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AGENDA
1.
2. 3. 4.
Standard Finance
Investors are rational Markets are efficient Investors should design their portfolios according to the rules of Mean-Variance portfolio theory Expected returns are a function of risk and risk alone
Describes the behavior of investors and managers; it describes outcomes of interactions between investors and managers in financial and capital markets Doesnt follow four parts of standard finance
Behavioral finance
Investors are not rational, they are normal Markets are not efficient Investors design portfolios according to the rules of Behavioral Portfolio Theory Expected returns are determined by more than risk. Behavioral Asset Pricing Theory
Normal?
Cognitive biases and emotions come into play E.g. not realizing loses because it brings pain and regret Ill kick myself if I sell for $1 those dotcom shares I bought for $100. maybe I should wait to see if the stock recovers.
Market Efficiency
Stocks are always equal to its intrinsic value You can not beat the market Much evidence that stock prices regularly deviate from price E.g. crash in 1987
People build portfolios like layered pyramids Each layer represents a specific goal Your risk aversion depends on the specific goal
Stocks with desirable characteristics have lower expected returns Market capitalization and price to book ratio are added to beta to get expected returns Social responsibility?
Cognitive Biases
Identify biases affecting investors Consultants duty to educate investors Scientific knowledge is key
Availability Bias
Stock market
Retain perspective
Anchoring Bias
Stock market
Confirmation Bias
Preconceived opinion
Emphasize favorable information Seek information to prove true Avoid red flags
Hindsight Bias
Causes overconfidence
Overconfidence
More trades and lower yields Less trades and higher yields
Confident manager
Mental Accounting
Paying debt vs. savings Varying values associated with assets Money is fungible
Invariance
Imagine that you face the following pair of concurrent decisions
1):
A. B.
a sure gain of $240 25% chance to gain $1000 & 75% chance to gain nothing a sure loss of $750 75% chance to lose $1000 and 25% chance to lose nothing
2):
A. B.
Framing Outcomes
1) Assume yourself richer by $300 than you are today. You have to choose between: A. a sure gain of $100 B. 50% chance to gain $200 and 50% chance to gain nothing 2) $500 richer than today A. a sure loss of $100 B. 50% chance to lose nothing and 50% to lose $200
Rational Choice
Our decisions about money are often driven by psychological factors over which we have little conscious control Personality tests help to recognize which errors are commonly made and to use this knowledge to prevent them So, which type are you?
Mostly As
Youre an Artisan
Good instincts will prevail You are a trust your gut kind of person, who enjoys the thrill of investing Very comfortable at taking risks Tend to lack interest in long-term planning and discipline
Mostly Bs
Youre an Idealist
Money just isnt the top priority More concerned with assisting others and improving society rather than building personal wealth Your lack of interest in money matters can be a failure to reach any financial goals - that is, if you have set any
Put your investing on autopilot Have your cause and money too
Mostly Cs
Youre a Guardian
Discipline is key to security Greater emphasis is on financial security You are disciplined, patient, organized, and cautious Prefer fixed-income investments to relatively volatile equities
Mostly Ds
Youre a Rational
Cool reason conquers all You enjoy problem solving, fact finding, and have an interest in science and technology You tend to stay calm in tense situations
Feed your taste for systematic thinking Remember: The market isnt always rational
QUESTIONS