How our emotions impact investment decisionmaking

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(No Transcript)
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opening thought
Only two things are infinite, the universe and
human stupidity, and Im not sure about the
former. Albert Einstein
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how our emotions impact on our investment
decisions

• Robert Macdonald
• ipac South Africa

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overview

• how do our emotions influence investment
  decision-making?
• what evidence is there of emotional influence in
  investment markets?
• what can we do about overcoming the influence of
  emotions?

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overview

• how do our emotions influence investment
  decision-making?

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the paradox of investing

• the future is always uncertain
• BUT.
• investors always seek certainty

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behavioural finance

• looks at two broad areas of behaviour
• how we form expectations
• how we frame decisions

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forming expectations

• we tend to form expectations and make decisions
  on the basis of rules of thumb

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rules of thumb - biases

• status quo
• availability
• recallability
• representativeness
• ambiguity
• overconfidence
• herding

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status quo

• research conducted by two US academics, William
  Samuelson (Boston) and Richard Zeckhauser
  (Harvard)
• key finding
• majority of people inclined not to change the
  status quo of their investments, even if they
  feel other options are intrinsically better

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availability
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recallability (1)
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recallability (2)
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recallability (3)

• People tend to give too much weight to recent
  experience and extrapolate recent trends that are
  at odds with long-run averages and statistical
  odds.
• People are more optimistic when the market goes
  up and more pessimistic when the market goes down.

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representativeness (1)

• Linda is 31, outspoken and very bright. She got
  her college degree in philosophy, is deeply
  concerned with discrimination and other social
  issues, and participates in anti-war
  demonstrations.
• What statement is likely to be true?
• a. Linda is a bank teller
• b. Linda is a bank teller and active in the
  feminist movement

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representativeness (2)

• 87 studied said that b is an answer more
  likely to be true than a
• a. Linda is a bank teller
• b. Linda is a bank teller and active in the
  feminist movement
• Tversky Kahneman, 1979

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representativeness (3)
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ambiguity

• Investors dont like ambiguity and uncertainty
• Investors will therefore put more emphasis on
  new and easily understood information with
  immediate consequences, than on less readily
  decipherable types of information with longer run
  consequences.

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overconfidence (1)

• think of your driving ability.
• are you
• above average,
• average,
• below average?

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overconfidence (2)

• we tend to overrate our own abilities!

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overconfidence (3)

• any individual who is not professionally
  occupied in the financial services industry (and
  most of those who are) and who in any way
  attempts to actively manage an investment
  portfolio is probably suffering from
  overconfidence.
• Belsky Gilovich, 1999

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overconfidence (4)

• When people succeed, they most often give
  themselves too much credit for the success.
  Failures, on the other hand, are blamed on others
  and misfortune. It is likely that investors
  attribute the excellent returns they earn to
  their own investment acumen, rather than to
  luck.
• Odean, Barber Zheng, 2000

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herding (1)

• US Morningstar study found that the average
  diversified fund returned 12.5 pa over 5 years,
  but that investors only achieved -2.2.
• Morningstar, 1994

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herding (2)

• In the first ten months of 2000, approximately
  90 of net inflows went into 4 and 5 star
  fundsgrowth and technology funds were the
  biggest winners.
• Goldstein Krutov, 2001

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overcoming bias

• we need to be well calibrated
• face similar problems everyday
• make explicitly probabilistic predictions
• get swift precise feedback on outcomes
• two professions well-calibrated

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behavioural finance

• looks at two broad areas of behaviour
• how we form expectations
• how we frame decisions

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framing decisions

• loss aversion
• minimise regret
• mental accounting
• reference points
• innumeracy

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loss aversion

• scenario
• an investor needs cash
• must sell one of two stocks
• one stock has gone up, the other down
• ..
• which stock does the investor sell?

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fear of loss and regret

• study of 10 000 investor records
• investors most likely sell the stock that went up
• sold stock outperformed held stock by 3.4
• investors are afraid to realize losses
• Odean (1998)

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Sappi vs Didata
Sappi
Didata
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mental accounting

• an example
• saving for childrens education
• paying off a bond
• saving for a holiday
• borrowing to buy a car
• investors run the risk of considering
  investment, saving, spending options in
  isolationas a result, considering decision
  problems one at a time, guided by the
  attractiveness of options immediately available

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innumeracy
HHHTTT or HTHTTH ?
the hot hand fallacy
human mind is a pattern-seeking device
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decision-making in action

• scenario 1 imagine that you are richer by
• R20 000 today and you have a choice
• A. you receive R5000 or
• B. a 50 chance to win R10 000 and a 50
• chance to win nothing
• scenario 2 imagine that you are richer by
• R30 000 and that you have a choice
• C. lose R5000 or
• D. a 50 chance to lose R10 000 and a 50
• chance to lose nothing

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error of preference

• the perfectly rational decision-maker is
  concerned about where he or she gets to in the
  end, not the gains or losses along the way.
• the rational decision-maker does not flip
  preferences between the gamble or the sure thing
  
• a decision maker who makes different choices in
  the two problems has been influenced by the
  irrelevant emotions of gains and losses

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framing decisions
we can frame a decision problem in narrower or
broader terms
broader and narrow frames often lead to different
preferences
rationality is best served by broad frames and a
focus on objectives not changes
narrow framing is easier, more natural and more
common
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behavioural finance

• looks at two broad areas of behaviour
• how we form expectations
• how we frame decisions

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overview

• how do our emotions influence investment
  decision-making?
• what evidence is there of emotional influence in
  investment markets?

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this time its different
1630s tulips 1720s shipping 1960s
electronics 1980s biotechnology 1990s
information
technology
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shipping 1720s

• shipping was the gateway to trade
• South Sea Co granted
• monopoly on trade
• frenzy in South Sea
• stock
• explosion of start-ups

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explosion of start ups

• Extract from a company prospectus
• A company for carrying on an undertaking of
  great advantage, but nobody to know what it is.
• Bubble Act
• bans share certificates

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Newtons response

• I can calculate the motions of heavenly bodies,
  but not the madness of people.
• Isaac Newton

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explosion of start ups... SA style

• from 1997 to 1999 there were more new listings on
  the JSE than in the previous nine years
• 1988 to 1996 206 listings (9 years)
• 1997 to 1999 229 listings (3 years)
• 1997 54 2000 14 listings
• 1998 101 2001 11 listings
• 1999 74

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SA small caps
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information technology 1990s
a miracle for consumers
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information technology 1990s
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investment efficiency

• has two components to it
• financial efficiency
• non-financial efficiency

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financial efficiency

• is achieving a desired return at a palatable
  level of risk
• in other words, being able to
• eat well

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non-financial efficiency

• deals with behavioural issues and has two main
  aspects to it
• sleep well
• seems good

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behavioural issues
Urwin, 2000
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behavioural influence
Watson Wyatt Global Asset Study, 1999
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overview

• how do our emotions influence investment
  decision-making?
• what evidence is there of emotional influence in
  investment markets?
• what can we do about overcoming the influence of
  emotions?

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some advice
To invest successfully over a lifetime does not
require a stratospheric IQ, unusual business
insights, or inside information. Whats needed
is a sound intellectual framework for making
decisions and the ability to keep emotions from
corroding that framework. Warren Buffett
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prologue

• acknowledge two fundamental truths of
  investing
• the future is uncertain
• inherent personal biases

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step one

• set investment objectives
• identify time frame

this helps to overcome problems such as narrow
framing
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step two

• adopt an investment framework to guide your
  decision-making

this helps overcome emotions corroding your
perspective
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step three

• use your own investment objectives and your
  investment framework as the reference points for
  your investment decisions

this helps to avoid the temptation of using
inappropriate reference points
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step four

• remember that investing is a means to an end, not
  an end in itself

this helps avoid focusing on short-term market
fluctuations and noise
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epilogue

• thorough research is the cornerstone of any
  successful investment activity

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keys to overcoming emotions

• prologue acknowledge investment truths
• step 1 set investment objectives
• step 2 adopt investment framework
• step 3 use appropriate reference points
• step 4 remember investing is means to an end
• epilogue research the cornerstone

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review

• how do our emotions influence investment
  decision-making?
• what evidence is there of emotional influence in
  investment markets?
• what can we do about overcoming the influence of
  emotions?

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