Finance paper
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Behavioral Finance: Money Over Mind
Wealth Management Services
Introduction
Behavioral finance, the study of how emotions impact financial decisions and markets, has piqued the interest of investors and investment professionals alike for decades.
This paper examines behavioral finance concepts, including its history, classic investor behaviors, recent evidence and the role of the financial advisor in educating clients on behavioral biases and implementing strategies to help dampen their effects on investor behavior.
Background on Behavioral Finance
As early as 1936, behavioral finance played a role in economic theory. In his classic publication, “The General Theory of Employment, Interest and Money,” John Maynard Keynes suggested that while “most economic activity results from rational economic motivations… animal spirits are the main cause for why the economy fluctuates as it does.”1
In 1952, Harry Markowitz introduced Modern Portfolio Theory, which largely ignored behavioral finance effects on the market. Since its introduction more than sixty years ago, Modern Portfolio Theory has been at the heart of most market analysis, seeking to minimize the impact of emotions on financial markets and on individuals’ investment experiences.
Modern Portfolio Theory is based on the assumption that markets and investors are rational. Two basic assumptions of this theory are:
1) A security’s price is an accurate reflection of all the information available about the security. This assumption further assumes that any incorrect price for that security will be quickly corrected through an arbitrage process.
2) Investors are, by nature, risk averse; when given a choice between two investments having the same expected returns, investors will always choose the investment that is less risky.
In 1979, two researchers, Amos Tversky of Stanford University and Daniel Kahneman of Princeton University, introduced research that challenged Markowitz’s assumptions. Their research, which became the basis for Prospect Theory, maintains that people feel the pain of financial loss more severely than the joy of financial gain. Today, this pain of loss is most often referred to as “loss aversion.” Through this work, behavioral finance emerged as a “new branch of economic and finance analysis.”2
In their continued research, Kahneman and Tversky observed that humans make decisions using one of two thought processes – the automatic and the reflective. Today, these thought processes are commonly referred to as System 1 (the automatic system) and System 2 (the reflective system).
1 “Animal Spirits,” George A. Akerlof, and Robert J. Shiller, page ix, 2009. 2 “Behavioral Investing,” Worth, Volume 18, Edition 2, Page 76, October/November 2009.
CONTENTS
1 Introduction
1 Background on Behavioral Finance
2 The Power of Emotions
3 Classic Bias Behavior
7 Role of the Advisory Relationship
8 Conclusion
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1) System 1: the automatic system – a rapid, associative, effortless, unconscious process using mental shortcuts and rules of thumb.
2) System 2: the reflective system – a slower, effortful, rule-governed, deductive process. Behavioral finance provides insight into how, at times, the rules of thumb deployed by System 1 fail, causing individuals to succumb to behavioral biases. These biases can result in irrational investment decisions, which may lead to portfolio underperformance. The field of behavioral finance holds that investors’ thought processes, as well as the way information is presented, systematically influence investment decisions and market outcomes.
The Power of Emotions
The irrational behavior caused by behavioral biases can impose significant costs on individual portfolio performance. The chart below illustrates the negative impact of bad investing habits. For the 15-year period ended December 31, 2016, the average equity mutual fund investor, as calculated by Morningstar Associates, experienced annual returns of 4.86%. During the same period, the equity mutual funds themselves posted returns of 6.26% annually, or 1.40% more per year than the individual investors experienced. How could fund investors experience significantly lower gains than the actual funds in which they are invested? The answer is that behavioral biases often result in investors buying high and selling low, which is contrary to most investment goals of buying low and selling high. This example illustrates how behavioral biases can have a real, negative impact on investment returns.
The graph below is another visual representation of how individual investors tend to sell at markets troughs, precisely the time when they should be buying, instead of market peaks. It shows the past 15-year performance of the S&P 500, a market average commonly followed by
Individual Investor Returns – 15 Year Period Ended December 31, 2016
Source: Morningstar Direct SM. Funds used to compute average Investor Returns and Mutual Fund Returns meet the following criteria: 1) Broad Category Group is Equity, 2) Primary Prospectus Benchmark is S&P 500 TR, 3) Morningstar Category is Large Blend, 4) Equity Style Box (Long) is Large Blend, 5) Oldest share class = yes. 56 funds with available data met these criteria. Within this dataset, average Investor Return is 4.86% and average Fund Return is 6.26%.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Past performance is no guarantee of future results. All indices are unmanaged and unavailable for direct investment. Please see disclosures for additional information.
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individual investors, and fund flows into and out of U.S. equity funds over the same time period. The gray bars highlight periods of market drops coinciding with flows out of mutual funds.
A trusted relationship between an advisor and investor can mitigate the impact of these behaviors on an investor’s long-term goals. Recognizing a few common behaviors can provide valuable insight into how people think, and how an advisor can better guide investors to make decisions that inspire a smoother, more disciplined approach to investing.
Classic Bias Behavior
Three classic bias behaviors are Paralysis, Illusion of Control and Valuation Confusion. This section describes these behaviors and accompanying biases and offers ideas to help counter their negative influences.
Investor Paralysis – Loss Aversion
Investor paralysis occurs when an investor is either unwilling or unable to make a decision. Investor paralysis is present when an investor refuses to diversify outside of a familiar industry, delays the sale of a stock to stop losses and keeps a large percent of assets in cash because he is overwhelmed with investment choices.
Loss aversion is a common cause of investor paralysis. As stated earlier, Kahneman and Tversky found that individuals feel the pain of loss more severely than they feel the joy of gain. Their research concluded that loss aversion can impact investors in three ways:
Undisciplined Investing and Untimely Decisions
Source: Morningstar Direct
Past performance is no guarantee of future results. Performance assumes the reinvestment of dividends and capital gains. All indices are unmanaged and unavailable for direct investment. Please see end of presentation for important disclosures.
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1) Selling winning investments too soon – individuals may find themselves selling investments too early because they are trying to capture a gain before experiencing any potential loss.
2) Holding losing investments too long – investments that show little promise of posting a gain are often held because investors don’t want to realize the loss.
3) Assuming additional risk – in order to make up for potential losses, individuals are often willing to take on more risk than they would under normal circumstances.
To clearly illustrate the impact of this bias, consider one of the experiments conducted by Kahneman and Tversky during their landmark research. The study separated individuals into two groups:
▪ Group One was told that they had been awarded $1,000 and were further asked to choose between: (a) a certain gain of $500 or
(b) a 50% chance to gain an additional $1,000 and a 50% chance to gain nothing.
▪ Group Two was told that they had been awarded $2,000 and were further asked to choose between: (a) a certain loss of $500 or
(b) a 50% chance to lose $1,000 and a 50% chance to lose nothing.
In both groups, the choices would have resulted in exactly the same outcomes: choice (a) would result in an ending balance of $1,500 and choice (b) would result in an ending balance of either $1,000 or $2,000. However, when given the choice, 84% of the participants in Group One chose option (a), a certain gain, while 69% of the participants in Group Two chose option (b), accepting the risk to potentially lose $1,000.3
The study concluded that while individuals may not be willing to take on additional risk for a prospective gain, they may be willing to take on additional risk in order to avoid a potential loss.
To help your clients mitigate the impact of loss aversion, consider the following approach:
1) Set sell targets and stop-loss prices at the time of purchase – decide the prices at which one would consider selling the investment. By implementing sell targets and stop-loss prices, individuals may avoid selling winning investments too soon and holding losing investments too long.
2) Analyze the opportunity cost of holding an investment that has declined in value, rather than selling it. These opportunity costs include: o Realizing the loss – by selling an investment at a loss, the investor may offset capital
gains from other investment activity, resulting in a potential tax reduction. o Taking advantage of other investment opportunities – by selling a losing investment,
the individual may be able to invest the remaining proceeds in an investment that carries a higher expected return, or less risk.
3) Invest using dollar cost averaging. Dollar cost averaging is a technique where an investor contributes a portion of the total investment amount periodically, instead of all at once. This technique avoids gain and loss being fixed to one price point.
3 “Prospect Theory: An analysis of Decision under Risk,” Daniel Kahneman and Amos Tversky, Econometrica, 47(2), pages 263-291, March 1979.
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Illusion of Control – Overconfidence and Hindsight Bias
There is often an illusion of control among individuals who are overconfident. These individuals tend to overestimate their own abilities, knowledge and skills. Overconfidence is a powerful behavioral motivator and influences a broad range of investor behaviors. It causes an investor to believe in his ability to predict the next market crash, to refuse to diversify beyond her own company because of her confidence in its performance and to seek out opportunities to “time the market” with frequent trades.
Overconfidence bias stems, in part, from the brain’s tendency to confuse probability with plausibility. When we’re asked to judge how probable an event or outcome might be, our minds (both System 1 and System 2) work on constructing coherent stories about how the event might turn out. For example, if we’re asked to assess the probability that a stock will gain 30% over the next year, we begin to craft stories about how the shares could be driven higher. Often, if we’re able to construct a story that’s coherent and plausible, we judge its outcome as likely or probable. Our ability to construct a good story causes us to be confident about the predictions we make without the proper regard for their true probability.
Overconfidence is especially prevalent among experienced investors, who tend to take credit for positive outcomes and attribute negative outcomes to external factors that are beyond their control. A study by Itzhak et al (see chart next page) analyzed stock market predictions made by a group of chief financial officers over a 10-year period.4 The CFOs were asked to give their predictions for the stock market over the next 12 months. In addition, they were asked to give their high and low estimates for the market’s performance, such that they were 80% confident the next year’s returns would fall somewhere within their high-low range. The chart below shows the results. If the CFOs are appropriately confident, market returns will fall within the stated range of returns 80% of the time. In fact, the ranges given by the CFOs captured the market’s returns less than 40% of the time. This phenomenon occurs because the CFOs’ ranges are too narrow. In other words, they are overconfident about their predictions.
Overconfidence is often exacerbated by a related behavioral bias: hindsight bias. Hindsight bias is the tendency to look at past events with rose-colored glasses, believing we predicted or foresaw events that we, in fact, did not. When individuals reconstruct their recollection of the past, they tend to focus on a few salient events that happened and ignore the myriad events that did not happen, but could have. This occurs because the human memory system is designed to adapt to the future, not to accurately reconstruct the past.5 In other words, we remember judging the events that happened as more probable than we really believed them to be at the time. For example, now that the 2008-2009 financial crisis has come and gone, how many prognosticators claim to have predicted it? Certainly more than were predicting a financial crisis before it actually happened. Many of these people genuinely “remember” foreseeing the crisis because of their poorly reconstructed version of past events.
Hindsight bias causes individuals to believe that they knew the past better than they actually did. This mistake feeds even greater overconfidence and causes these individuals to believe that they can also foresee the future with greater certainty than they actually can.
4 “Managerial Miscalibration”, Itzhak Ben-David, John R. Graham, and Campbell R. Harvey, SSRN working paper. 5 “Hindsight does not equal foresight: the effect of outcome knowledge on judgment under uncertainty”, B. Fischoff, 1975.
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After all, they remember accurately predicting past events, so they believe they should be able to know the future as well.
The following techniques may be useful for managing against overconfidence:
▪ Rebalance portfolios with discipline. Consult the original plan and investor’s investment philosophy before making any rash portfolio changes.
▪ Seek an outside opinion from a reliable source. It is human nature to look for evidence that confirms our current beliefs; therefore, it is important to look for evidence that challenges our opinions.
▪ Utilize hedging strategies such as limit orders, collars and puts to minimize any drastic negative outcomes.
Valuation Confusion - Anchoring
Valuation confusion happens when we focus on value at certain points in time or we conceptualize different values to different expenses and investments. Valuation confusion can cause an investor to misjudge an investment’s performance by using an inappropriate benchmark, take larger risks after a big gain or increase in wealth and refuse to sell an investment for less than the price for which it was purchased.
Anchoring is the tendency to use an idea or fact as a reference point for future decisions, even though these reference points have no bearing on future judgments.
To illustrate this bias, consider a hypothetical example:
▪ Suppose an individual purchased a home in 2001 for $200,000.
Overconfidence – CEO Confidence Intervals vs. Actual Returns
Source: “Managerial Miscalibration”, Itzhak Ben-David, John R. Graham, and Campbell R. Harvey, SSRN working paper.
The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure the performance of the broad domestic economy. Past performance is no guarantee of future results. Performance assumes the reinvestment of dividends and capital gains. All indices are unmanaged and unavailable for direct investment. Please see disclosures for additional information.
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▪ At the peak of the housing market in 2007, the home appreciated in value to $1,000,000 (the individual did not sell the home at this time).
▪ In 2011, the homeowner learns that the current value for his home is $600,000 (the individual is now ready to sell his home).
Many investors would see this new home value as a $400,000 loss, because they have anchored on the 2007 high value of $1,000,000. However, if the investor sells his home for $600,000, he will actually realize a gain of $400,000. The annualized return on this investment for the 10 year holding period would have been 11.6%.
Anchoring can influence an investor’s decision making by “ever-so-subtly suggesting a starting point for an investor’s thought process.”6 To manage this type of behavior, consider the following:
▪ Challenge the investor to justify the chosen reference point. Communicate appropriate benchmarks and relative performance to an investor.
▪ Explain performance with a long-term perspective. Compare the investor’s current situation versus where they were and where they are headed, to determine if the investments still reflect the investor’s overall goals and objectives. Typically, monthly or quarterly written account statements focus on short-term performance. By providing “since inception” data, the advisor can move the focus of the investment performance to a more rational, long-term perspective.
Role of the Advisory Relationship
The planning process – client discovery, creating an investment policy statement, client review meetings and ongoing professional advice – presents many opportunities for advisors to potentially preempt behavioral biases and ensure clients’ financial well-being. Education about behavioral biases does not immunize one from their detrimental effects, and advisors are often susceptible to those same biases. Utilizing planning strategies and processes can help standardize decisions and block out emotional influence. Bias education coupled with planning strategies and processes raises bias awareness and lowers their effect on investment decisions.
Client Discovery
The client discovery process gives advisors a chance to access clients’ particular behavioral inclinations. A thorough and comprehensive interview helps advisors develop a deeper understanding of clients’ different personalities, concerns and priorities and assures clients of advisors’ abilities and expertise.
Creating an Investment Policy Statement
A well-crafted investment policy statement helps define boundaries and set goals for investors’ investments. Financial advisors can help investors control their emotions by creating and implementing an investment policy statement that provides disciplined asset allocation, diversification and rebalancing strategies.
Client Review Meetings
Debriefing client on investment performance and recalibrating strategy is a good opportunity to address any behavioral mistakes. After constructing an appropriately diversified asset allocation,
6 “Nudge, Improving Decisions About Health, Wealth, and Happiness,” Richard H. Thaler and Cass R. Sunstein, page 24.
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a thorough client review meeting and formal rebalancing process requires investors to reduce exposure and add to assets independent of how client feels about individual investments or asset classes.
The Value of Professional Advice
Effectively communicating advisor value to clients helps ensure that clients will be receptive to advice. An advisor’s objective, professional perspective can help to increase the probability that an investor will achieve his unique financial goals and increase the value that the advisor provides.
Conclusion
Recognizing that human emotions drive many investor decisions can elevate the quality and consistency of an advisor/investor relationship. Discuss investor paralysis, the illusion of control and valuation confusion and the corresponding biases. Education along with implementing a formalized planning process can help advisor minimize the detrimental effect these biases have on investment decisions.
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Disclosure
This report is provided for informational and educational purposes only. The statements contained herein are the opinions of Nuveen Wealth Management Services. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Hypothetical examples are shown for illustrative and educational purposes only. Information was obtained from third party sources, which we believe to be reliable but not guaranteed for accuracy or completeness. The information provided is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. The information provided does not take into account the specific objectives, financial situation, or particular needs of any specific person. Investing entails risk including the possible loss of principal and there is no assurance that an investment will provide positive performance over any period of time.
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