Why%20Do%20Individuals%20Exhibit%20Investment%20Biases?

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Why Do Individuals Exhibit Investment Biases?
Henrik Cronqvist Claremont McKenna
College Stephan Siegel University of Washington
National Taiwan University International
Conference on Finance December 6, 2012
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Genes and Household FinanceResearch Agenda So Far
More risk
Participate in stock market
Investment biases
Today
Save
Less risk
Dont participate in stock market
Investment styles value vs. growth
Consume

• We use twin study research design to examine, for
  each of the above choices, the effects of i)
  genetic and environmental influences, and ii) GxE
  moderators.
• Parallel to molecular genetics and
  neuroscientific studies by Camerer, Bossaerts,
  Kuhnen, Laibson, Zak, and others.

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Investment Biases

• Long list of investment behaviors that cannot be
  explained by standard preferences and belief
  formation
• Underdiversify
• Prefer local securities home bias
• Avoid realizing losses
• Trade a lot
• Chase past performance
• Prefer lottery-type stocks
• Some of these behaviors have been shown to be
• Wide-spread present also among professional
  investors
• Related to fundamental psychological mechanisms
• Costly
• But, degrees of behavior vary across investors

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Biological Basis for Investment Behaviors
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Existing Evidence

• Experimental evidence (previous slide)
• Capuchin monkeys exhibit loss aversion
• Capuchin monkeys prefer gambles with good
  outcomes framed as bonuses over identical pay-off
  gambles with bad outcomes framed as losses
• Loss aversion is part of decision-making process
  that evolved before humans and capuchins
  separated (Chen et al. (2006), Lakshminarayanan
  et al. (2011))
• But No empirical evidence on the genetics of
  investment biases based on real world financial
  decisions and data

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Research Methodology Twin Researc
Identical Twins
Fraternal Twins
Josefin and Elin Nordegren
The Hodgson Twins
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Intuition of Methodology

• Use identical fraternal twins to decompose the
  variation in investment behaviors
• Identical (monozygotic, MZ) twins share 100 of
  their DNA
• Fraternal (dizygotic, DZ) twins share on average
  50 of their DNA
• Twins who grew up in same family share a common
  environment
• Each twin has his/her individual (non-shared)
  environment

If genes matter, then identical twins should be
more similar than fraternal twins in terms of,
e.g., their investment behaviors.
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Methodology

• Random effect model with genetic effect a, common
  effect c and individual-specific effect e
• Covariance structure implied by genetic theory

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Methodology, contd

• Estimate parameters s2a, s2c, and s2e via maximum
  likelihood estimation (MLE) with bootstrapped
  standard errors
• Derive the variance components

A-share genetic component C-share common
environment (parenting) E-share individual
environment measurement error
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Data

• Swedish Twin Registry
• Matched with annual financial data (including
  holdings of assets and sales transactions) and
  socioeconomic data from Statistics Sweden (1999
  2007)
• Filters
• At least 18 years old
• Both twins hold some equities (directly or
  indirectly) in one year
• Average all variables over the years that
  individual is in sample

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Measuring Investment Biases

• Diversification
• Number of stocks in portfolio
• Home Bias
• Proportion of equity portfolio in local
  (Swedish) equities
• Turnover
• Annual sales volume scaled by value of portfolio
  at beginning of year
• Disposition Effect
• Proportion Gains Realized (PGR) Proportion
  Losses Realized (PLR) (Odean (1998))
• Performance Chasing
• Proportion of equities acquired with raw returns
  in top two deciles
• Skewness Preference
• Proportion of lottery securities (Kumar (2009))

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Evidence from Correlations
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Variance Decomposition
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Variance Decomposition
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Robustness

• Opposite-sex twins
• Model misspecification
• Allowing for negative variance components
• Communication
• Identical twins communicate more with one another
• Financial decisions are influenced by
  communication (e.g. Shiller and Pound (1998),
  Hong, Kubik, and Stein (2004))
• Sort pairs into 10 communication intensity bins
  and randomly drop identical/fraternal pairs until
  both types are equally often present per bin.
  Estimate model across all 10 bins.
• A component is somewhat reduced, but overall,
  results are robust.
• Equal environments assumption

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Identical Twins
Unrelated Look-Alikes www.francoisbrunelle.com
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Two Additional Results

• Moderators of genetic investment biases
• Behavioral consistency Investment biases and
  behaviors in other, non-investment, domains

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Moderating Genetic Effects

• Environment can enhance or reduce the effects of
  genetic predisposition
• Example Education seems to reduce genetic
  variation in health outcomes (Johnson et al.
  (2009))
• Examine how years of education interact with the
  genetic effects
• No significant evidence that years of education
  reduces genetic predispositions to investment
  biases

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Moderator Years of Education
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Financial Experience

• Does work experience in the financial industry
  or, e.g., in a corporate treasury department
  reduce genetic predispositions to investment
  biases?
• Repeat analysis for individuals working with
  finance
• A components reduced (generally by gt50).
• Experience in the finance industry seems to
  reduce the genetic predisposition to investment
  biases.

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Behavioral Consistency

• Behavior across different domains is often
  consistent
• If genetic factors matter, source of consistency
  should be genetic
• Correlate Home Bias with
• Distance to birthplace
• Indicator whether spouse is from same home region

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Behavioral Consistency
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Conclusions

• A long list of investment biases are human in
  the sense that investors are born with
  pre-dispositions
• ?25-50 of variation explained by genetic
  variation
• Provide empirical support for evolutionary models
  of investment biases (e.g., Brennan and Lo
  (2009))
• Education does not reduce the genetic
  predisposition to investment biases. But finance
  industry experience reduces genetic effects.
• Genetic factors influencing investment biases
  affect behaviors in other, non-investment,
  domains.

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Why Are Investment Behaviors Genetic?Why Are
Some More Genetic Than Others?

• Nature selects behaviors that are fitness
  maximizing.
• Several recent models show that non-standard
  preferences are indeed fitness maximizing e.g.,
  Rayo and Becker (2007), Brennan and Lo (2009).

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Public Policy Implications

• Do the results of significant genetic effects
  make public policy initiatives irrelevant in the
  domain of household finance?
• No.
• But policy should be designed assuming that
  individual investors exhibit investment biases,
  rather than based on a notion that biases may be
  easily educated away or otherwise eradicated in
  markets (Cronqvist and Thaler (2004)).