Psychology of Money: Its Impact on Risk Tolerance. Brian M. Rom. Investment Technologies. Outline
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1 Psychology of Money: Its Impact on Risk Tolerance Brian M. Rom Investment Technologies Outline 1. Two Theories of Investor Behavior 2. Designing Effective Risk Tolerance Questionnaires 3. Portfolio Selection.
2 How Rational Are We? (Part 1) Morningstar Ratings Make Difference Financial Research Corp., Boston, has proven that Morningstar s star system for ranking funds does have a huge influence over the buying behavior of investors... 71% of net sales in 1998 went to 4- and 5-star funds. Investment News How Rational Are We? (Part 2) Morningstar star ratings do not measure how well a fund competes in its asset class, but instead give good marks for any fund that happens to be in an asset class of ascendance... The laws of reversion to the mean cause the star ratings to have little predictive value. Morningstar s Risk Adjusted Ratings, William F. Sharpe.
3 1. Two Theories of Investor Behavior Standard Finance/Expected Utility Theory Behavioral Finance/Prospect Theory Standard Finance/ Expected Utility Theory Markowitz 1952 Prescriptive Now includes CAPM, APT, option-pricing Focus on wealth maximization If expected values are equal, choose the certain result
4 Behavioral Finance Recommended Reading The Psychology of Judgment and Decision Making. Scott Plous. McGraw Hill. Dow Jones Asset Management. Nov.- Dec Tversky Behavioral Finance/ Prospect Theory Descriptive Satisficing rather than optimal decisions Multifaceted preferences Reliance on analogy, intuition, experience, feelings Weight evidence inconsistently Replaces net wealth with value (gains/losses from a reference point)
5 Elements of BF Framing 1 Choose between A and B: A: A 50% chance of gaining $1000. B: A sure gain of $500. Elements of BF Framing 2 Choose between C and D: C: A 50% chance of losing $1000. D: A sure loss of $500.
6 Elements of BF The Certainty Effect 1 Russian Roulette Gun A has 4 bullets. Paying some amount will remove 1 bullet. Gun B has 1 bullet. How much would you pay to remove the bullet? More, less, the same? Elements of BF The Certainty Effect 2 Probability of being shot in Case A: Before payment: 4/6 = 0.67; After payment: 3/6 = Risk reduction: Probability of being shot in Case B: Before payment: 1/6 = 0.17; After payment: 0/6 = Risk reduction = 0.17.
7 Elements of BF The Certainty Effect 3 Standard Finance: Utility of the payment is 0.17 in both cases, so prediction is payment would be the same. Behavioral Finance: Predicts people would much rather eliminate risk than reduce it since in BF small probailities are overweighted. Other Elements of BF Pseudocertainty Regret Theory
8 Conclusion BF/PT provides a more accurate description of how people actually make decisions. BF/PT represents a great improvement over SF/EUT. Some Reasons Evolution Humans designed to deal with wide range of problems Shared beliefs Genetic and biological causes
9 What Can You Do? Get training in statistics and intuitive decision procedures. Take broad view: Aggregate wealth. Don t compartmentalize. Understand luck and skill often indistinguishable. Identify your own inclinations. Investment Implications Higher volatility Herding Selling winners early, losers late Mistaking good/bad cos. for good/bad investments IPO performance
10 2. Designing an Effective Risk- Tolerance Questionnaire Use computer technology to integrate investment theory, psychometrics and behavioral finance. Questionnaire Design Do... Employ psychometrics and behavioral finance: Incorporate Prospect Theory. Incorporate myopic loss aversion. Consider framing of questions. Ensure response consistency.
11 Questionnaire Design Do... Consider the entire portfolio. Use wealth scaling. Would you accept the following investment with $<PctWealth*Wealth> of your investable funds? Double your investment with 50% probability, or lose the entire investment with 50% probability. Yes No
12 Questionnaire Design Do... Use adaptive questions Would you place 5% of your assets in an investment with the following chances of doubling/total loss? Y 60/40% N Y N 20 59/41% PTS Y 80/20% N Y 50/50% N Y 70/30% N Y 90/10% N 25 PTS 20 PTS 15 PTS 10 PTS 5 PTS 0 PTS
13 Questionnaire Design Don t... Assume risk=losing money. I would only select investments where it is unlikely I will lose my original investment Questionnaire Design Don t... Assume that asking individuals about their risk preferences can provide meaningful information.
14 Which of the following statements best describes your feelings about investment risk? I would only select investments that have a low degree of risk. I prefer investments with emphasis on those with a low degree of risk and a small portion in others that have a higher degree of risk that may yield greater returns. I prefer to select a balanced mix of investments -- some with a low degree of risk, others will have a higher degree of risk that may yield greater returns. I prefer to select an aggressive mix of investments -- some that have a low degree of risk, but with emphasis on others that have a higher degree of risk that may yield greater returns. I would select an investment that has only a higher degree of risk and a greater potential for higher returns. Questionnaire Design Don t... Confuse the long-term investment strategy with day-to-day cash flow issues
15 I find it easy to pay my monthly bills from my current pay. I strongly disagree I disagree I somewhat agree I agree I strongly agree Questionnaire Design Don t... Make assumptions about the relationship between past behavior and risk tolerance
16 Have you ever invested in individual stocks or stock mutual funds? No, and I would be uncomfortable with the risk if I did. No, but I would be comfortable with the risk if I did. Yes, but I was uncomfortable with the risk. Yes, and I felt comfortable with the risk. Which of the following activities have you participated in? Sky-diving. Race-car driving. Gardening. Jogging.
17 Questionnaire Design Benefits of Computerization Customization of questionnaires. Response consistency. Wealth scaling. Sensitivity analysis. Feedback. Reporting. Electronic delivery. 3. Portfolio Selection Identify the invesment horizon Identify the investment goal. Use questionnaire to get risk-tolerance score Identify portfolios Portfolio-selection techniques: Absolute mapping Relative mapping
SUMMARY. a) Theoretical prerequisites of Capital Market Theory b) Irrational behavior of investors. d) Some empirical evidence in recent years
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