Know active stock picking rarely produces winners



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Know active stock picking rarely produces winners

  • Know active stock picking rarely produces winners

    • Efficient markets tells us information immediately is reflected in prices
  • If buy baskets/indices and dollar cost average can avoid market timing and active management costs

  • Just an issue of portfolio mix

    • % stocks, bonds, etc
  • Not that hard to learn or do own research

    • Are people that lazy? Or dumb?
    • If so, why do so many high-income professionals in finance use advisors?


Procrastinate

  • Procrastinate

  • Have information but don’t act on it

  • Self-control – cannot resist spending

  • Sophisticated investors knows his/her limitations

    • Needs external controls / constraint


Traditional

  • Traditional

    • Rational
      • Fully informed
      • Make Choices Consistent with Expected Utility


Bridge the gap between classical economics and psychology

  • Bridge the gap between classical economics and psychology

  • Individual behavior systematically show psychological patterns

    • Overconfidence
    • Anchor too low/high and too slow to adjust
    • Frame losses as worse than relative gains; Valued more highly if owned
    • Chase Trends; Overwhelmed by choice
    • Lack of self-control; Trade at wrong time; Emotional investing
  • Markets can still be rational when investors are individually irrational.

    • But that does not mean individuals don’t make major mistakes!


Study of men and women investment accounts

      • Study of men and women investment accounts
        • All had negative returns after trading; men 2xs worse than women
        • B/c males traded too much


Strategies decision makers use when faced with decisions, that involve uncertainty:

  • Strategies decision makers use when faced with decisions, that involve uncertainty:

  • 1. Representativeness

    • People tend to infer that a single observation is representative of the entire population
      • Sample Size Neglect in Learning Distribution (6 Tosses vs. 1000 Tosses)
      • Gambler’s Fallacy - Base Rates are Under-Emphasized Relative to Evidence
      • Judgment based on similarity. “Patterns in random sequences”.
  • 2. Saliency or Availability: “familiarity breeds investment”.

    • People tend to over-estimate probabilities of a low frequency event if they have recently heard such an event has occurred
  • 3. Prospect Theory

    • Investors more risk-adverse in domain of losses than gains


Proposed by two psychologists: Daniel Kahneman (won Nobel for Economics 2002) and Amos Tversky

  • Proposed by two psychologists: Daniel Kahneman (won Nobel for Economics 2002) and Amos Tversky

  • Gambles are evaluated relative to a reference point.

    • Decision maker analyzes “gains” and “losses” differently.
    • Anchoring
      • Initial Arbitrary Value and Make Adjustments
  • Incremental value of a loss is larger than that of a loss.

    • “the hurt of a $1000 loss is more painful than the benefit of a $1000 gain”.


Have $300 (“Initial endowment”).

  • Have $300 (“Initial endowment”).

  • Consider a choice between:

    • a sure gain of $100
    • a 50% chance to gain $200, a 50% chance to gain $0.
  • Have $500. Consider a choice between:

    • a sure loss of $100
    • a 50% chance to lose $200, a 50% chance to lose $0.
  • Case 1: 72% chose option 1, 28% chose option 2.

    • Framed as a gain: decision maker is risk averse.
  • Case 2: 36% chose option 1, 64% chose option 2.

    • Framed as a loss: decision maker is risk seeking.


Regret Aversion

  • Regret Aversion

    • anticipation of a future regret can influence current decision.
  • Disposition Effect

    • Hold losers too long and sell winners too early
    • Status Quo effect – inertia
    • Endowment effect – value owned item more
  • Belief Perseverance

      • Different search & treatment of contradictory information
  • Mental Accounting

    • “Found money” effect
  • Self-attribution bias

    • Successes due to talent but failure due to bad luck


Herding: may select stocks that other investors select to avoid “falling behind”

  • Herding: may select stocks that other investors select to avoid “falling behind”

    • Socionomics: People are influenced by each other.
    • Herding behavior: “safety-in-numbers”
      • Subjective, unconscious, pre-rational impulses
      • Rationalize mood-induced moves
      • ‘Wise’ crowds become foolish – especially as become more uniform
  • Informational Cascades & Positive Feedback

    • Example: excessive demand for internet IPOs.
      • Extremely high opening day returns.
    • Hindsight Bias
      • “of course Google was a good buy in 2002”


Visceral – anger, jealousy, etc

  • Visceral – anger, jealousy, etc

  • Mild mood or affect

    • Positive – negative
    • Anxious
    • Hopeful
  • Change self regulation and use of information

  • Sunny or Rainy Day

    • Related to market returns?


We are boundedly rational

  • We are boundedly rational

    • Not out to maximize every decision
    • “Good enough” not the “best” or optimal
  • People are ok with doing average

    • Not out to always beat the average
      • Works in favor or many investment strategies
  • When faced with a complex or difficult decisions tend to use two simple heuristics

      • Keep things as they are (via inertia) OR
      • Put the decision off (via procrastination)




Spend / consume too much now

  • Spend / consume too much now

  • Fail to save for future

    • Even though you know “future you” wants to “present you” save – “present you” fails to do it
      • “hyperbolic discounting” rate – not consistent over time/selves
      • sophisticate: someone who understands his irrationality and builds systems to cope with it
        • Automatic deposit
        • Penalty for withdrawal
    • Save More Tomorrow (use mental accounting to advantage)
      • Agree this year to save next year
      • Agree to save portions of future raises
    • Why do people get $3000 tax refunds?


Paying employees to save:

  • Paying employees to save:

    • matches don’t work very well
  • Educating investors:

    • financial education (alone) doesn’t work
    • Has some effects but not enough
      • A complement to other efforts
  • Change defaults / Re-design processes







Markets down

  • Markets down

    • Fear leads to selling at worst time
    • Start to question strategies
      • Buy and hold
      • Dollar cost indexing
      • Index funds
    • Having an external constraint helps
      • Stick to the plan
      • Make decisions public
        • Key role of investment advisor


Trusted advisor

  • Trusted advisor

    • Issues maybe very simple; not technical
  • Financial therapy

    • People want to tell their story
  • Self Control and discipline

    • Keeping promises and reaching goals
  • Coaching

    • Self-actuated goals & performance improvement



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