Reference manual trading psychology

People are not rational Fundamental analysis, and much of people’s education and knowledge about investing and trading, is the work of financial economists from the world’s best univers

The London Academy of Trading

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Professional Financial Trading

Programme - Course Reference Manual

Behavioural Finance & Trading Psychology

Behavioural Finance & Trading Psychology

CONTENTS:

OUR BEHAVIOUR MATTERS 4

PEOPLE ARE NOT RATIONAL 4

THIS COURSE: 4

THE BRAIN IS NOT A COMPUTER 5

ACAUTIONARY STORY -LONG TERM CAPITAL MANAGEMENT 5

BEHAVIOURAL FINANCE 7

HERD INSTINCT 10

DEFINITION OF HERD INSTINCT 10

BUBBLES IN FINANCE 10

SUCKER RALLY 10

OVERCONFIDENCE 11

BECOMING OVERCONFIDENT 11

THE ILLUSION OF KNOWLEDGE 12

THE ILLUSION OF CONTROL 13

Choice 13

Outcome of Sequence 13

Task Familiarity 13

Information 13

Active Involvement 14

OVERCONFIDENCE AND INVESTING 14

Overconfidence and Trade Frequency 14

Gender Differences 14

Trading Too Much 15

OVERCONFIDENCE AND RISK 15

OVERCONFIDENCE AND EXPERIENCE 15

WHAT I OWN IS BETTER 16

ENDOWMENT EFFECT 16

ENDOWMENT AND INVESTING 16

STATUS QUO BIAS 17

ATTACHMENT BIAS 17

Overcoming These Biases 17

SEEKING PRIDE AND AVOIDING REGRET (LOSS AVERSION) 18

DISPOSITION EFFECT (MORE LOSS AVERSION) 18

DO WE REALLY SELL WINNERS? 19

AVOIDING THE PAIN OF REGRET 19

DOUBLE OR NOTHING 19

HOUSE-MONEY EFFECT 19

SNAKE-BITE EFFECT 20

BREAK-EVEN EFFECT 20

THAT’S NOT THE WAY I REMEMBER IT 21

MEMORY AND INVESTMENT DECISIONS 21

COGNITIVE DISSONANCE 21

COGNITIVE DISSONANCE AND INVESTING 21

REFERENCE POINTS &ANCHORING 22

BEHAVIOURAL PATTERNS THAT SABOTAGE TRADERS 23

MOST TRADING PROBLEMS ARE VARIETIES OF PERFORMANCE ANXIETY 23

PERFORMANCE ANXIETY OCCURS AS MUCH DURING TIMES OF MARKET SUCCESS AS DURING TIMES 23

TRADERS COMMONLY TRY TO REPLACE NEGATIVE SELF-TALK WITH POSITIVE SELF-TALK DURING TRADING 23

PERFECTIONISM IS THE MOST COMMON SOURCE OF PERFORMANCE ANXIETY AMONG TRADERS 23

PERFECTIONISM LEADS TRADERS TO OVERTRADE 23

TRADERS THAT MASTER PERFORMANCE ANXIETY AT ONE LEVEL OF SIZE 23

TRADERS OFTEN THINK THEY HAVE WORSE PSYCHOLOGICAL PROBLEMS THAN THEY ACTUALLY HAVE 23

1 FOCUS ON PROCESS GOALS WHEN THINKING ABOUT TRADING, RATHER THAN PROFITS/LOSSES 25

2 TACKLE RISK INCREMENTALLY 25

3 STEP AWAY FROM THE SCREEN 25

4 USE MENTAL REHEARSALS TO MAKE THREATENING SITUATIONS FAMILIAR 25

5 ANCHOR MENTAL REHEARSALS TO DISTINCTIVE MIND STATES 25

6 PERFORM A MENTAL CHECKLIST BEFORE TRADING 25

7 GET A LIFE 25

HOW TO MANAGE RISK & UNCERTAINTY 27

STOP LOSS ORDERS 27

APPENDIX I 34

COLIN MCLEAN: HOW TO TELL A DUMB HERD FROM A SMART CROWD 34

APPENDIX II 36

COLIN MCLEAN: BEWARE THE ILLUSION OF KNOWLEDGE 36

APPENDIX III 38

BEHAVIOURAL FINANCE: WHAT DRIVES INSTITUTIONAL INVESTORS' DECISIONS? 38

APPENDIX IV 41

SHORT-TERM REACTIONS TO NEWS ANNOUNCEMENTS 41

Our Behaviour Matters

Humans are prone to specific psychological biases – procrastination is one good example These can cause us to act in ways which are bad for our wealth Consider the following choices that we all face

or have faced

 Should I contribute to my pension plan now, or later?

 Should I invest the extra that is in my savings account now or later?

 Should I convert the Gilts and Bonds I inherited into stocks now or later?

In every case the answer is the same – now The longer your money is invested, the larger your portfolio will be

However the bias towards procrastination causes employees to delay making pension plans, often losing time, tax advantages and employer contributions People’s bias towards the status quo allows substantial money to build up in savings accounts before it is transferred into investments accounts; therefore losing the higher rate of return offered by an investment account We also have a bias towards keeping securities we inherited instead of investing them in vehicles which are more

appropriate to our need This is called the endowment effect

Not only does our psychology cause us to delay some actions, it can also cause us to act too soon and too often, and to our detriment in some cases In investing, sometimes we act too soon and sometimes delay too long Is this a paradox? Probably, but it is because we are human

People are not rational

Fundamental analysis, and much of people’s education and knowledge about investing and trading,

is the work of financial economists from the world’s best universities However, these financial economists traditionally dismiss the idea that people’s own psychology can work against them when

it comes to making good investment decisions In recent years, the field of finance has operated on two basic assumptions:

 People make rational decisions

 People are unbiased in their predictions about the future

However, psychologists have known for some time that these are bad assumptions People often act

in a surprisingly irrational manner and make predictable errors in their forecasts Economists are now realising that investors can be irrational Indeed, predictable errors of investors can even affect the functioning of the markets But most important to you the trader or investor, your reasoning errors affect your investing, and ultimately your wealth!

I know that you could understand all the information in all the books on investment, and grasp all the hard fundamental data and still fail to make money if you let your psychological bias control your decisions

This course:

 Investigates many psychological biases that affect decision-making

 Will show you how these biases can affect your investment decisions

 Will help you see how these decisions can reduce your wealth

 Will show you how to recognise and avoid these decisions and avoid these biases in your daily lives

 Will point out the investing tools which allow you to measure the psychological bias of the investing crowd, and to predict its behaviour

One of the simplest and best known reasoning mistakes caused by the brain is visual illusion

Consider this optical illusion Of the two horizontal lines, which is the longer?

In fact, both lines are the same length Look again Although you know that the horizontal lines are equal in length, the bottom one still looks longer Just knowing about the illustration does not eliminate the illusion However, if you make a decision based on these lines, knowing that they look different lengths but also knowing they are in fact the same length; you will avoid making a mistake

The brain is not a computer

We say the brain is the most powerful computer there is but the brain does not act like a computer Indeed, it frequently processes information through short cuts and emotional filters to shorten analysis time The decisions made via this shorter route are often not the same as if the same

decisions are fully analysed without these emotional filters These filters and shortcuts are

psychological biases Knowing about these biases is a major step towards avoiding them

One problem is overestimating the precision and importance of information Let’s play a game! (Here we have a questionnaire where we answer questions with 90% certainty)

A Cautionary Story - Long Term Capital Management

Even Nobel Prize winners in economics are prone to overestimating the precision of their knowledge Consider Long Term Capital Management (LTCM) The partners of the fund included John Meriweather, Salomon Brother’s famed bond trader; David Mullins, a former VP of the Federal Reserve Board; and Nobel prize winners Myron Scholes and Robert Merton The firm employed 24 people with Ph.D.s

The hedge fund began in 1994 and enjoyed stellar returns In the beginning of 1998; LTCM had $94 billion in equity It had also borrowed $100 billion to leverage positions for higher returns Its original strategy was to find arbitrage opportunities in the bond market These low risk strategies were so highly geared the low returns were magnified into high returns After several years of terrific success, LTCM found it harder and harder to find arbitrage opportunities At that point the fund was forced into riskier positions to maintain returns As well as the compound effect improving performance, it compounded risk

In August 1998, Russia devalued its currency and defaulted on some of its debt This action started a chain reaction of events over the next few weeks that led to devaluations in several

emerging countries Bonds and stock markets around the world plunged There was heavy margin selling The prices of US Treasuries skyrocketed as investors fled to the safest investments

These events caused the equity in LTCM’s portfolio to drop from $4 billion to $0.6 billion in one month The Federal Reserve was concerned over margin calls at LTCM which were threatening a systemic collapse of the financial system They quickly arranged for a consortium of leading

investment houses to inject $3.5 billion into the fund in exchange for 90% of its equity

How could a hedge fund with such human brainpower lose 90% of its equity in one month?

In designing their models the fund’s masterminds did not think that so many things could go wrong

at the same time Doesn’t this sound like their range of possible outcomes was too narrow?

Behavioural Finance

All people (even very smart ones) are affected by psychological biases Traditional finance (i.e Efficient Market Hypothesis or EMH) has considered this irrelevant It assumes people are rational and tells us how people should behave These ideas have brought us arbitrage theory, portfolio theory, asset pricing theory, option pricing models

Alternatively, behavioural finance studies how people actually behave in a financial setting

Specifically, it is the study of how psychology affects financial decisions Technical analysis is a set of tools to evaluate and predict the behaviour of the investing crowd

Introduction

Efficient Market Hypothesis (EMH) has been the theoretical foundation of the professional asset management industry and guiding light in the field of economics and finance for the past few decades Any findings that contradict it have usually been dismissed as statistical anomalies

According to EMH, price movements follow a random walk, with changes in price induced by unforcastable ‘news’ about the underlying asset Consequently a trader would not be able to make money by looking at the freely available price history of an asset Any anomalies that did exist would

be spotted and immediately corrected by the market

The key word, hypothesis should be noted here We all know about the theory of gravity but we are also not all pinned down on the ground all the time You have probably heard the story of the fund manager and the academic, who were walking down the road The fund manager said, ‘Isn’t that a twenty pound note on the ground?’ ‘Can’t be’ said the academic ‘or else someone would have picked it up already.’

In recent years the pendulum has swung in favour of Adaptive Market Hypothesis (AMH) with more and more evidence of market predictability Contrary to classical Efficient Market Hypothesis, profit opportunities do arise in modern liquid markets Researchers have long argued that perfectly efficient markets are not possible, for if a market is perfectly efficient, there is no profit earned by information gathering, in which case there would be little reason to trade and markets would collapse

Critics outline that fundamental analysis is not flexible enough to take timely account of unexpected changes in the economic environment The effects of economic or political events often take effect with an unpredictable time lag As a result investors experience timing problems and it is due to these timing problems that people are increasingly turning to technical analysis For example according to Cutler, Poterba and Summers, 80% of the monthly price returns in S&P 500 index cannot be explained by macroeconomic news

In addition, contrary to the trend towards higher market efficiency as predicted by EMH, market dynamics are much more complex, with cycles, trends, panics, bubbles and crashes and other phenomena that are routinely witnessed in natural market ecologies

The search for theoretical explanation for the success of technical analysis has been a challenging one Increasingly the field of behavioural finance has been most successful in providing plausible explanations

Behavioural Finance

Psychology has not always played a central role in the discussion about the behaviour of market participants In the 1970’s for example, when EMH dominated academic thought, the human agent was described in non-human terms Under the efficient market paradigm, rational agents populate financial markets By ‘rational’ we mean normative Behaviour of market participants according to classical economic theory is said to be normative Normative theories are essentially concerned with how people ought to behave They are about rational choices, usually arrived at as a result of an optimisation process

Anyone involved in investing – at any level - knows that this is not the case in real life and that investors’ behaviour - their individual hopes, fears, greed and emotions - have a significant influence

on the movement of financial market prices

Behavioural Finance has emerged over the last decade from a realisation by both academics and particularly practitioners that EMH and Arbitrage Pricing Theory do not offer a good description of the capital market equilibrium nor do they provide any account of the real behaviour of market participants or satisfactorily explain the development of securities prices and anomalies that occur Although the topic of behavioural finance is a broad topic, there are outlined below are some concepts involved in behavioural finance that provide theoretical justification for the success of technical analysis

Conversely, the identification and analysis of trends and chart patterns with financial market instruments can be regarding as a graphical representation of this investor behaviour

Selective Memory

Human development requires an ability to forget terrible times so we can continue to function In financial terms, this may explain why humans fail to learn from past mistakes We convince ourselves that the future must be judged anew and that our current situation is special The technology bubble is a case in point: too many believed in a ‘new economy’ to justify stock overvaluations As a result of this repeated behaviour, cycles and patterns form

Gamblers’ fallacy

The gamblers’ fallacy is a belief that a trend must reserve, e.g if the roulette wheel has been black for so many goes, it must be red next It is essentially a misguided belief in reversion to the mean Reversals of lesser-scale corrections may be due to profit-taking or covering of losses, but it may be that humans have an inbuilt clock or sense of geometry that says when something just can’t go on Any these points may be described or explained by the likes of Gann, Fibonacci and Elliot Wave or oscillators such as RSI and stochastics

Why does Technical Analysis work so well in FX Markets?

Research on exchange rates has proven that technical analysis is useful for predicting short/medium term exchange rate dynamics and can generate significant profits It has been argued by some experts that in the short to medium term fundamental economic factors hardly have any effect at all

on exchange rate dynamics Surveys of foreign exchange market participants consistently find that more emphasis is placed on technical analysis the shorter the time horizon Technical trading strategies such as momentum strategies have proven to be profitable in foreign exchange markets Researchers have proven that intervention actions of central banks create trends in exchange rates that can be exploited by technical traders The success of technical analysis in FX markets can also be explained by the dominance of ‘noise traders’, who make their trading decisions based on past directional movements The FX market is extremely sentiment driven and as a result trends are created from the changing mood of the market participants – sometimes traders interpret macroeconomic data one way then on another occasion another

Long term economic pressures mean that trending behaviour is common in currency markets and within such trends the market level oscillates with changes in market consensus Continued oscillations of this type result in the formation of wave patterns within the underlying trend known

as channels Trend following strategies such as moving averages are historically very successful at capturing trends in FX markets Long term trends tend to be displayed in currency pairs which are the exchange rates between disparate economies like EUR/USD and USD/JPY

When analysing short term exchange rate dynamics, researchers have discovered clustering of orders Researchers have proven that exchange rates reverse course upon reaching round numbers more frequently than they reverse at other numbers, and that exchange rates tend to trend rapidly after crossing round numbers Take profit orders around these numbers tend to reflect trends, and stop-loss orders tend to intensify trends The clustering of execution rates at round numbers creates the support and resistance levels alluded to by technical analysts One research paper highlights that among support and resistance levels for currencies distributed by technical analysts to their customers, 96% end in 0 or 5, and 20% end in 00 (Osler 2000)

Summary

Good technical analysts understand the importance of market psychology They observe the clashes between rival tribes at support and resistance levels They know that prices sometimes reflect solely the emotions of people in the marketplace and totally ignore the hard fundamentals

They talk about the market being a ‘crowd’, like at a football match They are in this crowd Understanding the weakness and emotions of the crowd and their own weaknesses and emotions, and maximizing their strengths and discipline is the secret of trading success

This course is a study of this and of the tool for understanding and profiting from it, Behavioural Finance

Herd Instinct

Definition of Herd Instinct

A mentality characterized by a lack of individual decision-making or thoughtfulness, causing people

to think and act in the same way as the majority of those around them In finance, a herd instinct would relate to instances in which individuals gravitate to the same or similar investments, based almost solely on the fact that many others are investing in those stocks The fear of regret of missing out on a good investment is often a driving force behind herd instinct

Bubbles in Finance

Also known as herding, such investor behaviour can often cause large, unsubstantiated rallies or offs, based on seemingly little fundamental evidence to justify either Herd instinct is the primary cause of bubbles in finance For example, many look at the dotcom bubble of the late 1990s and early 2000s as a prime example of the ramifications of herd instinct in the development of

sell-unsustainable trends

Sucker Rally

Definition: A temporary rise in a specific stock (or the market as a whole) which cannot be justified

by positive fundamental information A sucker rally may continue just long enough for the “suckers”

to get on board, after which the stock (or the market as a whole) falls back – often quite sharply A sucker rally is a rise in price that doesn’t reflect the true value of a stock It is also known as a "dead cat bounce" or a "bull trap”

Example: Suppose that two high-tech companies, "A" and "B", see an increase in stock price due to

reporting strong financial statements, and a separate high-tech, company "C," sees a rise in stock price If the real reason for the rally turns out to be because of potential acquisitions of A and B, then

C will have had a sucker rally, rising along with A and B

Overconfidence

People are overconfident Psychologists have recognised that overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events Security selection and trading are precisely the type of tasks that cause people to exhibit the most overconfidence

Obviously these would be bad traits for an investor of trader Are you overconfident?

How many questions did you answer within range in our questionnaire? After asking these questions many times, no one has answered more than nine correctly despite people being 90% certain they were correct for each one

How good a driver are you? Compared with other drivers you encounter on the road, are you above average, average, or below average?

Statistically one third should be above average, one third average and one third below average While overconfidence in driving may not affect your health or safety, overconfidence in trading can adversely affect your trading and investing

Arnold Cooper, Carolyn Woo and William Dunkelberg asked 2,994 new business owners how they rated their chance of success 70% said they had a high chance of success But only 39%

of these new owners thought that a business like theirs would be successful Why did these new business owners think they were twice as likely to succeed as others in the same

business? Because they are overconfident1

a high margin Does the dart thrower also have a skill in stock picking? No, it is just luck

In the late 1990’s many investors experienced great returns in the US and Europe, Lately too

investors in commodities and the emerging markets have done the same Many new investors began trading or investing during these long bull runs when profits were easy The problem arises when the new investors attribute their success to their ability Don’t confuse brains with a bull market

Psychologists have found that people become overconfident when they experience early success in a new activity Also having more information available and a higher degree of control leads to higher overconfidence These factors are known as the illusion of knowledge and the illusion of control Institutional traders and investors are particularly susceptible to these factors

1 Article, 1988, “Entrepreneurs’ Perceived Chances for Success” in the Journal ‘Business Venturing’,

The Illusion of Knowledge

People have a tendency to believe the ability to forecast accurately increases with more information (i.e that having more information increases your knowledge about something and improves your decisions) However, this is not always the case – increased levels of information do not necessarily lead to greater knowledge There are three reasons for this

1 Some information does not help us make better predictions and can even mislead us

2 Many people do not have the training, experience or skills to interpret information

3 People tend to interpret new information as confirmation of their prior beliefs

Q I will roll a fair 6 sided dice What number do you think will come up?

Q I have rolled the dice and it has come up 4 the last four times in a row What number will come up next? A Next page (Don’t look)

A the probability is still 1in 6 of any number coming up However some people will think that is more likely to be 4 than the other 5 numbers Others may think that, because the number 4 has come up so often it is less likely to come up again The reality is there is a 1 in 6 chance of 4 coming

up on the next roll

The added information has not helped you forecast the next throw with any more accuracy, but many people will see this information as valuable and indicative

What return do you think ComTrack will earn next year? Don’t know? Last year ComTrack earned 38% and it earned 45% the year before Now what do you think?

It’s a fictional firm and so you have no other information How is this different to rolling the dice? Really not at all Yet many investors use past returns as one of their primary factors to determine the future Have you moved money into last year’s top performing fund?

There is a vast amount of information out there You have your Bloomberg or Reuters to tell you everything Private investors have the Internet Most individual investors lack the training and experience of professional investors and so they are less equipped to know how to interpret the information They may think they have access to all this incredible inside information and that may well be true, but without proper training, they can do little more than guess how that information will shape the future

People have a tendency to interpret new information as a confirmation of their prior held beliefs Instead of being objective, people look for the information that confirms their earlier decisions Consider what happens after a company reports lower earnings than expected – the price usually falls quickly, followed by high volume

Consider an earnings warning by Microsoft Microsoft waned that earnings would be closer to 42¢ a share instead of the expected 49¢ This warning was issued while the market was closed What would you have done? The opening trade the following day was $4.50 to $51 a share When

earnings information is released the market quickly adjusts to the new consensus on the company After the initial drop, the price hardly changed during the first hour of trading If you think Microsoft

is a not a good investment then this warning would probably induce you to sell However, by the time you sold, you had already lost $4.50/share The only reason you might sell after the news is that you think it is a bad investment in the future Or you might think Microsoft is a good investment and use this warning as a buying opportunity at a lower price A lot of people were induced to trade on the news – nearly 1.9 million shares were traded in the first 5 minutes Over half a million shares

were traded every 5 minutes during the next 25 minutes of trading Clearly many investors wanted

to sell and many wanted to buy One news report caused two different behaviours

The Illusion of Control

People become more overconfident when they feel like they have control of the outcome – even when this is clearly not the case

For example: people will bet more on the outcome of a toss of a coin if it has yet to be tossed If the coin has already been tossed and the outcome concealed, people will make smaller bets2 People act

as if their involvement will somehow affect the outcome of the toss In this case the idea of control is clearly an illusion

The key attributes that foster the illusion of control are:

 In 2000, CNBC surpassed CNN as the most watched cable news network

 There are more funds investing in stocks than there are stocks to invest in

 The term ‘day trader’ is a household term

Information

The greater the amount of information obtained, the greater the illusion of control We give more importance to new information than old information Too little emphasis is placed on its validity or accuracy Much information is just noise

2 E.J Langer 1975, “The Illusion of Control”, Journal of Personality and Social Psychology

Active Involvement

The more people participate in a task, the greater the feeling they have of being in control People

feel they have a greater chance of correctly guessing the toss of a coin if they toss it

The attributes psychologists believe contribute to overconfidence are certainly common in modern

trading and investing This overconfidence leads to having too much faith in their estimates of a

security’s value and their prediction of the future price

Overconfidence and Investing

Overconfidence causes you to misinterpret the accuracy of information and then overestimate your

ability to analyse it This leads to poor investment decisions, which often manifest themselves as

excessive trading, risk taking and ultimately, losses

Overconfidence and Trade Frequency

Overconfidence increases trading because it causes people to be over certain about their opinions

Your investment opinions derive from your beliefs regarding both the accuracy of the information

you have obtained, and your ability to interpret it As an overconfident investor, you believe more

strongly in your own valuation of a security and concern yourself less with the beliefs of others

Gender Differences

Men tend to be more overconfident than woman in tasks perceived to be in the masculine domain –

such as trading and investing As a consequence these more confident men trade more frequently

than woman Their portfolios have higher turnovers

Two financial economists, Brad Barber and Terrance Odean examined the trading behaviour of

38,000 households trading through a large discount broker between 1991 and 1997

Annual Portfolio Turnover by Gender and Marital Status

Single Women Married Women Married Men Single Men

Annual Portfolio Turnover in percent

Trading Too Much

There is ample proof that high turnover is detrimental to returns At its most basic, the high level of commission and slippage in high turnover trading must be subtracted If investor A has a buy and hold strategy and makes 15% and Investor B also makes 15% gross but trades very actively, investor

A will clearly be the winner as he (or she!) will incur fewer administrative costs

Overconfidence-based trading is truly hazardous to trading profitability Also, if men are more overconfident and trade more often than women, do male investors do worse than women

investors? On average, the answer is yes Overall, men earn nearly 1% less than women from their investments Single men earn nearly 1.5% less per year than women from their investments This occurs even though men report having more investment experience than women This extra

experience has probably simply caused them to behave in an overconfident manner

Overconfidence and Risk

Overconfidence also affects risk taking behaviour Rational investors try to maximise returns while minimising risk However, overconfident investors misinterpret the level of risk they take They are more susceptible to sure things

There are several measures of risk to consider:

Overconfidence and Experience

We know that overconfidence is learned However it does not seem to take long to learn it A study done by Gallup for PaineWebber in 1998 found that new or inexperienced investors expected a higher return on their investments than experienced investors Also, inexperienced investors were more confident of their ability to beat the market

Professional investors can be overconfident too In fact, psychologists have shown that in a field in which predicting the future is hard (as it is with investing), experts may be more prone to

overconfidence than novices

Since 1962, stock market mutual funds in the US have experienced an average annual turnover of 77% For funds delivering the best performance (the top decile) in one year, the turnover rate grew

to an average 93% the next year Successful fund managers trade more Is this overconfidence or skill? Apparently it is overconfidence This can be seen by the increased turnover the following year This overconfidence also shows up in returns The average fund underperforms the market by around 1.8% per year Funds cannot own too much of a firm So, if the fund has a lot of money to invest, it has to buy into larger firms to avoid breaking the regulator’s rules These institutional

investors like to purchase risky stocks.3 Due to the large size of most institutional portfolios,

professional fund managers are forced to purchase the stock of large companies However, they tend to pick the large stocks which have high volatility (higher risk) – again a sign of overconfidence Both individual and private investors can be overconfident about their abilities, knowledge and future prospects Overconfidence leads to excessive trading that can lower portfolio returns

Overconfidence also leads to greater risk taking

Trading volumes are increasing quickly, making traders and investors more overconfident Trading in the US stock market is now incredibly high The average dollar amount of stocks traded just on the NYSE in one year is roughly the equivalent to one quarter of the world’s total annual economic trade and investment flow

What I Own is Better

Faced with new options people often stick with the status quo Specifically there are three biases involved:

The Endowment Effect People often demand much more to sell an object than they would

be willing to pay for it

Status Quo Bias People have a tendency to keep what they have been given rather than

exchanging it

Attachment Bias People can become psychologically attached to a security, seeing it

through rose-tinted glasses

Endowment Effect

Consider a wine lover who buys several bottles of wine for ₤5 per bottle and puts them in the cellar Ten years later the wine sells for ₤200 per bottle What should the connoisseur do? Sell the wine and use the money to buy more bottles of a less expensive wine? Keep the bottles? Buy more bottles of the same wine at ₤200 a bottle? The endowment effect predicts that the wine lover will keep the bottles because he feels the wine is worth more than ₤200 per bottle and yet will not pay that price

to buy more

What causes the endowment effect? Do we overestimate the value of the objects we own, or does the parting with them cause too much pain? It appears to be the latter

Endowment and Investing

People have a tendency to hold on the securities they have Further if they are handed an

investment (say an inheritance and have a choice what to invest it in) they tend to keep it invested in the same security or type of security Whether it is high risk or low risk or cash in the bank, it is not the excitement or the safety which draws us to keep it in the same security It seems we are more affected by the pain associated with giving up the object

3 Richard Sias, 1996, “Volatility and the Institutional Investor,” Financial Analysts Journal

Status Quo Bias

In physics we know that an object at rest tends to remain at rest In decision-making, you will often choose the option allows you to remains at rest (i.e you prefer the status quo to change.)

Consider the plight of a small town in Germany Due to strip mining of lignite nearby, the law

required the government to relocate the whole town The government offered to relocate to a similar valley nearby Government specialists suggested various many alternatives for the layout of the new town However, the town’s people selected the same layout as the old town, even though the old town’s layout had evolved over centuries without rhyme or reason The people preferred the familiar over the more efficient and aesthetic plans

The status quo effect has a big influence on people’s pension contributions When people join a new firm which offers a pension plan and they are not currently contributing to a pension they are likely

to opt not to join, whereas those that are contributing will consider it a priority to continue to do so Also, the more complicated the decision needed, the more likely you will choose to do nothing

Overcoming These Biases

How can you overcome the biases? The first thing to do is to recognise you may be subtly influenced

by these problems

Ask yourself, “If I only had cash, would I use the cash to buy these investments?” If your answer is

no, you are definitely suffering from an endowment or status quo effect Making a change is hard If

it weren’t there would be no status quo bias In fact it may be the fear of making the wrong decision that stops you making any decision

You have many investment choices Which is the best investment? It does not matter The important thing is to get involved The penalty of not doing so is too great With no status quo bias, you can always adjust later

Seeking Pride and Avoiding Regret (Loss Aversion)

People avoid actions that create regret and seek actions that cause pride Regret is the emotional pain that comes with realising the previous decision has turned out badly Pride is the emotional joy

of realising that a decision has turned out to be a good decision

After having made an error or judgement, people tend to feel sorrow and grief The overwhelming desire not to regret something is very powerful in humans According to Gerald Butrimovitz, a behavioural finance expert, the pain of loss is 2.5 times stronger than the joy of gains As a result investors and traders will often clutch at straws to avoid a loss, even if it means taking even greater risks Related to the fear of regret, is the fear of looking stupid

Consider the feelings of envy or maliciousness that are standard emotions in dealing rooms Suppose

a colleague has reached a profit of £50,000 for the day, while you have not earned a penny You now become fixated on earning £50,000 As a result some traders, who have remained inactive the entire day, suddenly take on risky investments just before the end of trading in an attempt to catch up with their neighbour’s lead

Now, if your neighbour has made their profit by being long of a particular instrument, then you will

be strongly inclined to take the same position – albeit at a higher entry level Fear of regret and looking stupid are the main reasons why people tend to go along with the crowd If they are wrong, they can take some consolidation in not being the only one This behavioural characteristic leads to a continuation of price trends Furthermore loss aversion might explain why downward corrections tend to be steeper than upward moves, because investors tend to hold on to their losing positions for longer in the hope of avoiding pain and regret of having made a bad investment

Another illustration - You have been playing the lottery You have selected the same numbers every time and not surprisingly, you have never won A friend suggests a different set of numbers to use

Do you change numbers? There are two threats of regret: keeping to the same numbers and the new ones coming up or changing numbers and your old ones coming up The stronger regret is most likely from switching to the new numbers and the old ones coming up You have a lot of emotional capital tied up in these old numbers

Disposition Effect (more Loss Aversion)

The Disposition Effect is how we are affected in our investment decisions when they avoid regret and seek pride

Consider you own two stocks and have no spare cash The two stocks are Microsoft and IBM IBM has earned a 20% return since you purchased it, while Microsoft has lost 20% You want to buy Lucent but must sell one of your holdings to pay for it Which do you sell?

Selling Microsoft at a loss means realising your decision to buy it was wrong You will feel the pain of regret The Disposition Effect predicts that you will sell the winner, IBM Selling IBM triggers the feeling of pride and avoids the feeling of regret (which is much stronger) You are selling the good stock and holding the bad one – cutting profits and running losses

Do we really sell Winners?

It is apparent that traders are quick to take profits If you buy something and it quickly jumps in price the temptation is strong to lock in the profit This fills you with pride On the other hand if you buy something and it goes against you, you wait Later, if it goes up, you may sell or wait longer

Do we avoid selling losers? If you hear yourself saying the following things, then yes, you hold on to losers:

 If this stock would only get back to what I paid for it, I would sell it

 The stock price has dropped so much, I cannot sell now!

 I will hold this stock because it cannot possibly fall any further

Many traders will do their best never to sell at a loss because they do not want to give up the hope

of making their money back Meanwhile they could be making money elsewhere

Avoiding the Pain of Regret

Avoiding the pain of regret causes traders to sell winners too soon and to hold on to losers too long How to overcome this? These two steps will help:

 Make sell decisions before you are emotionally tied to a position – put in a stop loss

at the time of entry

 Keep a reminder of the avoiding regret problem Memorise this – “I must love to take losses and hate to take profits”

Double or Nothing

Consider this bet: Heads you win ₤20, tails you lose ₤20 Would you take the gamble?

By the way, you won ₤100 earlier Now would you take the gamble? Has your answer changed? What if you had lost ₤50 earlier? How does it look now?

You may gamble in one situation and not in another despite the odds being the same It is your reaction to risk and reward which changes between the scenarios People seem to use a past

outcome as a factor in evaluating a current risk decision In short, you are more likely to take risk after gains than after losses

House-money Effect

After winning, traders are more willing to take risk Gamblers refer to this as playing with the

house’s money After winning, traders will often not consider this money as their own Are you more willing to risk your opponent’s money than your own? Amateur gamblers don’t fully integrate their winnings with their own money They act as though they are betting with the casino’s money Good traders and professional gamblers overcome this bias They realise that this hard earned money is their money

The House-money Effect predicts that you are more likely to buy risky securities after closing out a profit Note that this behaviour magnifies the overconfidence behaviour we discussed earlier