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Personal Finance: Another Perspective

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Title: Personal Finance: Another Perspective


1
Personal Finance Another Perspective
  • Investments 10 -
  • Behavioral Finance
  • Much of this material is taken from the book The
    Psychology of Investing by John R. Nofsinger,
    Prentice Hall, 2008. This is for your enjoyment
    and learning onlyit will not be on an exam or
    quiz. John has given permissions for me to share
    this PowerPoint with my students.

2
Objectives
  • A. Understand behavioral finance
  • B. Understand why we should learn behavioral
    finance
  • C. Understand other alternatives to traditional
    finance
  • D. Understand how behavioral finance can help us
    become better investors

3
Investment Plan Assignments
  • Investments 10 Behavioral Finance
  • 1. Review this PowerPoint for information. It
    gives some good insights on investing you might
    not have thought of.
  • It will not be on any Quiz or Exam, but it may
    have a positive impact on how you invest and your
    investment returns

4
A. Understand Behavioral Finance
  • What is behavioral finance?
  • Behavioral finance is an upcoming field of
    financial theory that attempts to further
    understand securities prices through
    understanding investor behavior.
  • Why did it come about?
  • The field of Finance is based on two rigid
    assumptions
  • 1. People make rational decisions
  • 2. People are unbiased about their predictions
    of the future
  • Are these assumptions really valid?

5
Behavioral Finance (continued)
  • Are there specific aspects of personal behavior
    that go contrary to these rigid assumptions of
    rationality and unbiased predictions?
  • Behavioral finance tries to incorporate personal
    behavior in an effort to extend finance beyond
    its narrow assumptions

6
Behavioral Finance (continued)
  • Activity 1
  • You go to the grocery store and you need to
    purchase paper towels.
  • You find they are on sale at 10 below their
    normal price.
  • What do you do?
  • You buy a case of paper towels because you know
    this is a good price

7
Behavioral Finance (continued)
  • Activity 2
  • You invest in the stock market. You own 100
    shares of Boston Scientific stock
  • More news comes out, and Boston Scientific stock
    drops 20.
  • What do you do?
  • Instead of buying more, like the paper towels,
    you immediately think about selling the stock
  • Likewise, if the stock starts to appreciate in
    value, you think to buy more, rather than sell
  • Why the difference between the grocery store and
    the stock market?

8
Questions
  • Any questions on behavioral finance?

9
Why Should we Learn Behavioral Finance?
  • Why should we learn behavioral finance?
  • 1. Behavioral finance can help you learn about
    your psychological biases
  • 2. You can understand how those psychological
    biases affect your investment decision making
    process
  • 3. You can see how poor investment decisions
    caused by physchological biases affect your
    wealth
  • 4. You can learn to recognize and avoid poor
    investment decisions which come from those
    psychological biases, which can help you become a
    better investor

10
Behavioral Finance (continued)
  • Activity 3
  • Individual Biases Illusion Which is larger?
  • While we all know the answer, the top line still
    looks larger

11
Behavioral Finance (continued)
  • Individual Biases Prediction be sure!!!
  • The brain does not work like a computer.
    Instead, it processes information through
    shortcuts and emotional filters to shorten the
    analysis time
  • These filters and shortcuts lead to predictable
    errors in investing
  • We must be wise to these prediction errors so we
    can be better investors and better stewards over
    our resources

12
Behavioral Finance (continued)
  • Activity 4
  • Following are 10 questions. Enter your best
    guess so you are 90 sure the answer lies between
    the two guesses. If you follow this guidance,
    you should get 9 of 10 answers right. You can
    guess as high or as low as you want (or even a
    range), realizing you want to get at a minimum
    90 right (or at least 9 questions right)

13
Behavioral Finance (continued)
  • Answer the questions so you are 90 sure the
    answer is between your minimum and maximum guess.
    You can guess any number or range, but you must
    be 90 sure you are right.
  • 1. What is the average weight of an adult blue
    whale in pounds?
  • 2. What year was the Mona Lisa was painted?
  • 3. What is the number independent countries in
    the world in the year 2000?
  • 4. What is the air distance in miles between
    Paris, France and Sydney, Australia?
  • 5. How many bones are in the human body?

14
Behavioral Finance (continued)
  • 6. How many total combatants were killed in WW1
    from all sides?
  • 7. How many books were in the Library of Congress
    in 2000?
  • 8. How long is the Amazon river in miles?
  • 9. How fast does the earth spin at the equator in
    miles per hour?
  • 10. How many transistors are in the Pentium III
    computer processor?

15
Behavioral Finance (continued)
  • Following are the answers. Remember you were to
    be 90 sure with your guesses
  • 1. Weight of adult blue whale
  • 250,000 pounds
  • 2. Year the Mona Lisa was painted
  • 1513
  • 3. Independent countries in the world in 2000
  • 191
  • 4. Distance between Paris and Sydney Australia
  • 10,543
  • 5. Number of bones in the human body
  • 206

16
Behavioral Finance (continued)
  • 6. Combatants killed in WW1
  • 8.3 million
  • 7. Books in the Library of Congress in 2000
  • 18 million
  • 8. Length of the Amazon river in miles
  • 4,000 miles
  • 9. Speed of the earth at the equator (how fast
    does it spin)
  • 1,044 mph
  • 10. Transistors in the Pentium III computer
    processor
  • 9.5 million

17
Behavioral Finance (continued)
  • How many did you get right?
  • Since you were supposed to be 90 sure (and you
    could make your guess as large as you wanted),
    you should have only missed 1 of 10
  • Most will miss between 5 and 9 questions
  • This is an example of prediction error
  • We think we are more sure of our forecasts than
    we should be
  • In an average class, fewer than 30 are 90 right

18
Questions
  • Any questions on why we should learn behavioral
    finance?

19
C. Are there Other Alternatives?
  • Are there other alternatives to explaining
    investor behavior than rational behavior and
    unbiased predictions?
  • Following are a few ideas that may be helpful

20
Other Alternatives (continued)
  • 1. Cooperation and Altruism
  • Cooperation may be a viable investment strategy
  • Peoples motives may lead to actions different
    than conventional rationality, i.e. individual
    selfishness, would suggest
  • What about the people in 4th Nephi who had all
    things in common among them therefore there were
    not rich and poor (4 Nephi 13)
  • What to do?
  • Think about other alternatives, other
    perspectives on investing.
  • Learn to think outside the box

21
Other Alternatives (continued)
  • 2. Bidding and the Winners Curse
  • Bidding may lead to a suboptimal result when you
    bid your fair value
  • Assuming everyone else has the correct value, if
    you won you overpaid!
  • What to do?
  • Be careful in setting your bid prices
  • Generally, dont bid your fair valuebid lower
  • Dont get emotional in your bid prices for
    financial assets
  • You dont have to buy it at this price!

22
Other Alternatives (continued)
  • 3. Endowment Effect
  • Sometimes we perceive that an assets value
    increases by virtue of our ownership
  • Once you own something, its value hasnt
    increased or changed
  • Did the value really increase with your purchase?
  • What to do?
  • Realize that just because you own something does
    not increase the value of that asset
  • Do not get too emotionally attached to a
    financial or other asset that you own

23
Other Alternatives (continued)
  • 4. Status Quo Bias
  • Sometimes individuals prefer the status quo over
    a new, more preferable position
  • There is an aversion to change, even if the
    change is for the better
  • Change may actually be good
  • What to do?
  • Try to be open minded with new ideas
  • Be open to new ideas as long as they follow the
    principles of successful investing and your
    Investment Plan that you put together

24
Other Alternatives (continued)
  • 5. Loss Aversion
  • Often losses are given more weight in our minds
    than potential gains in any position
  • These weights are more than utility theory would
    suggest
  • What should this view on losses do to the way you
    form portfolios?
  • What to do?
  • Give gains and losses equal weight in your
    analysis
  • It is the gains and losses of the overall
    portfolio that are important, not individual
    securities

25
Other Alternatives (continued)
  • 6. Mental Accounts
  • Often investors keep mental accounts rather than
    viewing individual assets as part of a total
    portfolio
  • We try to save ourselves from ourselves
  • We borrow 12 for a car versus taking the money
    from our investment account for the kids college
    savings (which are earning 2 annually)
  • We know we may not pay it back if we do not
    borrow from a bank
  • What to do?
  • Set up separate accounts for separate goals

26
Other Alternatives (continued)
  • 7. Winning by Losing
  • Sometimes we actively trade stocks instead of
    buying index funds or ETFs which we know are
    lower cost and take a lot less time to invest
  • We know index funds generally outperform the
    actively managed funds
  • And we do not have the time, energy, or the money
    to try to beat the market
  • What to do?
  • If you do not have the time, energy, and money,
    invest in sleep-well portfolios of index funds
  • You will at least get market returns and will
    generally beat most actively managed funds

27
Other Alternatives (continued)
  • 8. Seeking Solace (abdicating responsibility)
  • Sometimes we follow newspaper/newsletter advice
    which we know has been shown to under-perform
  • We prefer to take others advice rather than
    doing our own homework
  • If the performance goes bad, we can blame others
    (we dont have to take responsibility)
  • What to do?
  • Realize the limitations of these recommendations
  • If you have no better knowledge, invest in index
    funds/ETFs which are passively managed

28
Other Alternatives (continued)
  • 9. Fun
  • Sometimes we trade for fun and entertainment
    instead of financial performance
  • This is OK, but make sure your fun money is no
    more than 5 of the value of your portfoliothat
    way you dont lose too much
  • What to do?
  • If you want fun money, set up a trading account
    in a retirement vehicle (so you dont have to pay
    taxes until later)
  • Trade until the money is gone--then stop

29
Other Alternatives (continued)
  • 10. Percentages
  • We sometimes move in and out of asset classes and
    stocks instead of keeping specific asset class
    percentages relatively constant (within our
    minimum and maximum amounts from our Investment
    Plan)
  • We get lower returns from increased trading costs
    and may have more risk than we want
  • What to do?
  • Develop a good Investment Plan and rebalance as
    needed to your limits
  • Work to reduce trading, taxes, and transactions
    costs

30
Other Alternatives (continued)
  • 11. Calendar Effects
  • The impact of tax and reporting is not consistent
    with theory. Behaviorists point out
  • Returns are a function of cash flows, which tend
    to be concentrated around calendar turns.
    Institutions tend to window dress, i.e., sell
    unwanted and buy desired stocks for period-end
    reports
  • What to do?
  • Dont worry about calendar effects
  • Invest for the long-term consistent with your
    Investment Plan and calendar effects will take
    care of themselves

31
Other Alternatives (continued)
  • 12. Cash Dividends
  • Theory has shown that dividends are irrelevant in
    the absence of taxes and transactions costs.
    Behaviorists suppose
  • Dividends can be justified by mental accounts
    which increase current income at the expense of
    higher self control equity accounts
  • Older high-net worth investors value dividends
    more highly and concentrate in high income
    securities (preferred habitat) theory
  • What to do?
  • Invest for the long-term according to your
    Investment Plan and follow your strategy
  • Emphasize capital gains over dividends

32
Other Alternatives (continued)
  • 13. Overreaction
  • Many investors assign a probability to asset
    returns based on past theory
  • Appropriate reaction to a negative event is to
    update a prior probability to the most recent
    event
  • Overreaction is when they assign too high a value
  • What to do?
  • Stay diversified, true to your Investment Plan,
    and dont invest on rumors
  • Invest for the long-term, not on rumors

33
Other Alternatives (continued)
  • 14. Mean Reversion
  • Prices tend to correct themselves as investors
    correct for overreaction
  • Long-term prices tend to revert to the mean
  • What to do?
  • Realize that the best performing stock or mutual
    fund last year will not be the best performer
    this year
  • Winners revert to average performance over time
  • Dont buy last years best performers
  • Invest for the future--not from the past

34
Questions
  • Any questions on behavioral finance and
    explaining individual behavior?

35
D. How Behavioral Finance can Help us Become
Better Investors
  • There are specific strategies you can take for
    overcoming psychological biases understood
    through behavioral finance. Key principles
    include

36
Becoming Better Investors (continued)
  • 1. Understand your psychological biases and
    control your investing environment
  • Recognizing biases is an important step in
    avoiding them
  • Are you overconfident or do you trade too often?
  • What to do?
  • Limit the opportunity for these actions or
    biases. Articulate your ideas in your well
    thought out and well written Investment Plan.
    Ideas include

37
Becoming Better Investors (continued)
  • a. Check your stocks once per week (when you do
    your budget), not once per hour
  • It avoids excess trading, rumors, and pride
  • b. Make trades once per month on the same day of
    each month
  • This avoids too-frequent trading and trading on
    rumors
  • c. Review your portfolio annually and rebalance
    as needed
  • But rebalance in the most tax-effective manner
  • Add to underweight assets with new funds
  • Make asset allocation changes using donations of
    appreciated assets (NMD) to charity

38
Becoming Better Investors (continued)
  • 2. Know why you are investing
  • Know your personal and family goals
  • Investing is a means to an end, not an end in
    itself.
  • What to do?
  • Review your goals often and invest according to
    your Investment Plan and goals
  • If you want to trade for fun, that is fine. But
    set a specific dollar amount in a special
    retirement account and only trade that account.
  • Once the money is gone, stop trading

39
Becoming Better Investors (continued)
  • 3. Have Quantitative Investment Criteria, i.e.
    your thoughtful Investment plan, and follow it
  • Having a written Investment Plan allows you to
    avoid investing on rumor, emotion or other biases
  • Write it well and then follow it closely
  • What to do?
  • Develop and write a good Investment Plan, and
    follow that Plan closely
  • Do not invest in areas outside of your Plan or in
    areas you know you do not add value

40
Becoming Better Investors (continued)
  • 4. Follow the Principles of Successful Investing
  • Following the principles discussed in class will
    help you to avoid many of the problems faced by
    other investors
  • We must determine correct principles and follow
    them
  • What to do
  • Know yourself, know your goals, invest low cost
    and tax efficiently, invest long-term, know what
    you invest in, monitor performance, etc.
  • Follow your Investment Plan, and it will save you
    thousands in the long-term

41
Becoming Better Investors (continued)
  • John Nofsinger adds these 5 additional
    suggestions
  • 1. Avoid stocks selling for less than 5 per
    share
  • Most investment scams are conducted in penny
    stocks
  • 2. Chat rooms and message boards are for
    entertainment purposes only
  • Overconfidence is fostered in these places
  • 3. Before you place a trade on a stock that
    doesnt meet your criteria, remember that it is
    unlikely that you know more than the market
  • Do you really know more than the market?

42
Becoming Better Investors (continued)
  • 4. Have a goal to earn the market return
  • Active trading is motivated by the desire to earn
    a higher return than the market
  • Active trading usually fosters psychological
    biases and ultimately contributes to lower
    returns
  • 5. Review your psychological biases annually
  • Successful investing is more than knowing about
    financial markets, asset classes, and financial
    assets. It includes knowing yourself
  • These main ideas and questions are from John R.
    Nofsinger, The Psychology of Investing Prentice
    Hall, 2008, p. 87-91.

43
Review of Objectives
  • A. Do you understand behavioral finance?
  • B. Do you understand why we should learn
    behavioral finance?
  • C. Do you understand other alternatives to
    traditional finance?
  • D. Do you understand how behavioral finance can
    help us become better investors?
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