Know active stock picking rarely produces winners

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