Behavioral Finance and the Market Meltdown: What We Should Have Expected.(No Trust = No Liquidity)

Robert A. Olsen, Ph.D.Financial EconomistOregon, U.S.A.

Behavioral Finance- What?

Behavioral Finance is premised on the existence of a satisficing decision maker who uses a slowly evolving brain to adapt to a world that is not fully predictable.

It assumes an individual who is social and culturally absorbed.

It eschews traditional model assumptions of Newtonian determinism, Behaviorism and optimization.

Behavioral Finance - Why?

Many years of research in decision science, cognitive and evolutionary psychology, network theory and neuroscience indicate that modern finance is behaviorally flawed.

In addition empirical “anomalies” in modern finance testing suggest that its mathematical elegance has been bought at the price of real world predictive inaccuracy.

Behavioral Finance - Where from?

Behavioral Finance concepts first appeared in writings of Finance and Psychology Professors at the University of Oregon from 1951 through 1972.

Investigation and acceptance has accelerated in recent years as the discipline has become multidisciplinary and academically widespread.

Behavioral Finance - Where to?

Some have suggested that Behavioral Finance be assimilated into modern finance. This appears unworkable because the behavioral assumptions of the two approaches are inconsistent.

A paradigm shift is the most likely future outcome.

Evolution of Behavioral FinanceStage 1: ~1970 to 1990

Primary Disciplines Involved Cognitive

Psychology Decision Science Experimental

Economics Game Theory

Topics Studied Availability,

Anchoring and Adjustment,

Representativeness, Confidence, Hindsight Bias

Endowment Effect, Loss Aversion, Framing

Herding, Over Reaction

Evolution of Behavioral FinanceStage 2: ~1990 to 2010

Primary Disciplines Involved Social

Psychology Evolutionary

Psychology Network Theory Adaptive

Economics Neuroscience

Topics Studied Group Behavior,

Home Bias, Bubbles,

Multi Attribute Risk Perception,

Dual Brain Decision Process, Intuition,

Naturalistic Decision Making, Adaptive

Decision Making, Complexity, Affect

Traditional Finance Paradigm Primary Background Assumptions

1. Reductionist Science can conquer uncertainty (at least in a probabilistic sense).

2. Negative Feedback dominates over time leading to approximation of a stationary equilibrium.

3. The Human Mind is a “general problem solving device” like a computer

4. Emotion has a generally negative influence on the quality of decisions.

5. Humans are generally disposed to make decisions focused on a narrow interpretation of self-interest.

6. Objectivity is possible because a human decision maker may be able to “stand outside” a decision frame.

Traditional Finance Paradigm

Primary Background Assumptions1. Reductionist Science 2. Negative Feedback 3. The Human Mind 4. Emotion 5. Self-Interest6. Objectivity

• Behavioral Finance research indicates that all six assumptions are in error to various degrees. Assumptions 1 and 6 are wrong on general scientific grounds. Assumption 1 is refuted by quantum theory and complexity theory. Assumption 6 by neuroscience. Assumption 2 is refuted by Agent Based economic modeling. Assumptions 3, 4, 5 are refuted by social and evolutionary psychology and neuroscience.

Markowitz Portfolio Theory

Primary Background Assumptions1. Investors consider each investment alternative as

being represented by a probability distribution of expected returns over some holding period.

2. Investors attempt to maximize single-period expected utility with utility curves demonstrating diminishing marginal utility of wealth.

3. Risk is based on expected variability of potential returns.

4. Investment decisions are based solely upon estimates of risk and expected return.

5. For a given level of risk, investors prefer a higher level of return. Investors are RISK AVERSE. They would prefer a certain return to an investment that is risky but offers the same expected return.

Behavioral Finance calls into question all 5 assumptions.

Informationally Efficient Markets Hypothesis

Hypothesis: The expected returns implicit in the current price of a

security should fully reflect its perceived risk.

Rationale:1. A large number of competing profit maximizing

participants analyze each security.2. New information comes into the market in a random

fashion.3. Competing investors attempt to adjust prices rapidly

to reflect the effect of new information.

Sources of Inefficiency: Cost of Information. Trading Costs. Limits of Arbitrage

Behavioral finance calls into question profit maximization, frame independent learning, and independent action.

The U.S. Financial Crisis:A Behavioral Perspective

1. The Behavioral Perspective on Investment Risk

2. Trust as a Risk Attribute

3. Housing Decline and the Collapse of Trust

The Behavioral Perspective on Investment Risk Research Summary:

1. Risk Perceptions are a function of personal experience and asset characteristics.

2. Risk is an internal construct and does not exist “out there” in investors’ minds. Perceptions are by necessity subjective and assumption laden.

3. Risk perceptions are generally multi attribute wherein Affect becomes the common denominator of influence.

4. Strong Affect usually causes expected returns and perceived risk to vary inversely.

5. Attributes and general weights (Likert scale). Chance of significant loss = 10 Trust in Investment manager = 9 Felt Knowledge = 7 Variability of return = 5

Trust as a Risk Attribute

PerceivedPersonalIndependence

HazardCharacteristics

PerceivedSocietalDependence

PerceptionsPersonalControl

PerceptionsTrust

RiskPerception

Housing Decline and Collapse of Trust

1. The U.S. has almost no economic middleclass.

Top 10% wealthiest own about 75% of all private

assets.

2. Attempt of offset stagnant middle class wages

since 1970 have resulted in

Working wives increased from 20% to 60%.

Working hours per household have increased by

25%.

Debt as a % of yearly after tax income rose to

138%.

Savings rate fell to near 0%.

3. Real estate became primary source of loan

collateral.

Housing Decline and Collapse of Trust

4. Traditional lenders became focused on

“transaction fees” as a primary source of

income as opposed to traditional services

(i.e., loan investment)

5. Mortgage backed Bonds marketed on seller

reputation.

6. Regulatory control and oversight reduced

since 1980s.

Trust Facts

1. Trust is fragile and easily broken2. Trust takes much time and consistency to build 3. Trust destroying events are more salient.4. Trust destroying events seen as more informative.5. Trust is more oral and personally based.6. Trust is not a function of one’s level of risk

aversion.7. Women rely upon trust more than men but less

trusting.8. Trust is the financial network unmeasured GLUE.

9. When trust is questioned perceived risk is heightened.

Behavioral Investment Implications

1. Global investing will become more difficult to implement because Trust risk increases when dealing with “outsiders”. This is already apparent with “Home Bias”. Survey evidence from a sample of 8,000 individual investors indicates that neither contracts or statistical measures of risk are viable substitutes for trustworthiness. Risk premiums and interest rates are lower in countries with higher levels of interpersonal trust.

Behavioral Investment Implications

2. Complexity theory and investor distrust of complex methodologies suggests that financial predictions will not become significantly more accurate or believed in the future.

More emphasis should be placed on indentifying good opportunities rather than good current prices, and with matching assets to investor experience, values and horizons.

Behavioral Investment Implications

3. The influence of Affect on investment should be given greater emphasis because it is the evolutionary inborn common denominator between cognition and emotion.

It will be necessary to control for the affective bias between expected return and perceived risk.

Because decision makers have little ability to imagine how they would feel about different potential investment outcomes greater use of experiential exercises should yield better choices and greater satisfaction.

More Investment Implications

Women investors will be less confident than men with equivalent backgrounds. Trust will be given greater weight.

Women will focus on an adequate return and then try to reduce risk. Men will do just the opposite.

Risk perceptions will vary inversely with time horizon.

Risk perceptions will be emergent and thus vary by client and investment.

More Investment Implications

Clients will exhibit “desirability bias” and perceive a greater chance of good things coming to pass.Westerners will see the future as linear. Easterners will see the future as circular.The possibility of extreme events will usually be underestimated.Clients will prefer investments that seem consistent with their values and time horizons. They favor consistency.

More Investment Implications

Clients will associate more regret with actions not taken than actions taken but gone wrong.Clients will associate more regret with actions not taken than actions taken but gone wrong.Clients don’t well comprehend probability. They better understand “chance” presented in “real world” stories.

Behavioral Finance Reading List

Introductory1. Ariely, Dan, (2010), Predictably Irrational,

Harper.2. Belsky, Gary,(2010), Why Smart People Make

Big Money Mistakes, Simon and Schuster3. Nofsinger, John, (2010) Behavioral Finance,

Kolb.4. Peterson,Richard, (2007), Inside The

Investor’s Brain, Wiley5. Wilkinson, Nick, (2007) Introduction to

Behavioral Economics, Palgrave Macmillian.

Behavioral Finance Reading List

Professional Audience1. Fox, Justin, (2009), Myth of Rational Markets, Harper2. Glimcher, Richard, (2010), Foundations of Neuroeconomic

Analysis, Oxford University Press.3. Hens, Thorsten, (2009), Behavioral Finance For Private

Banking, Wiley Finance4. Mitchell, Olivia, (2004) Pension Design and Structure: New

Lessons From Behavioral Finance, Oxford University Press.

5. Montier, James, (2007), Behavioral Investing: A Practitioners Guide, Wiley

6. Pompian, Michael, (2006), Behavioral Finance and Wealth Management, Wiley.

7. Shefrin, Sidney, (2007), Beyond Greed and Fear, Harvard.8. Wayneryd, Karl-Erik, (2001) Stock Market Psychology,

Elgar.