Investments: Analysis and Behavior Chapter 8- Psychology and the Stock Market ©2008 McGraw-Hill/Irwin.

Slides:



Advertisements
Similar presentations
1 Behavioural Slides 2007 Behavioral Corporate Finance.
Advertisements

Behavioral Finance & Technical Analysis
Psychology and Behavioral Finance Fin254f: Spring 2010 Lecture notes 3 Readings: Shiller 8-9, Nofsinger, 1-5.
Behavioral Finance Ahmed Elshahat October 27 th 2006 CPE.
Vicentiu Covrig 1 Behavioral Finance Behavioral Finance (see chapter 8 Hirschey and Nofsinger)
CHAPTER ELEVEN Practical Investment Management Robert A. Strong BEHAVIORAL FINANCE.
Behavioral Finance and Technical Analysis
Investments: Analysis and Behavior Chapter 8- Psychology and the Stock Market.
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Behavioral Finance and Technical Analysis 9 Bodie, Kane, and.
1 BM410: Investments Behavioral Finance Much of this material is taken from the book The Psychology of Investing by John R. Nofsinger, Prentice Hall, 2002.
The Endowment Effect, Loss Aversion, and Status Quo Bias Daniel Kahneman, Jack L Knetsch, and Richard H Thaler (1991) Harish K Subramanian (11/18/03)
Investment and portfolio management
Copyright © 2004 South-Western 27 The Basic Tools of Finance.
Common Stocks: Analysis and Strategy
Chapter McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. 1 A Brief History of Risk and Return.
FIN352 Vicentiu Covrig 1 Risk and Return (chapter 4)
The Basic Tools of Finance
Basic Tools of Finance Finance is the field that studies how people make decisions regarding the allocation of resources over time and the handling of.
Asset Management Lecture 19. Agenda Behavioral finance (Chapter 12) Challenges to market efficiency Limits to arbitrage Irrational investors.
Copyright ©2004 Pearson Education, Inc. All rights reserved. Chapter 18 Asset Allocation.
Chapter McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. A Brief History of Risk and Return 1.
1 Chapter 1 Brief History of Risk and Return Ayşe Yüce – Ryerson University Copyright © 2012 McGraw-Hill Ryerson.
Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. 1 A Brief History of Risk and Return.
Experience Schulich 2010 Mini-lecture: Finance. S As Far as Investors were concerned… the last decade was a miss!
Pauline Shum Schulich School of Business York University
Chapter The Basic Tools of Finance 14. Present Value: Measuring the Time Value of Money Finance – Studies how people make decisions regarding Allocation.
PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University The Basic Tools of Finance 1 © 2011 Cengage Learning. All Rights Reserved.
Thinking and Decision Making
Chapter 22 Behavioral Finance: Implications for Financial Management
Behavioral Finance: Implications for Financial Management
JSE/Liberty Staff Investment Challenge June 2011.
Copyright © 2004 South-Western 27 The Basic Tools of Finance.
Investments: Analysis and Behavior Chapter 4- Risk and Return ©2008 McGraw-Hill/Irwin.
1 FIN 2802, Spring 10 - Tang Chapter 7: Optimal Investment Portfolio Fin 2802: Investments Spring, 2010 Dragon Tang Lecture 18 Optimal Investment Portfolio.
Chapter McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. A Brief History of Risk and Return 1.
Understanding Human Behavior Helps Us Understand Investor Behavior MA2N0246 Tsatsral Dorjsuren.
McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Efficient Markets & The Behavioral Critique CHAPTE R 8.
Rossohin V.V. Rylkin A.Y. Vlasova J.A.. Analysing the actions of traders made under the influence of psychological biases, emotions and other main factors.
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Behavioral Finance and Technical Analysis Chapter 9.
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved Market Efficiency Chapter 11.
1-1 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
1 1 Ch11&12 – MBA 566 Efficient Market Hypothesis vs. Behavioral Finance Market Efficiency Random walk versus market efficiency Versions of market efficiency.
Chapter 13 Investing in Mutual Funds Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.
Ashish Mali Josh Cavers Ian Herle Lindsey Polishuk
CHAPTER 19 Behavioral Finance. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Finance Traditional financial.
1 Chapter 10 Estimating Risk and Return McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Managing Portfolio for Individual Investors Jakub Karnowski, CFA Portfolio Management for Financial Advisers.
BEHAVIORAL FINANCE.
Investment and portfolio management MGT 531.  Lecture #29.
Portfolio Management Unit – III Session No. 23 Topic: Asset Allocation Unit – III Session No. 23 Topic: Asset Allocation.
Investing Fundamentals. Investing for the Future: Goal Setting Investment goals should be specific and measurable. Develop your goals by asking questions:
On Investor Behavior Objective Define and discuss the concept of rational behavior.
FIN 437 Vicentiu Covrig 1 Behavioral Finance Behavioral Finance (see chapters 1 and 4 from Shefrin)
The New Finance. CHAPTER ONE SEARCH FOR THE GRAIL.
CHAPTER 11 The Stock Market. Section 3: The Stock Market  Objectives:  Evaluate the benefits and risks of buying stock by comparing them to those of.
 Each group much choose a spokesperson.  Each student in the group much tell the spokesperson what she or he things the right responses are for the.
- Characteristics of Successful People Federal Reserve Bank of Philadelphia How to Really Be a Millionaire.
Chapter The Basic Tools of Finance 27. Present Value: Measuring the Time Value of Money Finance – Studies how people make decisions regarding Allocation.
Who Wants to Be A Millionaire?. Rules Each team needs speaker. Each person must give their opinion on each of the statements. If there is disagreement.
Chapter 11 Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons 11-1.
Chapter 15: Financial Markets Opener. Copyright © Pearson Education, Inc.Slide 2 Chapter 11, Opener Guiding Questions Section 3: The Stock Market –How.
Behavioural Finance Impact on financial markets and individual investors.
Investment Planning Chapter 11. Investing Placing money in some medium such as stocks, bonds or real estate in the expectation of receiving some future.
Investments: Analysis and Behavior
Personal Finance Asset Allocation
The Basic Tools of Finance
Behavioral Finance.
Investment Analysis and Portfolio Management
Finance For Normal People: How Investors and Markets Behave
The Basic Tools of Finance
Presentation transcript:

Investments: Analysis and Behavior Chapter 8- Psychology and the Stock Market ©2008 McGraw-Hill/Irwin

8-2 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.

8-3 Behavioral Finance Much in finance has evolved from the perspective that investors behave rationally and markets are efficient.  Asset pricing models, like CAPM  Option pricing  Portfolio Theory But what if people do not always act rationally in economic decisions?  Cognitive errors  Psychological biases  Emotions  2002 Nobel Price in Economics award to psychologist Daniel Kahneman and experimental economist Vernon Smith  Bad decisions

8-4 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? _____ _____ _____ _____

8-5 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

8-6 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!

8-7 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 2003, the DJIA was at 10,454. The DJIA is a price-weighted average. Dividends are omitted from the index. What would the DJIA average be at the end of 2003 if dividends were reinvested each year?

8-8 If dividends were reinvested in the DJIA, the average would have been 251,046 at the end of 2003! 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.

8-9 Try these examples! Which choice do you prefer? People prefer a lottery ticket over the expected value of that ticket—risk seeking behavior. People also prefer a small loss (small insurance premium) over a small probability of a large loss—risk averse behavior.

8-10 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:

8-11 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.

8-12 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, …

8-13 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?

8-14 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 well running car.  Good companies must be good investments.  Past returns represent what should be expected in the future  But a clean car doesn’t run well because it is clean, a good company can be overpriced, and stocks that went up in price often go down.

8-15 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

8-16 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

8-17 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.

8-18 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.  Obviously, many people are simply mistaken. People are mistaken because they are overconfident about their skill and knowledge. Misattribution bias - Attributing an unrelated feeling to the decision at hand.  Good moods lead to great risk taking and optimism  Bad moods lead to pessimism and less risk

8-19 Cognitive Dissonance The mental discord between the memory of an event that conflicts with a positive self-perception. What was your performance like?  Absolute  Relative to the general market

8-20 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

8-21 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

8-22 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.

8-23 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