Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 7–Behavioural Finance & the Psychology of Investing–Nov 1
Chapter 9 Outline
Introduction to Behavioural Finance.
Sentimentbased risk and limits to arbitrage.
Behavioural Finance, Introduction
Sooner or later, you are going to make an investment decision that winds up costing you a
lot of money.
Why is this going to happen?
o You made a sound decision, but you are ‘unlucky’.
o You made a bad decision – one that could have been avoided.
The beginning of investment wisdom:
o Learn to recognize circumstances leading to poor decisions.
o Then, you will reduce the damage from investment blunders.
Behavioural Finance, Definition
Behavioural finance – The area of research that attempts to understand and explain how
reasoning errors influence investor decisions and market prices.
Much of behavioural finance research stems from the research in the area of cognitive
o Cognitive psychology – The study of how people (including investors) think,
reason, and make decisions.
o Reasoning errors are often called cognitive errors.
Some people believe that cognitive (reasoning) errors made by investors will cause
Economic Conditions that Lead to Market Efficiency
Independent deviations from rationality. Arbitrage
For a market to be inefficient, all three conditions must be absent. That is,
o It must be that many, many investors make irrational investment decisions, and
o The collective irrationality of these investors leads to an overly optimistic or
pessimistic market situation, and
o This situation cannot be corrected via arbitrage by rational, wellcapitalized
Whether these conditions can all be absent is the subject of a raging debate among
financial market researchers.
Prospect theory provides an alternative to classical, rational economic decisionmaking.
The foundation of prospect theory: investors are much more distressed by prospective
losses than they are happy about prospective gains.
o Researchers have found that a typical investor considers the pain of a $1 loss to be
about twice as great as the pleasure received from the gain of $1.
o Also, researchers have found that investors respond in different ways to identical
o The difference depends on whether the situation is presented in terms of losses or
in terms of gains.
Investor Behaviour Consistent with Prospect Theory Predictions
There are three major judgement errors consistent with the predictions of prospect theory.
o Frame dependence.
o Mental accounting.
o The house money effect.
There are other judgment errors that are also consistent with the predictions of prospect
If an investment problem is presented in two different (but really equivalent) ways,
investors often make inconsistent choices.
That is, how a problem is described, or framed, seems to matter to people.
Some people believe that frames are transparent. Are they?
Mental Accounting and Loss Aversion
Mental accounting – Associating a stock with its purchase price. If you are engaging in mental accounting:
o You find it is difficult to sell a stock at a price lower than your purchase price.
o If you sell a stock at a loss:
It may be hard for you to think that purchasing the stock in the first place
You may feel this way even if the decision to buy was actually a very good
o A further complication of mental accounting is loss aversion.
Loss Aversion – A reluctance to sell investments after they have fallen in value. Also
known as the ‘breakeven’ effect or ‘disposition’ effect.
If you suffer from Loss Aversion, you will think that if you can just somehow ‘get even’
you will be able to sell the stock.
If you suffer from Loss Aversion, it is sometimes said that you have ‘getevenitis’.
The House Money Effect
Las Vegas casinos have found that gamblers are far more likely to take big risks with
money that they have won from the casino (i.e. ‘house money’).
Also, casinos have found that gamblers are not as upset about losing house money as they
are about losing their own gambling money.
It may seem natural for you to separate your money into two buckets:
o Your very precious money earned through hard work, sweat, and sacrifice.
o Your less precious windfall money (i.e. house money).
But, this separation is plainly irrational.
o Any dollar you have buys the same amount of goods and services.
o The buying power is the same for ‘your money’ and for your ‘house money’.
Whether you lose money from your original investment or lose money from your
investment gains is irrelevant.
There are two important investment lessons here:
o Lesson 1 – There are no ‘paper profits’. Your profits are yours.
o Lesson 2 – All your money is your money. You should not separate your money
into bundles labeled ‘my money’ and ‘house money’.
A serious error in judgement you can make as an investor is to be overconfident.
Overconfidence and Portfolio Diversification
Investors tend to invest too heavily in shares of the company for which they work. This loyalty can be very bad financially.
o Your earning power (income) also depends on this company.
o Your retirement nestegg also depends on this company.
Another example of the lack of diversification is investing too heavily in the stocks for
which they grow.
o Perhaps you know someone personally who works there.
o Perhaps you read about them in your local paper.
o Basically, you are unduly confident that you have a high degree of knowledge
about local companies.
Overconfidence and Trading Frequency
If you are overconfident about your investment skill, it is likely that you will trade too
Researchers have found that investors who make relatively more trades have lower
returns than investors who trade less frequently.
Researchers have found that the average household earned an annual return of 16.4%.
Researchers have found that households that traded the most earned an annual return of
The moral is clear – Excessive trading is hazardous to your wealth.
Is Overtrading a ‘Guy Thing’?
Psychologists have found that men are more overconfident than women in the area of
o Do men trade more often than women?
o Do portfolios of men underperform the portfolios of women?
Researchers show that the answer to both questions is yes.
Men trade about 50% more than women.
Researchers show that both men and women reduce their portfolio returns, when they
o The portfolio return for men is 94 basis points lower than portfolio returns for
o The portfolio return for single men is 144 basis points lower than the portfolio
return for single women.
Accounting for the effects of marital status, age, and income, researchers also show that
men invest in riskier positions.
Misperceiving Randomness and Overreacting to Chance Events Cognitive psychologists have discovered that the human mind is a patternseeking device.
Humans conclude that there are casual factors or patterns at work behind sequences of
events even when the events are truly random.
The representativeness heuristic: Concluding that there are casual factors at work behind
random sequences. Or, if something is random, it should look random.
The HotHand Fallacy
Clustering Illusion – Our human belief that random events that occur in clusters are not
The Gambler’s Fallacy
Gambler’s Fallacy – Assuming that a departure for what occurs on average will be
corrected in the short term.
o Because an event has not happened recently, it has become ‘overdue’ and is more
likely to occur.
Sentiment Based Risk and Limits to Arbitrage
The efficient markets hypothesis (EMH) does not require every investor to be rational.
All that EMH requires that there be at least some smart and wellfinanced investors.
o These investors are prepared to buy and sell to take advantage of any mispricing
in the marketplace.
o This activity is what keeps markets efficient.