Behavioral Finance A Challenge to the EMH

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1 This is a brief selection from our Accredited Portfolio Management Advisor SM Program Behavioral Finance A Challenge to the EMH We have learned about the underlying assumptions of the efficient market hypothesis, and these include that markets are informationally efficient. Another assumption is that investors behave rationally within the market, and will not pay too much for a security nor sell a security for too little. But if investors do behave rationally, how do you explain extremes such as the market crash on October 19, 1987? Or the run-up in real estate prices in many areas of the country from 2000 through 2005? Or the panic selling and volatility we experienced in the market in 2008? Can we so readily discount the impact of human emotions in the marketplace? What impact does fear and greed have on human behavior, and subsequently the markets? A number of academic studies are now questioning how far to take our acceptance of the EMH. The study of investor behavior is known as behavioral finance, and it has been gaining in momentum and importance. In fact, in 2002 a Nobel Memorial Prize in Economic Sciences was awarded to Daniel Kahneman, whose work involved integrating both economics and psychology. More practitioners are becoming aware of its value in helping their clients avoid some of the common self-destructive money traps. Behavioral finance looks at the emotions, irrational decision-making, and biases that can come into play when individuals invest and handle money. Here are some of the most common behavioral emotions and mistakes that investors can make: Loss Aversion Investors hate to take losses. While this seems obvious, the degree to which investors are averse to taking losses was illuminated in a 1979 study by Kahneman and Tversky. They found that a loss has about 2.5 times the impact of a gain of the same magnitude. Loss aversion, which is related to fear of regret, explains why many investors will not sell anything at a loss. Instead, if required to sell something, they sell those securities in which they have a profit, the opposite of the cut your losses and let profits run strategy recommended by many savvy investors. (The tendency to keep losing investments and sell profitable investments is called the disposition effect.) Selling at a loss not only admits a mistake, but also ends any hope of at least getting back even. Investment professionals often hear from clients who state that rather than selling at a loss, they will sell when the stock gets back to the price at which they bought it. This get-evenitis attitude can be very harmful to investment results because some stocks never will get back

2 to where an investor bought them, or at least will take a very long time to do so. In the meantime, better investments are passed by while waiting for the stock to rebound. In this case, what an investor does not do can be as harmful as what he or she does. Fear of Regret A great quote from Mark Twain is Twenty years from now you will be more disappointed by the things you didn t do than by the ones you did do. Regret is a strong human emotion, and it can come into play with investments, and how one invests. Fear of regret may drive someone to buy the latest hot stock because of the fear of missing an opportunity. Regret is more than experiencing the pain of a loss. Regret involves the pain of feeling responsible for the loss. Using the example above, investors can avoid not only the loss but the feeling of regret if they can hold on to a poorly performing stock until it gets back to where he or she bought it. Of course, this may not be the best investment decision because some stocks never come back or at least take several years to come back. Usually, there is more regret associated with taking an action that turns out poorly than with not taking an action that would have benefited the investor. One way to approach an investor with this mind-set is to ask if he or she would like to buy more of the same security. A typical response might be, Are you crazy? I wouldn t buy any more of this dog! To which the advisor can gently ask, If you think it s a dog and you wouldn t buy it here, why do you think it is a good investment to hold? If the advisor can help the client admit that the outlook for the security s performance is poor, the client may be more inclined to sell the security and put the cash from the sale to work in another investment. Regret can also be experienced when a stock takes off and the investor either did not buy it or sold it before the price increase. Overconfidence One study of stock analysts revealed the following: If analysts forecast that a stock will increase in value with 80% confidence, they are right about 40% of the time. Ask anyone if they are an above-average or below-average driver and most will say they are above-average. Other research shows similar evidence in other areas of human behavior, including overestimates of leadership ability, athleticism, and competence. With investor behavior, this overconfidence can lead to illusions of control that can lead to biased judgments, investing too much in investments about which they know too little, taking undue risks, and failure to realize they are at an informational disadvantage to institutional investors. During strong bull markets, it is easy for investors to credit themselves for their strong performance and ignore the contribution of the bull market itself to that strong performance. Successful investing decisions can become a source of pride and ego gratification, and the modern-day equivalent of a successful hunter during the caveman days. A consequence of this can be not meeting financial goals. If investors are overconfident about the returns they expect to get, they may save and invest less than they

3 otherwise would. Then if those expected returns are not realized, they could very well come up short of achieving those goals. This is particularly relevant as baby boomers are approaching retirement. Overconfidence can also mask errors investors make. So instead of learning from their errors, investors attribute poor investment results not to their own mistakes, but to some other cause over which they have no control. For example, with the meltdown of technology stocks in the period, some investors blamed their losses on poor recommendations from brokerage firms or a bad market rather than their buying stocks of companies with poor business plans and P/Es approaching 100, or even companies with no earnings and price-tosales ratios of 40 to 50. These grossly inflated valuations were reason enough for investors to avoid such stocks. Another aspect of overconfidence is optimistic bias, which is the tendency for an investor to be convinced that he or she will do better than other investors. However, investing is a zero sum game in that for every seller there is a buyer, so if one made the correct decision the other did not. Overconfidence is often manifested in overtrading by investors, and especially by male investors. A 1998 study by Brad Barber and Terrance Odean, which analyzed the trading histories of 60,000 investors over a six-year period ending in 1996, revealed that the individuals beat the value-weighted market index by 60 basis points (1% = 100 basis points), gross of trading costs. However, trading costs were 240 basis points, resulting in underperformance compared to the index. Furthermore, individuals who traded the most had the worst performance, underperforming the index by 500 basis points. In general, there is no correlation between confidence and better performance. This was clearly demonstrated between 1999 and 2001 when investors generally, and day traders particularly, were exceedingly confident in 1999 and early 2000 only to encounter significant losses by the first quarter of 2001 and, in the case of numerous technology stocks, huge losses. Even many professional money managers become overconfident and end up underperforming the market, as was seen with the performance of many mutual funds during this time period. Representativeness Representativeness involves making judgments based on stereotypes. It is a method the brain uses to classify things rapidly and thereby creates shortcuts. You can see a classic example of this in politics. If you have two individuals, one from the right and another from the left, and have them watch the same political program, they will have different opinions of the objectivity and fairness of the program. As applied to investments, representativeness appears when investors become overly negative about investments that have done poorly in the past and overly positive about investments that have done well in the past. From this, stocks, in particular, can become undervalued and overvalued respectively. With mutual funds, the SEC tries to help mutual fund investors avoid

4 representativeness with its prospectus statement that past performance is no guarantee of future results. Yet the tracking of new cash flow into mutual funds almost always shows investor money chasing those funds with high rates of return during the last one, three, or five years. This tendency often results in investors buying after the funds have had their best performance. Investors form a bias and believe that a fund manager who performed well in a prior period of time has a good chance of continuing to perform well in the future. Representativeness, then, can be a misleading guide to future investment performance. In addition, individuals place too much value on what they know based on their experiences this familiarity can be confused with knowledge. This explains why investors who have not invested in international securities are reluctant to do so. Another example is employees allocating too much of their company s retirement plan to company stock. Obviously they are familiar with the company so they are comfortable investing in it. While the idea of investing in what you know makes sense, the danger is in the difference between an investor s actual knowledge versus what one thinks he or she knows. Many employees unfortunately found out this difference when so many Internet and telecommunication companies went bankrupt between 2000 and This also became apparent again in 2008 when many financial institutions went into bankruptcy or were forced to merge, resulting in large losses for shareholders. Many investors were comfortable owning these banks, and had no idea of the large amount of risk these banks were taking, and how shaky the banks financials actually were. Framing the Problem Framing is the notion that it matters how a concept is presented to an individual. For example, assume a meal at a restaurant normally is priced at $10. The restaurant might offer an early bird special where that price is $8 before 6 p.m., and thereby get more business if people think they are getting a discount. Now assume, instead, the price of the meal is $8 but after 6 p.m. there is a $2 surcharge. Of course, the restaurant will be perceived in a more favorable fashion by offering a discount rather than a surcharge even though the pricing structure is identical. In like manner, how an investor views a situation can have a significant impact on the investor s decision. Investors often choose a guaranteed positive outcome (while avoiding a chance of greater gain that also carries the possibility of no gain at all), but they will take a chance to avoid a negative outcome (rather than taking a certain smaller loss). Another aspect of this is when an investor frames a situation based on their invested assets. This is illustrated by the following examples: Scenario 1. You have been given $1,000, and have the following choices: a. You can receive another $500 for sure. b. You can flip a coin, and if it comes up heads you get another $1,000, but if it comes up tails you get nothing.

5 Scenario 2. You have been given $2,000, and have the following choices: a. You can lose $500 for sure. b. You can flip a coin, and if it comes up heads you lose $1,000, but if it comes up tails you lose nothing. What were your choices for the two scenarios? Was your choice a in the first scenario and b in the second? If so, you are guilty of just focusing on gains and losses, and not looking at the overall big picture and the effect on your wealth. About 85% of people choose option a in the first scenario, and about 70% of people choose option b in the second scenario. If you take a close look at both scenarios you will see that they are actually identical. For both scenarios you will end up with $1,500 for sure if you pick option a, or else have a 50/50 chance of either ending up with $1,000 or $2,000 if you pick option b. So you should pick the same option under either scenario. Which option you prefer is up to you, but if you pick a in the first scenario you should also pick a in the second, or if you pick b in one scenario you should pick it in the other. People pick different answers because of how the questions are asked in other words how they are framed. Generally, investors are better off framing a decision in broad terms based on overall wealth, rather than in narrower terms based on gains and losses. One final example: Department stores have become masters at framing with sales that never end. You feel much better buying a $50 shirt for $35, then buying the same shirt priced at $35 as the normal price. In either case you are out of pocket $35 for the same shirt. Rationalization This problem suggests that investors search for and rely on information that supports their decisions. The tendency to give too much importance to information that confirms one s impressions or preferences is called confirmation bias. Bad news and facts that might challenge one s opinions tend to be ignored. In research circles, this can be referred to as data mining (reporting only evidence that supports your case). In investment circles, rationalization often occurs when one analyst gives a buy signal while another gives a sell signal; both cannot be right. But both will point to convincing evidence sometimes even the same evidence with a different spin to support their positions. Hindsight Bias This is the characteristic of investors, when looking back, seeing events that took place in the past as having been more predictable than they seemed before they happened. Likewise, things that didn t happen seem, with hindsight, much less likely to have happened than they did beforehand. In other words, there is a reconciliation of a person s beliefs based on the outcome of events. For example, if a financial professional recommends an investment that does well, a client tends to think of that recommendation as one he or she liked from the start, even if that

6 was not the case. With recommendations that do not turn out well, however, the client often thinks that he or she had doubts to begin with about them, even when, in fact, that was not true. This thinking results in a client giving less credit to the investment professional for good recommendations and more blame for recommendations that do not work out. The stock market sell-off in 2008 can be seen as a classic example of hindsight bias. Looking back one might think they should have been able to tell that the market was going to correct dramatically because of the sub-prime market and decline in real estate prices. But how was one to know how long it would last? How could one have predicted the credit crunch and subsequent government bailouts? Everything is always clearer in the rearview mirror. Anchoring Anchoring refers to the tendency to hold to certain beliefs even when faced with new information that should alter those beliefs, thereby creating, in effect, tunnel vision. In other words, investors start at an initial mental reference point based on past experience. This might lead to overweighting irrelevant data or slowly adjusting to a correct answer or decision as they receive additional information. As applied to the announcement of a company s earnings, anchoring results in security analysts underreacting to unexpected earnings announcements. This does not mean there is not a reaction, because such announcements typically move the stock quickly and, in some cases, significantly. It does mean that security analysts do not revise their earnings estimates enough to reflect this new information. As a result, positive or negative earnings surprises tend to be followed by more positive or negative earnings surprises. Individual investors, of course, also experience anchoring. Their investment experiences create beliefs that they subsequently rely on, and then they underreact to new information. One of most vivid examples of this can be seen by examining investor conduct with technology stocks in the late 1990s. It appeared that investors could do no wrong by buying technology stocks and, no matter what prices were paid, technology stock prices would be higher in the future. However, even though valuations went to extremes and it became evident that the prospect of any earnings for many of these companies was well in the future, if ever, many investors did not react to this information. By the end of 2002, the cost of anchoring to these stocks prices was obvious. Recency This is the problem of putting too much weight on current events or data and not enough weight on past, historic trends. Many investors expect the market to continue rising in a current bull market; likewise, these same investors often expect a current bear market to get worse. Recency is shown in momentum investing when investors buy hot stocks simply on the basis of their recent strong performance. One difference between recency and representativeness is that recency involves a shorter, more recent time frame than representativeness.

7 An example of recency occurred in the 1990s bull market. At that time there were many individuals projecting annual returns of 20% or greater in their retirement accounts based on the recent performance of the stock market, even though historical returns were half that amount. Another good example of recency is the market sell-off in With the overall market down over 40% for the year, going into the presidential elections many investors were either selling stocks or no longer investing in stocks in their retirement accounts. Recent events had impacted their outlook, and the concern was that the market was going to continue going down indefinitely. This is the opposite of what occurred in the 1990s. In the 1990s we had extreme optimism and unrealistically high long-term expectations, whereas in 2008 we experienced extreme pessimism and unrealistically low long-term expectations. Mental Accounting Mental accounting involves treating one dollar different from another depending on where it comes from, where it is kept, and how it is spent. This can lead to being too quick to spend, too slow to save, and too conservative or aggressive with investing. For example, receiving a gift from a grandparent seems more valuable than the same dollar amount earned from a job. So that gift might be invested more conservatively than money earned because losing grandma s money would be more traumatic than losing one s own money. Mental accounting can also be affected by the amount of money involved. For example, most people would go to greater lengths to save $25 on a $100 purchase than they would to save $25 on a $1,000 purchase the $25 seems to have more value with the $100 purchase. Mental accounting is the reason investors divide their assets into different pockets and therefore interferes with them thinking of their overall portfolio. To illustrate this concept, assume a person invests $1,000 in a speculative stock and in two months sells the investment for $4,000. With mental accounting, the investor will then be more conservative when reinvesting the $1,000 (since that was his real investment) and tend to take greater risks with the $3,000 profit. This is called the house money effect, because it is similar to a gambler thinking of the $3,000 as the house s money and if it is lost, well, it wasn t really the gambler s money to begin with. Of course, the $3,000 really is the investor s (or gambler s) money, but it is thought of differently. This compartmentalization not only distracts from considering the total portfolio, but also gets the investor to thinking of his or her investments in terms of individual winners and losers rather than in their entirety. Money Illusion Money illusion is the misunderstanding people have in relating nominal rates or prices with real (inflation-adjusted) rates or prices. For example, if an investor is given the choice of a 10% gain when inflation is 12% or a 4% gain when inflation is 2%, most investors would select the 10% gain. In real terms, however, the investor would be better in the 2% inflation scenario. This example also relates to the fact that people can more easily dismiss small numbers without

8 putting them into the correct financial perspective. This misunderstanding can lead to incorrect financial decisions or cloud their financial judgment. Availability Bias This bias centers on giving more importance to data or information that is easy to obtain. For example, in an annual report, it is easy to find the earnings per share for a company, but reading the financial footnotes takes more effort to interpret. Behavioral finance continues to evolve and will become more important for financial planners in the years to come. By having a good understanding of the basics of behavioral finance, advisors can not only become better investors themselves, but they can also help their clients become better investors. Advisors who spot these behaviors in their clients can educate them on what is happening and why. Then their clients can become more successful long-term investors. Unlike the efficient market hypothesis that assumes all investors are rational, behavioral finance takes into account that we are all human and prone to our emotions, and that we do not necessarily always act in our own best interests. Behavioral finance is gaining wider acceptance in the financial planning field, especially in light of the recent credit crisis. Everything cannot be quantified and reduced to formulas and numbers the markets are created and used by humans, who are not perfect. We all have various emotions, and we do not always behave rationally. As we saw with modern portfolio theory, a basic assumption is that investors behave rationally, always doing what is in their best interest. This is not necessarily the case. A good understanding of behavioral finance will hopefully enable advisors to help their clients avoid common behavioral traps. Our behavior as investors, whether rational or not, has an impact on the market. The same applies to institutional investors: If they all head for the exit at the same time, which essentially happened in the credit crisis in 2008, then the markets will no longer behave the way that the formulas and numbers say they should! Numbers can perhaps give us an idea of probabilities, but even an event with an extremely low probability can still happen, as was the case recently. An awareness of both the quantitative and qualitative sides of the market is important investing is not pure science, it is both a science and an art. 2010, College for Financial Planning, all rights reserved. This publication may not be duplicated in any way without the express written consent of the publisher. The information contained herein is for the personal use of the reader and may not be incorporated in any commercial programs, other books, databases, or any kind of software or any kind of electronic media including, but not limited to, any type of digital storage mechanism without written consent of the publisher or authors. Making copies of this material or any portion for any purpose other than your own is a violation of United States copyright laws. The College for Financial Planning does not certify individuals to use the CFP, CERTIFIED FINANCIAL PLANNER, and CFP (with flame logo) marks. CFP certification is granted solely by Certified Financial Planner Board of Standards, Inc. to individuals who, in addition to completing an educational requirement such as this CFP Board-Registered Program, have met its ethics, experience, and examination requirements. Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP, CERTIFIED FINANCIAL PLANNER, and federally registered CFP (with flame logo), which it awards to individuals who successfully complete initial and ongoing certification requirements. At the College s discretion, news, updates, and information regarding changes/updates to courses or programs may be posted to the College s website at or you may call the Student Services Center at