CHAPTER 19 Behavioral Finance

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Behavioral Finance Traditional financial theory assumes investors are _________; it ignores some aspects of personal behavior Behavioral finance identifies various human behaviors and examines their implications for investment decisions

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Study Behavioral Finance? Goals: ◦Avoid common ______________ ◦Profit from mistakes of others

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Common Investing Mistakes Two mistakes that many investors make are: ◦Sell winners too ___________ ◦Keep losers too ___________

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Common Investing Mistakes Peter Lynch: “selling the winning investments and keeping the losers is like pulling up all the flowers in the garden and watering the weeds.”

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Endowment Effect: The value you place on an asset is affected by ownership. Often you will not sell an asset for a price that is more than you would have paid for it.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Status Quo Bias: ◦People have a bias for the status quo and are unwilling to recognize __________________ or to realize ________________.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Loss Aversion: ◦The pain of losing is approximately 2X as acute as the joy of winning.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Pain of Regret: ◦In general, investors don’t admit to themselves that losses are real until the asset is _____________ at a loss.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior For many investors, the size of a gain is not as important psychologically as realizing the gain, reinforcing the notion that you are a successful investor.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Conversely, the size of a loss is not as important psychologically as the pain of admitting a mistake.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Status quo bias, loss aversion and the pain of regret are all related and contribute to the tendency to keep losers too long.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Solution: you can avoid keeping losers too long by placing _____________________ orders to sell your stocks; adjust the sell price over time.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Bidding and the Winner’s Curse: ◦Auctions are won by the person with the most optimistic view, not the person with the most realistic view. ◦Knowing this should cause bidders to “shade” their bids, however this does not appear to happen.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior Mental Accounts: People engage in mental accounting by allocating a maximum dollar limit to various activities. This can result in some apparently silly behavior (preferring dividend paying stocks, even though the after-tax return is lower) but can also be a way to manage risk.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior In forming expectations, people overweight recent experience, and disregard other relevant experience. This can result in: ◦__________________ in securities markets ◦Speculative boom & bust cycles

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior People vastly overestimate the likelihood of things that are highly improbable and dismiss things that are very likely. They also focus on relatively trivial risks and ignore critically important risks.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Individual Behavior People use extremely high discount rates in making decisions ◦50% annual rate in evaluating energy efficient appliances ◦50% weekly discount rate in skipping a morning class to cram for an afternoon exam