  Avoid the mistakes of gambler’s fallacy.  Learn the social and emotional influences on investment behavior.  Use rules of thumb to improve investment decisions.

Current Events Article  Title: Hot Market Demands A Cool Head  Author: Bill Fleckenstein  Source: MSN Money  Link: ing/ContrarianChronicles/hot-market- demands-a-cool-head.aspx 3

Behavioral Finance  Much in finance has evolved from the perspective that investors behave rationally and markets are efficient. –Asset pricing models, like CAPM (helps determine required rates of return) –Option pricing (relates to prices, risk, and time) –Portfolio Theory (making security choices based on portfolio expected returns and risks)  What if people do not always act rationally? –Cognitive errors (perception, memory, judgment, and reasoning) –Psychological biases –Emotions –Bad decisions (mistakes)

Enter the range (minimum and maximum) for which you are 90% certain that the answer lies within. Min Max 1. How long (in miles) is the Grand Canyon? _____ _____ 2. In what year did Michael Angelo finish painting the ceiling of the Sistine Chapel? _____ _____ 3. How many countries were members of the United Nations in 2004? _____ _____ 4. How many species of spiders have been identified in the world? _____ _____ 5. How many hair follicles are on an average adult human? _____ _____ 6. In what year was the Great Pyramid of Giza built? _____ _____ 7. How many new copyrights were registered at the US Copyright Office in 2003? _____ _____ 8. How many planets the size of the Earth would fit into the sun? _____ _____ 9. On average, how many magnitude 3.0 and higher earthquakes are located worldwide annually by the US Geological Survey? _____ _____ 10. What was the 2000 Census estimate for the US population? _____ _____ _____ _____ Table 8.1 Ten Questions

Answers 1. How long (in miles) is the Grand Canyon? 277 miles 2. In what year did Michael Angelo finish painting the ceiling of the Sistine Chapel? How many countries were members of the United Nations in 2004? 191 countries 4. How many species of spiders have been identified in the world? 38,432 species 5. How many hair follicles are on an average adult human? 5 million hairs 6. In what year was the Great Pyramid of Giza built? 2560 BC 7. How many new copyrights were registered at the US Copyright Office in 2003? 514, How many planets the size of the Earth would fit into the sun? 1.3 million 9. On average, how many magnitude 3.0 and higher earthquakes are located worldwide annually by the US Geological Survey? 14,000 earthquakes/year 10. What was the 2000 Census estimate for the US population? 280 million people

Did you get 9 out of 10?  Most people miss five or more –Overconfident about level of knowledge –Desire to be “accurate”  Range is too narrow –Usually the higher number is too low  Misses are predictable!

One more question On October 1, 1928, the “modern era” began for the Dow Jones Industrial Average (DJIA) began when the component list was expanded to 30 from 20 stocks, and several substitutions were made. A divisor was also introduced to adjust for the effect of stock splits, stock distributions, and stock substitutions. In 1929, the year began with the DJIA at 300. At the end of 2007, the DJIA was at 13,265. The DJIA is a price-weighted average. Dividends are omitted from the index. What would the DJIA average be at the end of 2007 if dividends were reinvested each year?

If dividends were reinvested in the DJIA, the average would have been 327,011 at the end of 2007!  Where you right?  Anchoring –Mental attachment to a specific number or price –People tend to anchor on the current DJIA and try to add an appropriate amount.

Consider The Following  People prefer a lottery ticket over the expected value of that ticket—risk seeking behavior. –The odds of winning the NY Mega Millions Lotto Jackpot is 1:175,711,536  People also prefer a small loss (small insurance premium) over a small probability of a large loss—risk averse behavior.

Prospect Theory Investors tend to frame investment choices in terms of potential gains and losses relative to a specific reference point according the S shaped value function: Positive versus Normative Twice the loss doesn’t always make one feel twice as bad, and vice-versa

Interpretations  Concave for gains –Investors feel good (i.e., have higher utility) when they make a $1,000 gain. denoted as X in the figure –Investors feel better when they make a $2,000 gain, measured as Y. –However, Y is not twice the level of X even though $2,000 is twice as much as $1,000.  The function is convex for losses –This means that investors feel bad when they realize an investment loss, but twice as large a loss does not make the typical investor feel twice as bad.  Notice that the utility of wealth function is steeper for investment losses than for investment gains. –The asymmetry that exists between gains and losses leads to different investor reactions when dealing with winning and losing positions.

Mental Shortcuts  Heuristic Simplification –Mental shortcuts used by the brain to make quicker decisions and choices with uncertain outcomes.  One kind of heuristic simplification is the familiarity bias –Things that are familiar are considered better than unfamiliar things.  Companies that we are familiar with are assumed to be better investments.  Employees are most familiar with the company they work for. –As a consequence, they invest too much of their 401(k) retirement in their employer. –WorldCom, Enron, Kmart, Bear Stearns …

More Retirement Plan Oddities  Choice Overload –When employees are faced with too many choices to pick from in their defined contribution plan, they tend to not invest at all.  1/n heuristic –When just a few choices are available, employees tend to divide the contributions (1/n) into all the options. –How does the types of options available impact the risk level of the employee portfolios?

Representativeness Bias  Another heuristic simplification  A bias of stereotypes: the characteristics of something that we know are projected onto the characteristics of something that we do not know. –A clean car must be a good running car. –Good companies must be good investments. –Past returns represent what should be expected in the future. –A good company can be overpriced, and stocks that went up in price often go down.

More Behavior  Status quo –Unsure what to do? Do nothing.  Gambler’s Fallacy –Mistaken belief in a self-correcting process in a fair game.  Mental Accounting –Each investment is evaluated independently  Reference Points –Buy price –Recent high, low

When do investors feel like they are making profits or losses?

Psychological Limitations  Avoiding Regret –Regret of omission –Regret of commission  Act to avoid regret and seek pride  Disposition effect – predisposed to –Sell winners too soon Taxes Winners continue to do well –Hold losers too long Taxes Losers continue to do poorly

Behavioral Portfolios  People do not think of their portfolio like modern portfolio theory.  Instead, we think of it as a pyramid of assets held to meet a hierarchy of goals.

Self-Deception  Overconfidence - people overestimate their knowledge and ability. –Causes investors to overestimate their knowledge, underestimate the risks, and exaggerate their ability to control events. –Causes too much trading, low diversification, high risk securities. Question: How good of an investor are you? Compared with the broad market averages, are you above average, average, or below average?  Few believe they are below average investors. –People are mistaken because they are overconfident about their skill and knowledge.  Misattribution bias –Good moods lead to great risk taking and optimism –Bad moods lead to pessimism and less risk

Cognitive Dissonance  The mental discord between the memory of an event that conflicts with a positive self- perception. (e.g. your experience differs from your perception… one believes that his/her choice is better than that of others)  What was your performance like? –Absolute –Relative to the general market

Social Influences  Social norms –The informal opinions, rules, and procedures of a group. Your piers and social groups influence your investment participation  Herding –The movement into or out of a stock or industry of companies by large groups of investors. Desire for unprofitable Internet companies in late 1990s

Avoid Investment Pitfalls  “Fear and greed rule the market.” –Emotions play an important role in investor decisions. –The challenge for investors is to recognize and learn to avoid psychological biases that make rational decision making difficult.  Rules of Thumb  Investment Process

Rules of Thumb  Stay the course. Maintain a long-term perspective.  Long-run returns reflect fundamental business prospects. In the long run, you will do as well as the businesses you invest in.  Dumb money ceases to be dumb when it realizes its limitations. Low-cost stock and bond index investing is best for almost everyone. Most active speculators lose money.  Don’t confuse luck with brains. Most investors think they are smart if the stocks they buy go up, and merely unlucky when their stocks go down.  Cut your losses and let your profits run. Admit when you are wrong. Be willing to make small mistakes. Wrong and stubborn is expensive.  Bulls make money, bears can make money, hogs get slaughtered. Don’t take oversized positions in single companies.  Be skeptical of buy/sell recommendations. Assume that buy recommendations are made by investors with stock to sell.  Market professionals tend to be articulate, bright, well-trained, and make a very good living for themselves. Few market professionals help investors make money.  If everyone were right, everyone would be rich. Herding with everyone else causes you to earn substandard returns, like everyone else.  Significant capital accumulation requires time and money. The wealthy tend to be smart, lucky and old.

Plan for Success!  A good investment decision process can help control psychological biases and emotions.  Have realistic goals  Use quantitative criteria to evaluate stocks No “story” stocks  Have an investment plan Specific goals, road map to get there, measure progress  Portfolio rebalancing Sell high, buy low