1. Ashish Mali Josh Cavers Ian Herle Lindsey Polishuk
Behavioral Finance
Ashish Mali
Josh Cavers
Ian Herle
Lindsey Polishuk

2. Standard and Behavioral Finance Biases Rational Choice QUIZ
AGENDA
Standard and Behavioral Finance
Biases
Rational Choice
QUIZ

3. Standard Finance Investors are rational Markets are efficient
Investors should design their portfolios according to the rules of Mean-Variance portfolio theory
Expected returns are a function of risk and risk alone

4. What is behavioral finance?
Describes the behavior of investors and managers; it describes outcomes of interactions between investors and managers in financial and capital markets
Doesn’t follow four parts of standard finance

5. Behavioral finance Investors are not rational, they are normal
Markets are not efficient
Investors design portfolios according to the rules of Behavioral Portfolio Theory
Expected returns are determined by more than risk. “Behavioral Asset Pricing Theory”

6. Normal? Cognitive biases and emotions come into play
E.g. not realizing loses because it brings pain and regret
“I’ll kick myself if I sell for $1 those dotcom shares I bought for $100. maybe I should wait to see if the stock recovers.”

7. Market Efficiency Stocks are always equal to its intrinsic value
You can not “beat the market”
Much evidence that stock prices regularly deviate from price
E.g. crash in 1987

8. Behavioral Portfolio Theory
People build portfolios like layered pyramids
Each layer represents a specific goal
Your risk aversion depends on the specific goal

9. Behavioral Asset Pricing Theory
Stocks with desirable characteristics have lower expected returns
Market capitalization and price to book ratio are added to beta to get expected returns
Social responsibility?

10. Cognitive Biases Identify biases affecting investors
Consultants duty to educate investors
Scientific knowledge is key

11. Availability Bias Weigh decisions on recent information Stock market
Lottery winners
Stock market
Winners vs. losers
Retain perspective
Long-term focus

12. Winners vs. Losers

13. Anchoring Bias Attach to a reference point Stock market
Relevance
New & novel concepts
Stock market
Short-term volatility
Company fundamentals
Use an array of perspectives

14. Confirmation Bias Preconceived opinion Hot stock tip
Emphasize favorable information
Hot stock tip
Seek information to prove true
Avoid red flags
Look for a sober opinion

15. Hindsight Bias The outcome was predictable Causes overconfidence
Resulting incorrect oversimplifications
The .com bubble
Causes overconfidence

16. Overconfidence Fund managers & individuals Overconfident manager
More trades and lower yields
Confident manager
Less trades and higher yields
Ongoing battle to beat the market
Investment techniques require constant refinement

17. Mental Accounting Investors separate money Paying debt vs. savings
Subjective criteria
Creates different functions for asset groups
Paying debt vs. savings
Varying values associated with assets
Money is fungible

18. Rational Choice & Framing of Decision
Decision Theory
Perception of Situation
Normative Rules

19. Invariance 1): a sure gain of $240
Imagine that you face the following pair of concurrent decisions
1):
a sure gain of $240
25% chance to gain $1000 & 75% chance to gain nothing
2):
a sure loss of $750
75% chance to lose $1000 and 25% chance to lose nothing

20. Framing Outcomes
1) Assume yourself richer by $300 than you are today. You have to choose between:
a sure gain of $100
50% chance to gain $200 and 50% chance to gain nothing
2) $500 richer than today
a sure loss of $100
50% chance to lose nothing and 50% to lose $200

21. Rational Choice
Assumptions in economics occur when certainty in market is present

22. What Money Type Are You?
Our decisions about money are often driven by psychological factors over which we have little conscious control
Personality tests help to recognize which errors are commonly made – and to use this knowledge to prevent them
So, which type are you?

23. Mostly A’s You’re an Artisan Advice from the experts
Good instincts will prevail
You are a “trust your gut” kind of person, who enjoys the thrill of investing
Very comfortable at taking risks
Tend to lack interest in long-term planning and discipline
Advice from the experts
Use your confidence
But don’t indulge every whim

24. Mostly B’s You’re an Idealist Advice from the experts
Money just isn’t the top priority
More concerned with assisting others and improving society rather than building personal wealth
Your lack of interest in money matters can be a failure to reach any financial goals - that is, if you have set any
Advice from the experts
Put your investing on autopilot
Have your cause and money too

25. Mostly C’s You’re a Guardian Advice from the experts
Discipline is key to security
Greater emphasis is on financial security
You are disciplined, patient, organized, and cautious
Prefer fixed-income investments to relatively volatile equities
Advice from the experts
Deploy your discipline
Conquer your timidity

26. Mostly D’s You’re a Rational Advice from the experts
Cool reason conquers all
You enjoy problem solving, fact finding, and have an interest in science and technology
You tend to stay calm in tense situations
Advice from the experts
Feed your taste for systematic thinking
Remember: The market isn’t always rational

27. QUESTIONS ?