Investment Beahvioral Finance

People prefer the familiar to the unfamiliar.

An investment manager with deeper knowledge and experiences in bonds prefers the certainty of bond cash flows to the uncertainty of risk asset cash flows, even though investors might receive appropriately higher returns for assuming that risk.

People give more weight to evidence that (1) supports their beliefs and (2) ignore or modify evidence that conflicts with their beliefs.

“Human Ratio” behind it:

• faulty reasoning - easily corrected
• feelings - harder to correct

People classify new information based on past experiences and classifications. Judgements based on stereotypes.

• People tend to overestimate the representativeness of single observations and small samples

• May result in overreaction and correction anomalies, e.g. reversal in prices

• People judge by similarity to familiar types, without regard to base rate probabilities.

• Tendency to see patterns in what is really random walk
  – TechnicalAnalysis,e.g.randompatternsareusedforforecasting

People tend to believe that they can control or influence outcomes when, in fact, they can not.

Believe in technical analysis and trading signals or patterns.

People may see past events as having been predictable and reasonable to expect.

- Very similar to illusion of control bias.

Errors in information processing leads to: 

• misestimate of probabilities of

− Probable events.
− The probability of events. 

− Future risks and returns.

When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial default number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis. People place undue weight on the anchor.

Note: The “anchor” still works even if it’s not related to the actual problem at all!

People treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to.

Examples:

• Treatment of real estates
• Handling of wins on the stock market: “lets take more bets – is funny money anyway ...”
• Spending money you won in a lottery or you had to earn.

Framing bias occurs when people make a decision based on the way the information is presented

Framing for Minimal
People consider only differences between local options. Example: Gaining $5, disregarding common features.

Comprehensive Framing
People consider something in relation to one other. Example: A customer might include both camera and calculator in relation to something else, for instance total monthly expenses

Topical Framing

People considers the context in which the decision arises. Example: The process of reducing the price of the calculator from $15 to $10. People usually frame decisions in terms of topical accounts.

Example: The savings on the calculators are considered relative to their prices in each option

According to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news.

People base decisions on available information and resonation information, which they weight.

Those information can have several sources: It can be caused by retrievability, categorization, a narrow range of experiences, and resonance.

People take a heuristic (mental shortcut) approach to estimating the probability of an outcome. Sometimes they measure it based on how easily the outcome comes to their mind.

• People tend to weight too much recent experience compared to prior beliefs – so called memory bias (also: exponential weighting in time series analysis).

• Analysts tend to excessively extrapolate historical trends when forecasting future earnings/cash flows - extrapolation bias.

Skinner Example:
B. F. Skinner 1948, fed hungry pigeons mechanically at 15-second intervals.

Pigeons developed superstitions

Peoples reactions to stock market events follow also patterns. These responses have similar origins.

• People bet more on coin not yet tossed.

• People pay more for lottery ticket in which they choose the

  number

• ... a bit like Illusion of Control Bias

Example 1: Playing with a tennis elbow in a tennis club, in spite of pain. This maintains the evaluation of the membership fee as a cost rather than a sunk loss.

Example 2: Continuing a project that has already cost a lot without any results, rather than starting a new one, although the previous costs are sunk costs.

Example 3:

People tend to eat bad-tasting food just because they have already paid for.

Framing negative outcomes as costs rather than as a loss improves subjective feelings

People prefer avoiding losses as opposed to achieving gains.

Example:

Too late execution of stop loss order.
Feeling of pain, when loosing – “if you are in trouble double”

People demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities.

This high level of confidence - overconfidence may result in overestimating knowledge levels, abilities, and access to information or e.g. underestimating forecast errors.

• Some people exhibit overconfidence in their ability to pick stocks or

• have an exaggerated belief that they will not be hurt by risk. As a result, they are willing to pay a too high price for a certain stock, in which they belief.

People fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline.

People tend to have an inherent conflict between short-term satisfaction and achievement of some long-term goals:

- Choice between

• Going to a party or

• hard studying.

Short-term goals often “win” because they promise instant gratification!

– In economics, time preference (or time discounting, delay discounting, temporal discounting) is the current relative valuation placed on receiving a good at an earlier date compared with receiving it at a later date. => explains interest rates!

People do nothing instead of making a change - Do-nothing strategy.

Example: Given no apparent problem requiring a decision, the status quo is maintained. This could result from a lack of knowledge or simply laziness.

People tend to make an initial asset allocation and then do nothing. Even when the portfolio risk and return characteristics are changing people tend to stick to their previous decisions. Thereby they might miss potentially return-enhancing opportunities.

How frequently are investment portfolios reviewed?

Perceiving the cognitive cost too high, participants might not evaluate their changing personal circumstances or the even different funds in the plan.

• People value an asset more when they already have in their portfolio.

• Thereby people tend to loose their objectivity.

• It is more painful to give up an asset than it is pleasurable to buy it.

People sometimes avoid making decisions because they fear that the decision will turn out poorly.

Remember “Status Quo Bias”

Simply put, people try to avoid the pain of regret associated with (probably) bad decisions.

Investment decisions that resulted in a loss might stop the involved investors from making similar decisions, even if the new investment appears to be the best alternative.

• –  relates to framing and regret aversion.

• –  People tend to divide their assets equally among all available alternatives.

• –  Knowing generally that they should diversify their portfolios but unsure of exactly how to go about doing that, people tend to invest equal amounts in different investment opportunities disregarding the relevant return-risk profiles.

An individual erroneously believes that the onset of a certain random event is less likely to happen (again) following an event or a series of events.

Think of roulette, where 5 times Red occurred an people start betting on Black.

That could be incorrect because past events do not necessarily change the probability that certain events will occur in the future.

Herd behaviour describes how people act together in a herd / group like animals.

Especially in times of crises and extreme fear this strategy has proven to be a viable strategy for surviving.

People have to be aware of this tendency of their behaviour.

Remember: “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Sharpe ratio depicts the risk premium of an asset or portfolio in relation to the total risk

Treynor ratio depicts the risk premium in relation to the systematic risk Beta

utility is increasing with wealth at a decreasing rate:

u’(x) > 0 Mehr Reichtum mehr Nutzen

u’’(x) < 0 Nutzenwahrnehmung nimmt mit zunehmendem Gewinn ab

Variance refers to the spread of a data set around its mean value, and so it measures the risk of an asset/portfolio. 

Covariance refers to the measure of the directional relationship between two random variables.

A positive covariance means both investments' returns tend to move upward or downward in value at the same time. An inverse or negative covariance, on the other hand, means the returns will move away from each other.

covariance talks about the direction – positive or negative – of the relationship between two variables.

correlation talks about the direction, as well as, the strength of the relationship between the variables.