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BU 493 Behavioural Finance

Textbook #1: Behavioural Finance, Psychology, Decision-Making, and Markets, Ackert & Deaves, South-Western Cengage Learning 2018 (available through the library’s DTA program)

Thinking Fast and Slow by Daniel Kahneman (2013)

Suggested additional reading: The Psychology of Money, Morgan Housel

Testable cases: Enronn (2), Seagram, Risk Profiling, Shattered Sears

Marshmallow study: children taking one marshmallow now or waiting five minutes to get two. Study flawed because it only focused on stanford kids (affluence) and wasn’t transferable when looking at kids who are less affluent. Ability to postpone gratification at an early age led to more successful life.

James Flynn effect: IQ scores been rising without known effect.

Chapter 1 Expected Utility Theory

We seek to maximize our consumption utility. Imperfect measurements. Tradeoff is cost ($ and time). Rational. Self-aware.

Prospect theory

  • people make decisions based on how they perceive trade-offs
    • perceive: humane element; emotional, rational, instincts
    • Question: what is the mind behind a collector
  • Loss aversion: fear losses more than gains
    • Gains have to significantly outweigh the losses to incentivize humans
    • Investments have to be marketed
  • Cognitive limitations
    • People making weird decisions because they are ignorant
  • Bounded Rationality
    • you don’t know what you don’t know
    • bounded to your knowledge and experience
    • often in the case of investments
    • not daily job
    • mortgage timelines

How do we personally evaluate risk, rewards, preferences, and utility. Bias: emotional and cognitive bias. Requires high self-regulation, self-reflection, and humility.

  • Emotional
    • want to moderate these
  • Cognitive
    • Bounded Rationality
    • Using Heuristics (everyone says so, commonly accepted)

Lamay got people to consume and move away from the buy once use forever mindset.

Cognitive Dissonance

  • Anything contrary to your belief is disregarded
  • Halo effect on someone

Decision Making Process

  • Consumer behaviour and investment behaviour is similar for people without training
  • need better frameworks
  • Pros vs Cons
  • Impulse, lack of time

Traditional finance

  • rational assumption: people still not doing things good for themselves
  • efficient at obtaining the right information: is the information really readily accessible and do they know it’s relevant
  • unbiased
  • Requires discreteness, indifference curves, transitivity
    • indifference curve optimally is the biggest slope tangent to the curve
  • Bayes Theorem
    • P(expected given I) =P(E) * P(I given E) / P(I)
      • bayes updates probability given new information
  • Rational Economic Man
    • Challenges: humans affected by many emotions

Behavioural finance

  • people are normal (may exhibit flaws)
  • people relying on others
    • tulips crisis
    • genetic mutations that were rare
  • challenges efficient market hypothesis
  • based on observed investor and market behaviour
  • macro (herd, society, bubble)
    • functional of policy, incentives (e.g. Soviet Union using tonnage of the shipped for compensation instead of quality)
    • worst examples used
  • micro

Attitude Towards Risk

  • Traditional: risk averse and curve is upward sloping and diminishing
  • Behavioural: risk evaluation is reference dependent. Risk seeking for some level of wealth (e.g. lottery)
  • double inflection: utility function
  • move from risk averse to risk seeking at different income levels

Neuroeconomics

  • neuroscience and brain imagery
  • psychology
  • economics
  • Emotiv company

Bounded Rationality

  • Herbert Simon
  • Good enough is what we aim for (satisfice)
  • We all use heuristics (to save time, hack the problem, but is complacency)
  • Time bounded rationality governing

Bernoulli

  • father of decision making
  • contradiction of systemic bias and expected value notion in 1738
  • proposed utility function → people want highest utility
  • bias towards value

About Biases

  • Most systematic errors are from biases
  • Emotional and cognitive biases

System 1

  • automatic
  • skillful system 1 through training, experience, and tacit knowledge
  • thinking takes a lot of effort, our brains conserve energy by relying on short cuts such as heuristics - can lead to biases (e.g. confirmation bias, anchoring, halo effect, priming, availability, sunk cost fallacy, loss aversion)

System 2

  • contemplative decision making
  • more holistic, somewhat self-aware
  • new, unfamiliar, complicated
  • can still be influenced by biases; e.g. bounded rationality pushing us to seek shortcuts

Certainty over Uncertainty

  • inconsistent risk taking choices
  • nature of uncertainty and situation can change risk seeking or averse behaviour

Prospect Theory

  • Different way to look at utility
  • Loss aversion (gain and loss not the same)
  • Framing of risks has an impact
  • miscalculation of risk to reward due to the framework used
  • framing
  • manipulation of people
  • common outcomes (bias)
  • Allais paradox
    • good loss aversion question: lose 100% change to lose $750 or 75% chance to lose $1000 and 25% change to lose nothing.
  • reference (expectations) changes behaviour
  • hedonic editing: framing losses and gains as differently

Ridging Finance Scandal

  • Limited partnership
  • Couple that worked for ridging finance
  • Create their own private lending firm
  • Securitized or funded the loan and sold it to Bay St.

Morbidity vs Mortality

Higher probability to be financially hurt from being disabled than family is from death. Therefore, probably best to purchase disability insurance instead of life insurance.

Endowment Effect

  • owning something gives it more value than not owning it
  • somewhat like sunk-cost fallacy
  • house money effect: putting away initial capital and gambling with the “wins”
  • mental accounting / portfolio layering

Week 3

Cognitive Error

  • Stat, info processing or memory errors
  • Faulty reasoning
  • Can be corrected through education
  • Dissonance - ignore new info
  • Conservatism
    • prior view
    • want to stick with what is known and not deal with the unknown
  • Confirmation Bias - info confirms beliefs
  • Representativeness
    • confidence that the results from a sample can be used to represent the entire population (for example, does a single quarter of loss mean that the company won’t be profitable in the future earnings?)
  • Illusion of control
    • belief that they are in control
    • gambling mentality - overtrading
    • risk seeking
  • Hindsight - past events predictable
    • selective perception and retention
    • “could have”
  • Anchoring & adjustment - heuristics
    • Initial Cost
  • Mental accounting - buckets
  • Framing - depends on presentation (questions)
  • Availability - heuristic, answer related to familiarity

Emotional Biases

  • Feeling or emotive
  • Spontaneous
  • Less easy to correct
  • “Blind spots” of mind
  • Regret aversion
    • The most powerful and common emotional bias
    • Make the wrong decision to avoid regretting missing out; FOMO?
  • status quo
  • endowment
  • self-control
    • weighing benefits
    • delay of gratification

Representativeness Bias

IPS and Asset Allocation

Investment policy statement: what do you want from the fund and what are the restrictions

  1. Types of biases demonstrated
  2. Biases that dominate (C or E)
  3. Impact on asset allocation
  4. What adjustments should be made

Standard of Living Risk

  • Pompian and Longo
  • high wealth (low SLR): Adapt to the client’s behavioural biases
  • low wealth (high SLR): Moderate the client’s behavioural biases

BBK Model

  • classification models
  • confident, impetuous, careful, anxious

The Adventurer: Investors who are confident as well as make impulsive decisions have been classified as the adventurer in the BBK model. These are the kinds of investors who will make very risky investments. They are often seen investing in the futures and options space with high amounts of leverage. Often, they put all of their money on one single bet based on the level of confidence they might have on that bet.

From the advisor’s point of view, such investors can be difficult to give advice to. This is because they have their own ideas about investing and are not afraid to test them in the marketplace.

The Celebrities: These investors are also known for making impulsive decisions. However, instead of being confident, they are known for being anxious. This is the worst combination of traits amongst the four quadrants! The celebrities are not confident. Hence, they do not have their own investment theories. This means that they are gullible and are often taken advantage of by middlemen who want them to trade excessively so that they can earn commissions in the process. As an ethical advisor, one may have to make emotional appeals to this type of investor since they often do not respond to rationality.

The Individualists: This category of investors is both confident as well as methodical. These types of investors have their own investment philosophy. They tend to know something about the market or at least make an attempt to learn before they invest their hard-earned money. Also, since they are very rational and analytical, they tend to come to the right conclusion. This is the best combination of traits in the four quadrants. Such investors are closest to the textbook rational investors. However, it needs to be noted that very few investors actually fall in this category. These are the best possible clients for an investment advisor since it is possible to make rational arguments and convince these investors. If it makes sense, then convincing these investors will be easy. If they are made aware of their behavioral biases, they are most likely to correct their course.

The Guardian: The guardians are anxious as well as careful at the same time. This category of investors generally comprises of old people who are nearing retirement. These people tend to be quite methodical when it comes to decision making. However, they are also quite anxious about the safety of the money that they invest.

Guardians are generally people who have a limited earning capability. Hence, they are more likely to preserve the assets that they have instead of taking risks. Guardians are generally not interested in volatile investments.

As an investment advisor, they can be difficult to advise since they are also partly driven by the emotion of fear. If these clients get a feeling that the advisor is overbearing, they are most likely to change the advisors as well.

The Straight Arrow: The four main quadrants are already described above. However, the BBK model has been extended to include a fifth category. This category is represented in the center, i.e., the interaction of the two axes. They are called the straight arrows. This is where a lot of investors tend to fall. These investors are known to have a composite of all the four traits and hence are known to be fairly balanced. Oftentimes, they are called the average investor since most investors a person comes across are likely to fall in this category.

Week 4

Rolling a Dice

If you get money of the face number you roll of the dice, and you need to pay $3.25, would you do it? If you can re-roll, when do you?

Mood and Risk Attitude

  • studies suggest happier people more optimistic and higher probabilities to positive events

Disposition Effect

Tendency to hold losers and sell winners.

Prior Gains and Losses, and RIsk Aversion

  • If we don’t crystalize a loss, we aren’t a loser
  • losing a movie ticket vs the money to buy the movie ticket

House Money Effect

  • Successful investment
  • Bad investments can caus distress
  • If you win at Blackjack and are up $200, do you play more or less aggressively

Conflicting Effects

Week 5

Regulatory Bodies

10 Provinces, 3 Territories. 13 Securities Bodies with their own laws. They form the national IIROC. Investment Industry Regulatory Body. IIROC creates bylaws where membership is voluntary but mandatory for investment advisors. Canadian Securities Administrators: powerless country club and spokesperson for what the regulators have said.

Regulators simply do not want to see a risk profiler because they don’t audit and comment on it.

RIsk Taking

Ability to take Risk versus WIllingness to take risk.

Investment Policy Statement

  1. Liquidity
  2. Time horizon
  3. Tax
  4. Legal/regulatory
  5. Unique circumstances

An organization like the Ontario pension plan chooses the asset mix by voting on it. Either by voting directly, or through a board.

Strategic Asset Allocation

Richard Thaler

  • Auto-enroll people into pensions
  • Make it super easy to opt-out, the more sticky auto-enrollment is
  • Choice architecture: choosing things

Self-Control

  • People’s best interests are on short-term needs
  • People can opt out
  • This can lead to making mistakes since it requires more self-control
  • A policy like sterilization for money might be wrong because poor people cannot properly think about the situation properly even if the policy was not directed at poor people but for anyone
  • Therefore, maybe have a policy of sterilization if the person already has no more than one child or they are 30 years old already

We need to do more

  • default saving rate of 3% is too low
  • automatic escalation

Corporate Governance

  • Institutional shareholders own over 50% of voting shares of US companies. In Canada it’s less than 40%
  • CEO is board chair in 60% of US companies compared to less than 35% of Canadian companies
  • 26% of Canadian companies are controlled by a single shareholder or group who exercise and influence the control of the company
  • Only 12% of Fortune 500 companies have a shareholder [group] with voting control

Committees

  • Mandated committee: audit
  • Compensation committee
  • Selection committee

Seagram

  • selling alcohol during prohibition
  • kept a lot of alcohol to sell at higher prices once legalized?
  • took 25% stake in Dupont
  • lost billions trying to make movies

Two Important Lessons

  • Are extreme valuations warranted by a new economy?
  • Loyalty can be misplaced in an organization and people are cautioned to keep a separate identity

Mind Over Money - Jessica Biasin

What is anti-social? Don’t listen or aligned with norms of society. Deviants?

Psychology and Sociology

Psychology; mind and behaviour, used for treating dysfunction.

Sociology: origin, development, organization ,and functioning of society. Analysis of various relationships.

Antisocial Traits

  • Impulsivity
  • Deceitfulness
  • Recklessness
  • Sensation-seeking

Affects .6% and 3.6% of adults, three times more common in men than women. Unsure what the same size for the self-reported study is.

Causes of Antisocial Behaviour

  • family history
  • childhood conduct disorder
  • low serotonin levels
    • contributes to level of happiness
  • low arousal levels???
  • low anxiety levels
  • moral development deficits
  • and more

Interventions

  1. Talk Therapy
  2. individual cognitive behavioural therapy
  3. group based CBT
  4. Contingency Management
  5. Multi-Agency Care

Q&A