Lecture 2 - DR MARIA MICHOU PDF

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DR MARIA MICHOU...

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Lecture 2:

Continued from lecture 1 slides. 1) Page 31: - Example of admission team, judgement for masters is based on your past grades and they predict your future grade on past performances and offer an admission. 2) Page 32: - Name change of firm, example of internet bubble when there was a huge number of internet companies that just placed the dot.com just beside their name and after the end of the bubble investors reacted positively to the name changes. - A value stock is a group of stock that have low prices relative to a fundamental measure of value, group of stocks have a higher fundamental value, cash earnings and sales for example. - Example of how we can use representativeness is on this page. - When analyst analyse and give advice to their clients, they consider an attractive stock that a company has a good performance which is down to a good management which is considered. A good stock and they advise their clients to buy it, known as good stock syndrome. 3) Page 34: - Rather estimating the probability using base rates, investments have substituted based on performance is insensitivity to sample size. - Because we have made a judgement already in our mind, we are very conservative in making decisions out of our comfort zone, is known as ignoring base-rate frequencies. - Gamblers fallacy is a situation when individuals, enormously believe that the existence of a particular event is less likely to happen following a series of events. - This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future. - A very good example is of recovery costs, investors will have a category of investors, these stocks have behaved badly in the future and they are like I am not going to take a chance. Another group of investors say although it has performed badly in the past the company has made changes to the management and now, they believe it will do good in the future therefore will invest in it. 4) Page 35: - It would be higher; people would base their judgements on past events. - Without any other information present they wouldn’t actually know the reason. - Using the ignoring base-rate frequencies which states, “insensitivity to prior information reliance on the representativeness of the event alone. - Second question, I choose B, don’t get context behind it though. 5) Page 36: - People expect extreme performances to be followed with similar extremes. - For example, extreme past losing stocks outperform extreme past winners. - Analyst earnings forecasts. - Illusion of validity; is a function of representativeness not underlying characteristics and insensitivity to predictability: ignoring the (lack of) reliability of the evidence. - Example would be the continuing reliance on the selection interview despite its well accepted lack of any predictive ability.

6) Page 37: - Some question 7) Page 38: - The affect heuristic. - CEOs play major role in M&A, lots of literature on how overconfident CEOs are, they are very much emotionally attached to the stocks or company they are in because of the time and effort they have put in. - They provide over optimistic advice. 8) Notes: - Discussion questions; - What examples of the operation of the availability, representativeness and affect heuristic can you suggest from your own experiences? - From my own…. - Are there any general lessons for market professionals and corporate financial decision makers e.g. in current market conditions? - ….. - Reference: 4th edition onwards is okay for the book. - Journal article is core.

Lecture 2 slides start.

1) Page 3: - Traditional finance assumes frame independence, decision makers can see through the different ways in which the same investment decision may be described. - Framing is transparent. - Behavioural finance indicates perceptions are highly influenced by how decision problems are framed. - Individuals are frame dependent - Framing in practice is opaque, we are unable to see through it. - Actual behaviour= f (how the decision problem is posed) - i.e. changing the form implies change in substance. - Why framing is associated with miller and … theory. - Dollar of wealth right or left pocket example doesn’t make you any richer. - Relationship between return and risk between a stock. - Investors expect to get higher returns, from high risk associated investments, - When people frame a situation with risk and return context then they usually get it right. But if they use a risker frame then they usually get it wrong. 2) Page 4: - Question.

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Page 5: First bias we want to discuss is loss aversion. This pretty much lies in prospect theory. Ability to tolerate loss is a key determinant of all financial decision making. Prospect theory (Kahneman and Tversky 1979) teaches us “losses loom larger than gains” A loss typically has about two and a half times the impact of a gain of the same magnitude. People hate to lose! Particularly acute investment environment.

Note: - Question asked in class, 1st chance is to lose £7500 for sure, or second option is to lose £10,000 at a 75% chance or lose nothing at a 25% chance. - The answer most of them chose was the 2nd option. However, most of the people interviewed hated using money. - They called this loss aversion. 4) Page 6: - Story of nick Leeson at Barings - He lost approximately $1.5bn through trading, Leeson began to engage in trading activities in order to hide the errors he made through his activities, he incurred so many losses than eventually. - He was gambling on the stock market to reverse the mistakes he made on his bank and as a result it made a loss of $1.5bn. - This is also very common in the computing industry; - Example is three com products, predecessor which was apple, Newman package the CEO of this project John scallop. He was pretty much invested in this product and made this product his heart and vision for the computer world. He argued it would be a very important step in the entertainment industry, the development of this product began in 1987 and it was launched in 1993. The thousandpound product was very expensive, by 1994 it was apparent that the sales of the product were very much disappointing. In this sense the product was considered to be a losing product, apple decided to change, but this individual CEO was very committed, apple instead had added in enhance feature in 1994 Newman product. A year later sales were disappointing despite the enhancements. In March 1997 newton and apple, used this product in their own activities however this was a losing whole product for their division. The takeaway from this product is that CEOs come and go they don’t stay in their jobs for long time. John after his product was a losing product he was replaced by Emilio, after enhancements to the product which failed Emilio also removed, after 10 years, when Steve Jobs became CEO, they terminated the product, it took them 10 years to terminate a losing product. For 6 years the CEO had a personal goal and they failed to remove the product. - Impact of loss aversion above, it is more specific to certain industries such as investment banking and computing industry. - Furthermore, the disposition effect is, “Investors are generally predisposed to sell their winners too soon but bold on to their losers too long”. - “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise”; (Kahneman and Tversky). - Standard finance, however, teaches that prior losses are sunk costs and are therefore irrelevant. - Computer driven sell disciplines.

5) Page 7: - Risk averse person would choose A. - Question.

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Page 8: Investors frame their losses; purchase price always seems to be an important factor. Value of gains and loses according to a function is very important as well. Shape is concave on gains, implies that investors feel great and good on their investment decisions they have higher utility when they make a 500 gain and they feel even better if it is going to double. However they do not feel as twice as happy when they gain 1000 pounds as compared to 500 pounds, the first characteristic is ….. We should see that the function is convex to a loss, it means that investors feel really bad when they make loses. Relationship between gains and loses post. In both cases choice behaviour is a function of probability and outcome. Standard finance teaches that investors are rational and make decisions as if they are always risk averse.

Prospect theory teaches that investors think in terms of gains or losses relative to some reference point such as the status quo or what the investor expects based on other people’s experiences or peers’ performance (benchmark).

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Page 10: Under the umbrella of prospect theory. Each account is treated separately. Sometimes we allow interaction between these accounts. Mental process can sometimes impact. Investors tend to avoid selling stocks with loses. They do not want to experience emotional stage of regret. Also selling lodging stocks. We can also look at this aspect at a mental budgeting aspect. People value the time of payment and benefits. The emotional pain of wasting some of your sunk costs on a loser, the emotional distress caused to sell by an investor to stock is more…. (I think). They tend to make cumulative sales of emotional regret Causing investors to misperceive adding.

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Page 11: Framing from mental accounting perspective. Self-control is also another significant role as well. The advice here is we have to use rules. Self-control means we are trying to control our emotions, some investors value dividends for selfcontrol reasons as well as for reasons in the form of human editing. Dividends are uncertain no guarantee as they will be paid, that is why they see it as a separate mental account Dividends are very much paid as income, extra pocket money but they are not capital. Self-control here plays significant role. Magic selling words, “The words that I consider to have magical power in the sense that they make for a more easy acceptance of the loss are these: Transfer your assets”. (Leroy Gross, 1982). This works because it re frames the problem. Assets are reallocated from one mental account to another rather than closing it at a loss. Self-control: use of roles; don’t dip into capital Dividends are a different mental account; they are framed as income not capital!

10) Page 12: - Questions. 11) Page 13: - Questions. - The takeaway form this scenario, regret is the key point we are trying to address, regret as an emotion as an investor. Experience when you don’t make the right decision, regret can cause more pain than a loss, pain feeling responsible for the loss. - Answer would be C. 12) Page 14: - His intention was to limit future regret, he decided to divide his investments. - We are trying to minimize regret. - We are trying to sell stocks in order to finance other stuff. - We use many different (unconscious) strategies against mourning and bearing loss including denial, blame, rationalisation and hope; key role of blame in explaining dot.com mania and the credit crisis. 13) Page 15: - Hypothesis were an individual value a good or service more once the property belongs to them. They are the owners of these property or services, they tend to value objects they own more than ones they don’t own. Same away investors tend to hold investments more they already have. - Status quo, cognitive bias, where people tend to change a …. - People tend to be bias towards doing the right or wrong in their decision making. 14) Page 16: - “Living backwards!” Alice repeated in great astonishment. “I’ve never heard of such a thing!” - “- but there’s one great advantage in it, that’s one’s memory works both ways…. It’s a poor sort of memory that only works backwards,” the queen remarked. - Some quote.

15) Page 17: - The investment decisions we make sometimes increase our belfies when the event is inventible, or when we are inflating probability for events that they have actually occurred or can be vice versa. - People passing investment decisions may look but at that time when the decisions were made, they looked correct but now right now they may look wrong. - We tend to overwrite memories and experiences in our brain. - Hindsight bias is of financial analysis where they already knew the company was a good investment - They will say I know that will happen they feel overconfident about their skills as well. - Fund managers in a bull market where the index has increased. - Hindsight bias “Inability to go back in time” once event outcome is known. Outcome awareness increases our belief the event was inevitable in foresight. - We will remember inflated prior probabilities for events that actually occur and vice versa (the prior probability is adjusted towards the posterior probability). - (other peoples) past decisions may look wring, whereas they were perfectly reasonable given the information set available at the time. - We tend to overwrite previously stored memories in our brain so making it difficult to reconstruct past experiences. 16) Page18: - Some illustrations of hindsight biasis; analysts will believe that they already knew (or would have known if they had thought about it) a company was a good investment once its share price has risen. - Fund managers know they “are” (not were) in a bull(bear) market once the index has increased (fallen) reasonably continuously for a long period of time. - Note the need to keep formal records of predictions and a note of the bases on which they are made in an attempt to learn how to correct for this bias.

Page 19: - Very imp question we need to consider. 17) Page 20: - Self-attribution bias (attribution theory). - The “lucky fool” syndrome among market traders; implies attributing skill to randomness. - This bias is a dependency that individuals have to attribute successful outcomes to their own skills, and if things go wrong it is simply bad luck. - Investors who tend to get successful runs, they tend to have an inflated opinion about their own skills and all, this is very common for fund managers and investment analysts and company chairmans. - For example, chairmen’s statements (letters to shareholders) demonstrate “self-serving” managerial behaviour; that is credit is taken for favourable outcomes and poor performance is blamed on the external environment. - “investors have been mugged” – fund managers blaming the government for their losses not their own investment judgement. - Internet stock traders blaming the market and internet trading sites for their losses. - “Don’t confused brains with a bull market” - Example of Thomas cook on the government point....