Experience Schulich 2010 Mini-lecture: Finance

S As Far as Investors were concerned… the last decade was a miss!

S&P 500 Return (%) The Lost Decade -24.1%

Twin Peaks

Bubbles Traditional belief: Financial Markets are efficient, in that they reflect all available information correctly and quickly. - Is there an alternative view about the markets?

Behavioural Finance Relatively new school of thought A marriage of psychology and finance It says psychology plays a role in financial decision making Cognitive errors and biases affect investment beliefs, and hence financial choices Challenges the traditional idea that financial markets are always efficient

Why Should We Care? To better understand our own investment behaviour, and that of others Set the right incentives for clients, pension plan design, financial product design CIBC Imperial Service: Investor Psychology 101 To better understand asset management companies that base their investment philosophy on behavioural finance. Examples: The Behavioural Finance group at JPMorgan Asset Management manages $10 billion LSV Asset Management manages $56 billion

Common Behavioural Biases Overconfidence Loss aversion Narrow framing Representativeness Regret avoidance Ambiguity aversion Mental accounting Anchoring

Overconfidence Better than average – “ I am a better than average driver.” – 95% of British drivers believe they are better than average (Sutherland 1992) Illusion of control – “I am unlikely to be involved in a car accident.”

Overconfidence As applied to investments, overconfidence may lead to excessive trading – “Trading is hazardous to your wealth” by Barber and Odean (2000a) – Find that portfolio turnover is a good predictor of poor performance: Investors who traded the most had the lowest returns net of transaction costs

Barber and Odean (2000a) Barber and Odean (2000b): Result mostly confined to one particular gender…

Why Don’t They Learn? Similar results in other studies: Overconfident traders contribute less to desk profits (Fenton- O’Creevy et al. 2007) Why don’t overconfident investors learn from their mistakes? – Self-attribution bias – Attribute successes to their own ability – Blame failures on bad luck

Gain Loss Pleasure Pain +10% -10% Small Pleasure Big Pain Loss Aversion Prospect Theory

Narrow Framing Loss aversion may be a consequence of narrow framing Narrow frame of evaluation – Limited set of metrics in evaluating investments – Obsessive about price changes in a particular stock – Myopic behavior even though investment is long-term – Can lead to over-estimation of risk

Narrow Framing / Loss Aversion Consequence – “Disposition effect”: Tendency to sell winners too soon, and hang on to losers for too long (Shefrin and Statman, 1985, Odean 1998)) – Affects design of financial products If investor cares more about loss, rather than risk, then products that limit downside risk is more attractive than products that have low volatility Another rationale for asset-liability management (ALM), rather than asset-only management

Myopic Loss Aversion Example: Currency hedging – Influenced by recent events or stick with long-term view?

Representativeness Making decisions based on recent history, or a small sample size Believe that it is representative of the future, or the full sample May lead to “excessive extrapolation” – Erroneously think that recent performance is representative of longer term prospects

Representativeness Results: Investors chase past winners – Overreacts to glamour stocks (e.g., technology bubble) – Overreacts to bad news which may be temporary (thus creating “value opportunities”) – Creates short-term momentum, but long-term reversal in returns

Regret Avoidance Leads to procrastination and inertia – Status quo bias – Good intentions but poor follow-through Consequences: – Delayed saving and investment choices – Limit divergence from peers’ average asset allocation, if sensitive to peer comparison  herding behaviour of asset managers

Ambiguity Aversion Sticking with the familiar – Results in under-diversification – Investors may exhibit home bias, local bias – Bias is more substantial if take into account human capital From a diversification point of view, DC plans should restrict company share ownership

Mental Accounting Tendency to divide total wealth into separate accounts and buckets – Ignores correlation between assets across portfolio – May result in tax-inefficient allocations Naïve diversification in DC pension plans (Benartzi and Thaler 2001) – 1/n is found to be the predominant rule – Authors find that “the proportion invested in stocks depends strongly on the proportion of stock funds in the plan” – Plan sponsor’s menu of options and choices very important

Impact on Committee Decision Making Lack of diversity in membership could pose a problem – Common knowledge syndrome Less willing to share unique or different information for the sake of social cohesion – It takes 16 similarly-minded committee members to generate the diversity of 4 different-minded members

Lessons on Investing Do not extrapolate the past too far into the future Do not wrongly equate a good company with a good investment irrespective of price Do not develop a "mindset" about a company Take a “total portfolio” view

Final Note Some empirical findings are more respected in the profession than others Stock market returns affected by number of hours of sunshine, seasonal changes …etc. – Point of disagreement

Questions?