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Behavior Short

Behavioral finance deals with how psychology influences financial markets and the behavior of investors, as human nature can lead to costly mistakes. The field recognizes that investors are overconfident and make cognitive errors, and some research suggests these psychological factors could systematically affect asset prices, though most economists remain skeptical that irrationality moves markets in the long run.

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42 views

Behavior Short

Behavioral finance deals with how psychology influences financial markets and the behavior of investors, as human nature can lead to costly mistakes. The field recognizes that investors are overconfident and make cognitive errors, and some research suggests these psychological factors could systematically affect asset prices, though most economists remain skeptical that irrationality moves markets in the long run.

Uploaded by

03217925346
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Behavioral Finance Behavioral Finance

The Psychology of Finance


Behavioral Finance deals with the influence of psychology on various aspects of financial markets, including the behavior of individual and institutional investors. Because of human nature, people make particular types of mistakes. Mistakes can be costly.

Objectives for Investors


Questionnaire

Recognize your own mistakes and others Understand the reasons for mistakes Avoid mistakes

2. Imagine that you face the following choice. You can accept a guaranteed $1,500 or play a lottery. The outcome of the lottery is determined by the toss of a fair coin. If heads come up, you win $1,050. If tails come up, you win $1,950. Would you accept the guaranteed $1,500 or play the lottery?

Questionnaire

Questionnaire

9. Imagine that you have just won $1,500 in one lottery, and have an opportunity to participate in a second lottery. The outcome of the lottery is determined by the toss of a fair coin. If heads come up, you win $450 in the second lottery. If tails comes up, you lose $450. Would you choose to participate in the second lottery? Yes or no?

5. Which one do you choose? A) Accepting a sure loss of $5,000, or B) taking a chance where there is a 50% chance you will lose $10,000 and a 50% chance that you will lose nothing. A) or B)?

Question #12

Disposition Effect

8. You bought two stocks X and Y last month, at the same price of $50 per share. Obviously you expected both stocks to go up in price. Since last month, the price of X has gone up to $60 and the price of Y has dropped to $40. So you have made $10 per share on X and lost $10 per share on Y. Now you need money to pay for your rent. Assuming you have to sell one of the two stocks. Which one do you sell? A: Definitely X. B. Definitely Y. C: Probably X. D. Probably Y.

People tend to sell their winners too quickly and hold on their losers for too long. Paper loss Tax implications

Questionnaire

Questionnaire
First decision: Choose A: a sure gain of $2,400, or B: a 75% chance to gain nothing and a 25% chance to gain $10,000. Second decision: Choose C: a sure loss of $7,500, or D: a 75% chance to lose $10,000 and a 25% chance to lose nothing.

7. Imagine that you face the following pair of concurrent decisions. First examine both sets of choices, then indicate the option you prefer for each.

Questionnaire

Questionnaire

6. Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which is more likely? A) Linda is a bank teller; B) Linda is a bank teller and is active in the feminist movement.

3. In a magic shop you find a coin that you know is biased, but you dont know whether it is biased towards heads or towards tails. If it is biased towards heads then it will, on average, come up heads on 2/3rds of all flips; if it is biased towards tails it will, on average, come up tails on 2/3rds of all flips.

Questionnaire

Bayes Theorem
Pr ( A B ) = Pr ( A) Pr ( B A) + Pr ( not A ) Pr ( B not A) Pr ( A ) Pr ( B A )

Consider two cases: Case A: You flip the coin 10 times. It comes up heads on 8 flips and comes up tails on 2 flips. Case B: You flip the coin 100 times. It comes up heads on 54 flips and comes up tails on 46 flips. In which case is it more likely that the coin is biased towards heads? A or B?

In fact, the probability that the first coin is biased is 0.9846 and the probability that the second coin is biased is 0.9961. B is more likely biased.

Questionnaire

Questionnaire

1. Compared to other students in the class how good of a driver do you consider yourself? (Of course you dont know the driving habits of many of your fellow students, use your best judgment in ranking yourself.)

I am probably in the top 10%. I am probably in the top 25% but not the top 10%. I am probably in the top half but not the top 25%. I am probably in the bottom half but not the bottom 25%. I am probably in the bottom 25% but not the bottom 10%. I am probably in the bottom 10%.

Response

There are 70 response. We should have (roughly): 7 in top 10% 10 in top 25% but not top 10% 18 in top 50% but not top 25% 35 in the bottom half

Heavier-than-air flying machines are impossible. Lord Kelvin British mathematician, physicist, and president of the British Royal Society, c. 1895

A severe depression like that of 1920-21 is outside the range of probability. Harvard Economic SocietyWeekly Letter, November 16, 1929.

To know that we know what we know, and that we do not know what we do not know, that is true knowledge. Confucius

Overconfidence
More data leads to greater overconfidence. (Oskamp and Slovic et. al.).

People take too much credit for their own successes. This leads investors to become overconfidence. Dont confuse brains with a bull market. Overconfidence leads to excessive trading

Data from Discount Brokerage


Trading is Hazardous to Your Wealth


Barber and Odean, 2000, Journal of Finance
25

78,000 Households/158,034 Accounts End-of-Month Position Statements (1-91 to 12-96) Trades (1-1-91 to 11-30-96) Demographic Information

Monthly Turnover and Annual Performance of Individual Investors


Net Return Turnover

Percent Annual Return Monthly Turnover

20

15

10

1 (Low Turnover)

5 (High Turnover)

Boys will be Boys


"Overall, men claim more ability than do women, but this difference emerges most strongly on masculine task[s]. Deaux and Ferris (1977)

Men are more overconfident than women. Men trade more than women. Men lower their returns more than do women.

Percent Annual Turnover


90 80 70 60 50 40 30 20 10 0 All Wom en All Men Single Wom en Single Men

Own Benchmark Annual Net Returns


0

All All Men W omen


-1

Single W omen

Single Men

-2

-3

Does Psychology Affect Prices?


Does Psychology Affect Prices?


The intrinsic value of any financial asset is the present value of the expected future cash flows. Prices are determined by fundamentals Conventional wisdom among academics two decades ago was that behavioral factors play no role in determining asset prices.

We tend to believe that, even if some people do goofy things, there will be rational others waiting to take advantage of their mistakes. Example: Overpriced internet stocks In the long run, price reflects fundamental value The rational will tend to survive and dominate, and will be the ones to drive market outcomes.

Does Psychology Affect Prices?


Does Psychology Affect Prices?


Some behavioral finance proponents propose that irrational behavior can affect market outcomes, such as stock prices. More and more academics are open to the possibility that behavioral factors affect prices. Most economists, including the financial economists are skeptical about this view.

If psychological bias is unsystematic, it will not affect prices. Half the time the irrational were too high the other half too low, so this cancels out and is perceived as noise. If bias is systematic, there is potential for them to affect asset prices

Limits to Arbitrage

Transactions costs Limited capital Noise trader risk Fundamental risk Horizon

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