SUMMARY. a) Theoretical prerequisites of Capital Market Theory b) Irrational behavior of investors. d) Some empirical evidence in recent years

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2 SUMMARY a) Theoretical prerequisites of Capital Market Theory b) Irrational behavior of investors c) The influence on risk profile d) Some empirical evidence in recent years e) Behavioral finance and wealth management industry 2

3 a. Theoretical prerequisites of Capital Mkt Theory Classical financial models Market efficiency Investors rationality 3

4 a. Theoretical prerequisites of Capital Mkt Theory Market efficiency: asset prices reflect all available informations Prices and returns change in a random manner: history does not influence future level of prices Portfolio Diversification: increase the number of asset and decrease the depedence among returns to reduce risk 4

5 a. Theoretical prerequisites of Capital Mkt Theory Review of the Classical Models Markets are not completely efficient, especially in the short term Equity prices and returns often reveal anomalies and inefficiencies Behavioral Finance shows that investors are not completely rational 5

6 a. Theoretical prerequisites of Capital Mkt Theory Are markets efficient? The discovery of anomalies Predictabilit y In an efficient market, returns cannot be predicted on the basis of existing information. For the italian stock market, data reveals that stock prices are at least partly predictable, if transiction costs are very low, on the basis of - P/E ratios level (D arcangelis, Calcagnini) - Dividend Yield (D Arcangelis) - Publication of economic information (Caparrelli, D Arcangelis) - Overreaction to news (D Arcangelis) 6 - Day of the week, monthly and size effects (Caparrelli)

7 a. Theoretical prerequisites of Capital Mkt Theory Are markets efficient? The discovery of anomalies Predictabilit y So real financial markets are different from those described by textbooks However, probably not so much as active managers generally don t beat the benchmarks 7

8 b. Irrational behavior of investors Errors in individual investment choices Collective Biases Prospect Theory 8

9 b. Irrational behavior of investors Errors in individual investment choices 1 Regret and Cognitive Dissonance Regret Tendency to feel emotions and regret in admitting past errors Cognitive Dissonanc e Mental conflict in discovering that own convictions are wrong 9

10 b. Irrational behavior of investors Errors in individual investment choices 1 Regret and Cognitive Dissonance Investors tend to choose assets (e.g. mutual funds) that realized higher returns in the past, but they gradually leave those that performed poorly with respect to benchmark. 10

11 b. Irrational behavior of investors Errors in individual investment choices 1 Regret and Cognitive Dissonance Not accepting past errors can cause huge losses in the future Investors should be directed towards a rational method, which will stop loss at a predetermined threshold 11

12 b. Irrational behavior of investors 2 Anchoring Anchoring is the tendency of investors to solve a problem heavily anchoring to biased information (or initial hypothesis) Errors in individual investment choices 12

13 b. Irrational behavior of investors 2 Anchoring Errors in individual investment choices Statman & Fisher (1998) examined the DJIA performance from in 1896 to 9, at the end of DJIA doesn t include dividends. A group of fund managers was asked what would have been the index level if all the dividends were included in the computation of the index. 13

14 b. Irrational behavior of investors Errors in individual investment choices 2 Anchoring Most estimate was double, the highest was triple compared to the 1998 level, but in reality- including dividends the index would have exceeded before 1998! Estimating the value of an asset, don t accept any price nor evaluate it only based on past information 14

15 b. Irrational behavior of investors 2 Anchoring Errors in individual investment choices EARNING ANNOUNCEMENTS Stock Exchange tend to react slowly fundamental information, such as earning announcements, future dividends estimates,.. SUE Effect Tendency of a stock s CAR to drift in the direction of an earning surprise for several weeks (months) following an earning announcement 15

16 EARNING ANNOUNCEMENTS 16

17 b. Irrational behavior of investors 3 Framing Errors in individual investment choices People tend to organize events in categories based on a superficial way of thinking and make decisions from fragments of informations A financial portfolio is not the sum of independent assets One should always consider the total risk, not the single components 17

18 b. Irrational behavior of investors 4 Representativeness Errors in individual investment choices Representativeness refers to the tendency to refer to stereotypes in making financial decisions The informative value of a single piece of information in a set tend to be over-weighted: an investor who sees a series of exceptional earnings tend to conclude that the performance will endure 18

19 b. Irrational behavior of investors 5 Overconfidence Errors in individual investment choices Overconfidence could also be a problem in the financial context For example, the choice of an asset that beats the market will convince of being financially talented (instead of merely lucky) 19

20 b. Irrational behavior of investors Collective biases. 6 - Herding Herding is the behavior of investors when they rush to buy similar asset The result is increasing of market volatility 20

21 c. The influence on risk profile Prospect Theory (PT) Prospect Theory explains how decision are made The Expected Utility Theory of classical finance models explains how decisions should be made in a context of uncertainty 21

22 c. The influence on risk profile According to PT, people: Prospect Theory (PT) evaluate extremely improbable events as if they were impossible (market crashes) evaluate extremely probable events as if they were certain ( a country like Argentina always pays his debt) evaluate probable events as if they had less probability evaluate very probable events as if they had better probability 22

23 c. The influence on risk profile Disposition effect Prospect Theory (PT) A study on the dynamics of 10,000 investment portfolios reveals that investors tend to keep losses for an average of 124 days, and gains for only 102 days. Losses that are equal in absolute value seem heavier than gains (loss aversion) The wrong behavior is to exceed in trading of stocks and holding on losing investments hoping that the losses will somehow be quickly recovered 23

24 c. The influence on risk profile Myopic loss avversion Prospect Theory (PT) According to PT mutual fund managers tend to increase the level of risk if his work is not evaluated often enough An investor who often evaluates his own performance, tends to overweight short term losses with the consequence of decreasing his risk profile Consequences for financial portfolio allocation Apart from time horizon, investors overweight the short term results 24

25 c. The influence on risk profile Prospect Theory (PT) US Equity Premium Puzzle Behavioral theories explain the perception of risk changes based on realized returns If a stock has a good track in the past, investors are more willing to invest and so they ask a lower risk premium for holding stocks 25

26 d. Some empirical evidence in recent years Equity Risk Premium - USA 1990 to 2005 S&P

27 e. BF and wealth management 1. Behavioral theories are not (still?) a good base for the portfolio allocations in the asset management industry 2. Empirical evidence of behavioral models refers to individual reactions to choices with a limited amount of risk. 3. Classical theories are better for decisions on great risks (e.g. pensions plans) 4. Models describe how investors really behave, not how they should behave. Investors can correct their behavioral mistakes benefitting from a correct financial education and from financial 27 planning advice.

28 e. Behavioral finance and wealth management Irrational investor behavior is often observed by wealth management practitioners in creating and administering investment portfolios for private clients. However, financial consultants and advisors usually use classical theory for studying the market and behavioral concepts for studying the clients 28

29 e. Behavioral finance BF and and wealth asset allocation management Generally the questionnaire that financial planning industry use with the clients, are directed toward the definition of the risk tolerance for mean variance optimization. Pratictioners employ only a restricted part of investors behavioral biases identified by researchers. 29 they are educated to decide whether to attempt to

30 e. Behavioral finance and wealth management financial literature and practitioners agree that, in order to reach the best financial allocation, it would be convenient A) adapting to biases at high wealth levels B) attempting to modify biased behavior at lower wealth levels. A1) adapting emotional biases B1) attempting to modify cognitive biases 30

31 e. Behavioral finance and wealth management High level of wealth ADAPT Cognitive biases MODIFY Emotional biases ADAPT Pompian -Longo (2008) low level of wealth 31 MODIFY

32 e. Behavioral finance and wealth management This approach can be too subjective. The decision to override the results of the optimizazion should be taken in a more objective manner, considering the level of wealth, the number and typology of the biases, considering the probability to realize long term targets (e.g. volatility cones) and calculating the maximum admissible distance with the classical asset allocation output.. 32

33 e. e. Behavioral finance and wealth management As financial consultants are accustomed to the use of optimization software, for the analysis of the market (Markowitz frontier, performance evaluation ) they could easily understand the advantage of a system that has the perfection of optimization but is 33 strongly tailored on the client