Pauline Shum Schulich School of Business York University Behavioral Finance Pauline Shum Schulich School of Business York University

Agenda What is behavioral finance? Behavioral biases and their implications for investment beliefs and decision making

1. What is behavioral finance? Relatively new school of thought Gradually recognized as a legitimate field in finance in the 1990s A marriage of psychology and finance It says psychology plays a role in financial decision making Is it a surprise that we are human?

1. What is behavioral finance? Cognitive errors and biases affect investment beliefs, and hence financial choices Poses a challenge to the traditional idea that markets are always efficient

1. What is behavioral finance? Why should we care? To better understand our own investment behavior, and that of others  set the right incentives for clients, pension plan design To better understand asset management companies and active strategies that base their investment philosophy on behavioral finance Even retail banking is talking to customers about it (e.g., CIBC Imperial Service: Investor Psychology 101)

2. Behavioral biases Summary of well-known cognitive errors and biases, and their impact on investment beliefs and decision making

Overconfidence Better than average: Illusion of control “I’m a better than average driver.” Illusion of control “I won’t have a car accident.”

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

Why don’t they learn? Why don’t overconfident investors learn from their mistakes? Self-attribution bias Attribute successes to their own ability Blame failures on bad luck

Loss aversion Pleasure Small pleasure -10% Loss Gain +10% Big pain

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

Narrow framing/loss aversion Consequence: Tendency to sell winners too soon, and hang on to losers for too long E.g., Nortel “If I haven’t realized the loss, then it isn’t yet a loss.”

Myopic loss aversion Example: Currency hedging Influenced by recent events or stick with long-term view? Combination of loss aversion and representativeness

Representativeness Making decisions based on recent history, or a small sample size Believe that it is representative of the future, or the full sample

Representativeness May lead to “excessive extrapolation” Erroneously think that recent performance is representative of longer term prospects 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

Representativeness Let’s look at performance of portfolio managers Quartile 1998-2001 2002-2005 1998-2001 2002-2005 1 55 21 21 55 2 11 12 12 3 9 10 4 14 Based on a sample of 220 U.S. equity managers (Wood, 2006)

Representativeness Another example of excessive extrapolation: Sample size Erroneously think that a small sample size is representative of the population E.g. opinion of a car vs. investing in the car company

Regret Avoidance Leads to procrastination and inertia Status quo bias Good intentions but poor follow-through Results in delayed saving and investment choices Defined Contribution Plans: A significant number of accounts are kept in their default allocation for a long time

Ambiguity aversion Sticking with the familiar Results in under-diversification Home bias, local bias Bias is more substantial if take into account human capital

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

Final Note Some empirical findings are more respected in the profession than others More controversial studies: Stock market returns affected by number of hours of sunshine, seasonal changes …etc. More and more asset management companies are using the “behavioral finance” buzz word (mostly value strategies)

Final Note Can the two schools of thought co-exist? How I like to think about it: Short-term: markets can be inefficient due to investor behaviour Long term, markets are efficient (on average)