Behavioral Finance

Behavioral Finance & the Psychology of Investing

*Source: The Psychology of Investing, Nofsinger

I. Psychology and Finance

Financial theory (such as modern portfolio theory) and pricing models (such as CAPM) assume:

- People make rational decisions.

- People are unbiased in their predictions about the future.

However…

* Emotionally based psychological biases; overconfidence, regret and pride, and past failures

* Information processing (cognitive); mental accounting, representativeness, and familiarity inhibit investors’ ability to make good investment decisions.

Problem: People tend to be too certain in providing answers to questions even if they have no (or limited) information or knowledge about the topic.

* DJIA example 1998 closed at 9181. As a price index the Dow does not include reinvested dividends. The Dow was started in 1896 at a price level of 40. With reinvested dividends, what do you think the price level would be as of 1998 (make your estimate so that you are 90 percent confident that the answer will lie between your low and high guesses)? Answer: 652,230.

II. Overconfidence

* Excess Trading

- Leads to purchasing the wrong stocks. Stocks sold outperformed stocks purchased by 2.5 % over next four months and 5.8% over the next year.

* Illusion of Knowledge

- People tend to believe that the accuracy of their forecasts increases with information (not always the case)

ex) Abundance of information on the internet BUT most investors lack the training to interpret properly (accounting adjustments etc…). Therefore, the information does not give them as much knowledge as they think.

* Illusion of Control

Choice – Making an active choice induces control. For example, people who choose their own lottery numbers (birthdays, anniversaries, lucky numbers) feel they have a better chance of winning than people who have the numbers given to them at random.

Outcome Sequence – Positive...