Behavioral Finance, Osa 3

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Tämä on kolmas osa käyttäytymisperusteisen rahoituksen eli behavioral financen kirjoitussarjasta. Sen on kirjoittanut Oulun yliopiston rahoituksen professori Hannu Kahra ja teksti perustuu pitkälle John Nofsingerin kirjaan Psychology of Investing. Lue myös sarjan ensimmäinen ja toinen osa. Tämän jälkeen tuleva neljäs osa on sarjan viimeinen.

2.6.6 Anchoring

Kahneman and Tversky (1974) argue that when forming estimates, people often start with some initial, possibly arbitrary value, and then adjust away from it. Experimental evidence shows that the adjustment is often insufficient. Put differently, people "anchor" too much on the initial value. In one experiment, subjects were asked to estimate the percentage of United Nations' countries that are African. More specifically, before giving a percentage, they were asked whether their guess was higher or lower than a randomly generated number between 0 and 100. Their subsequent estimates were significantly affected by the initial random number. Those who were asked to compare their estimate to 10, subsequently estimated 25%, while those who compared to 60, estimated 45%.

2.6.7 Availability biases

When judging the probability of an event the likelihood of getting mugged in Chicago, say people often search their memories for relevant information. While this is a perfectly sensible procedure, it can produce biased estimates because not all memories are equally retrievable or "available", in the language of Kahneman and Tversky (1974). More recent events and more salient events - the mugging of a close friend, say - will weigh more heavily and distort the estimate.


2.6.8 Illusion of control

Another important psychological factor is the illusion of control. People often believe they have influence over the outcome of uncontrollable events. The key attributes that foster the illusion of control are choice, outcome sequence, task familiarity, information, and active involvement. Online investors can routinely experience these attributes.

Choice
Making an active choice induces control. For example, people who choose their own lottery numbers believe they have a better chance of winning than people who have numbers given to them at random. Because online brokers do not give investors advice, investors must make their own choices regarding what (and when) to buy and sell.

Outcome sequence

The way in which an outcome occurs affects the illusion of control. Early positive outcomes give the person a greater illusion of control than early negative outcomes do. Investors were getting on the Web during the late 1990s and taking control of their investments, and because this period was an extended bull market interval, they likely experienced many positive outcomes.

Task familiarity

The more familiar people are with a task, the more they feel in control of the task. For example, investors have been becoming familiar with the online investment environment and have been active traders and participants in Web information services.

Information

When a greater amount of information is obtained, the illusion of control is greater as well. The vast amount of information on the Internet already has been illustrated.

Active involvement

When a person participates a great deal in a task, the feeling of being in control is also proportionately greater. Online investors have high participation rates in the investment process. Investors using discount brokers (such as online brokers) must conduct their own investment decision-making process. These investors obtain and evaluate information, make trading decisions, and place the trades.

The Internet fosters further active involvement by providing the medium for investment chat rooms, message boards, and newsgroups. Internet investment services firms such as Yahoo!, Motley Fool, Silicon Investor, and The Raging Bull sponsor message boards on their Web sites where investors can communicate with each other. Typically, message boards are available for each stock listed on the exchange. Users post a message about the firm using an alias or simply read the message postings.

2.6.9 Past success

Overconfidence is learned through past success. If a decision turns out to be good, it is attributed to skill and ability. If a decision turns out to be bad, then it is attributed to bad luck. The more successes people experience, the more they will attribute it to their own ability, even when much luck is involved.

During bull markets, individual investors will attribute too much of their success to their own abilities, which makes them overconfident. As a consequence, overconfident behaviors (e.g. high levels of trading and risk taking) will be more pronounced in bull markets than in bear markets.

This is borne out in the behavior of investors during the bull market of the late 1990s and the subsequent bear market. As the bull market raged on, individual investors traded more than ever. In addition, investors allocated higher proportions of their assets to stocks, invested in riskier companies, and even leveraged their positions by using more margin (borrowed money). These behaviors slowly became reversed as the overconfidence of the bull market faded and the bear market dragged on.

2.6.10 Conclusions

Economists are sometimes wary of this body of experimental evidence because they believe (i) that people, through repetition, will learn their way out of biases; (ii) that experts in a field, such as traders in an investment bank, will make fewer errors; and (iii) that with more powerful incentives, the effects will disappear. While all these factors can attenuate biases to some extent, there is little evidence that they wipe them out altogether. The effect of learning is often muted by errors of application: when the bias is explained, people often understand it, but then immediately proceed to violate it again in specific applications. Expertise, too, is often a hindrance rather than a help: experts, armed with their sophisticated models, have been found to exhibit more overconfidence than laymen, particularly when they receive only limited feedback about their predictions. Finally, in a review of dozens of studies on the topic, Camerer and Hogarth (1999, p. 7) conclude that while incentives can sometimes reduce the biases people display, "no replicated study has made rationality violations disappear purely by raising incentives".

2.7 Pride and regret

People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing that a previous decision turned out to be a bad one. Pride is the emotional joy of realizing that a decision turned out well. Consider this state lottery example. You have been selecting the same lottery ticket numbers every week for months. Not surprisingly, you have not won. A friend suggests a different set of numbers. Do you change numbers? Clearly, the likelihood of the old set of numbers winning is the same as the likelihood of the new set of numbers winning. This example has two possible sources of regret. Regret will result if you stick with the old numbers and the new numbers win. This is called the regret of omission (not taking an action). Regret also will result if you switch to the new numbers and the old numbers win. The regret of an action you took is the regret of commission. In which case would the pain of regret be stronger? The stronger regret would most likely result from switching to the new numbers because you have a lot of emotional capital in the old numbers - after all, you have been selecting them for months. A regret of commission generally is more painful than a regret of omission. Investors often regret the actions they take, but rarely regret the ones they do not.

2.7.1 Disposition effect

Avoiding regret and seeking pride affects people's behavior, but how does it affect investment decisions? Two financial economists, Hersh Shefrin and Meir Statman, adapted this psychological behavior to the investor. They show that fearing regret and seeking pride causes investors to be predisposed to selling winners too early and riding losers too long. They call this the disposition effect. Consider the situation in which you wish to invest in a particular stock. However, you have no cash and must sell a position in another stock hi order to have the cash for the new purchase. You can sell either of two stocks you hold. Stock A has earned a 20 percent return since you purchased it, whereas stock B has lost 20 percent. Which stock do you sell? Selling stock A validates your good decision to purchase it in the first place. It would make you feel proud to lock in your profit. Selling stock B at a loss means realizing that your decision to purchase it was bad. You would feel the pain of regret. The disposition effect predicts that you will sell the winner, stock A. Selling stock A triggers the feeling of pride and allows you to avoid regret.

2.7.2 Selling winners too soon and holding losers too long

The disposition effect not only predicts the selling of winners but also suggests that the winners are sold too soon and the losers are held too long. What does selling too soon or holding too long imply for investors? Selling winners too soon suggests that those stocks will continue to perform well after they are sold. Holding losers too long suggests that those stocks with price declines will continue to perform poorly.

When an investor sold a winning stock, Odean found that the stock generally beat the market during the next year by an average 2.35 per cent. During this same year, the loser stocks that the investors kept generally underperformed the market by -1.06 percent. Investors tend to sell the stock that ends up providing a high return and keep the stock that provides a low return.

2.7.3 Disposition effect and news

One study investigated all the trades of individual investors in 144 NYSE firms during the November 1990 through January 1991 period. Specifically, how investors react to news about the company and news about the economy was studied. News about a company primarily affects the price of the company's stock, whereas economic news affects all firms. Good news about a firm that increases the stock price induces investors to sell (selling winners). Bad news about a firm does not induce investors to sell (holding losers). This is consistent with avoiding regret and seeking pride.

However, news about the economy does not induce investor trading. Although good economic news increases stock prices and bad economic news lowers stock prices, this does not cause individual investors to sell. In fact, investors are less likely than usual to sell winners after good economic news. These results are not consistent with the disposition effect.

2.8 Risk perceptions

Consider this wager on a coin toss: Heads you win $20, tails you lose $20. Would you take this gamble? Assume, you won $100 earlier. Now would you take this gamble? Did your answer change after finding out that you had won earlier? What if you had lost $20 earlier? Would this make the gamble look any different to you?

Many people will take the gamble in one situation but not in another. The odds of winning the $20 do not change in the different scenarios, so the expected value of the gamble remains the same. Neither the risk nor the reward of the gamble changes between situations; therefore, people's reaction to risk must change. People's perception of risk appears to vary. One important factor in evaluating a current risky decision is a past outcome. In short, people are willing to take more risk after earning gains and less risk after losses. To illustrate this behavior, Richard Thaler and Eric Johnson asked 95 undergraduate economics students to take a series of two-step gambles using real money. In the first step, money was either given to or taken from the student. In the second step, the student was asked whether he or she wished to take the gamble presented. Their findings suggest a "house-money effect," a risk-aversion (or snakebite) effect, and a "trying-to-break-even effect," which are discussed next.

2.8.1 Snakebite (or risk aversion)

After experiencing a financial loss, people become less willing to take a risk. When faced with a gamble after already losing money, people generally choose to decline the gamble. Students who initially lost $7.50 were then asked to wager $2.25 on the flip of a coin. This time, the majority (60 percent) declined the gamble. After losing the initial money, the students might have felt "snakebit."

Snakes don't often bite people, but when it happens, the person becomes more cautious. Likewise, after having been unlucky enough to lose money, people often feel they will continue to be unlucky; therefore, they avoid risk.

2.8.2 Trying to break even

Losers don't always avoid risk. People often jump at the chance to make up their losses. After having lost some money, a majority of the students accepted a "double-or-nothing" toss of the coin. In fact, a majority of the students were willing to accept a double-or-nothing toss of the coin even when they were told the coin was not "fair"; that is, students were willing to take a risk even though they knew they had less than a 50 percent chance of winning. The need for breaking even appears to be stronger than the snakebite effect.

Another example of this break-even effect can be seen at the race-track. After a day of betting on the horses and losing money, gamblers are more likely to bet on the long shots. Odds of 15 to 1 mean that a $2 bet would win $30 if the horse wins. Of course, horses with odds of 15 to 1 are unlikely to win. The proportion of money bet on long shots is greater toward the end of the race day than at the beginning. It appears that gamblers are less likely to take this risk early in the day. However, those gamblers who have won money (house- money effect) or lost money (break-even effect) during the day are more likely to take this kind of risk. Winners take this risk because they feel as though they are playing with the house's money. Losers like the opportunity to break even without risking too much more. People without significant gains or losses prefer not to take the risk.

2.8.3 Summary

Everyone has heard the investment advice "buy low, sell high." Why is this so hard to do in practice? One reason is that the house-money effect causes investors to seek riskier investments. This often manifests as the buying of stocks that have already had substantial increases in price. These stocks are risky because expectations have been elevated too much. In short, you buy high. If stock prices decline, you feel snakebit and you want out, so you sell low. The combination of the house-money and snakebite effects causes you to do the opposite of buying low and selling high.

When many investors are affected by these problems, the entire market can be affected. The psychological bias of seeking (or ignoring) risk because of the house-money effect contributes to the creation of a price bubble. The psychological bias of avoiding risk in the snakebite effect leads to stock prices that are driven too low after the bubble collapses. Also, the human memory is more a recording of emotions and feelings of events than a recording of facts. This can cause investors to remember actual events inaccurately or even to ignore information that causes bad feelings.