Behavioral Finance in Action

Transcription

1 Behavioral Finance in Action Psychological challenges in the financial advisor/ client relationship, and strategies to solve them Part 3 Reining in Lack of Investor Discipline: The Ulysses Strategy By Shlomo Benartzi, Ph.D. Professor, UCLA Anderson School of Management, Chief Behavioral Economist, Allianz Global Investors Center for Behavioral Finance

2 Reining in Lack of Investor Discipline: The Ulysses Strategy In characteristically provocative manner, Warren Buffett had this advice for investors in his 2004 Chairman s Letter: Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful. According to standard economic theory, people make investment decisions based on a rational analysis of the present value and future prospects of equities. It is clear from his advice to investors, however, that the Oracle of Omaha recognizes that factors other than rational analysis are sometimes at play. Buffett understands from his years of experience that investors often buy high and sell low. They also often buy the wrong stocks, sell the wrong stocks and, in normal times, do far too much buying and selling. Academic insights from Behavioral Finance help explain why people behave the way they do, and they offer practical solutions to financial advisors to help their clients make better investment decisions. The idea is that people are not being stupid, they are just human. Here, we introduce The Ulysses Strategy, which engages the reflective mind for rational short- and long-term investment strategies, thereby avoiding the errors that the intuitive mind is otherwise prone to make. More Than Just Fear and Greed Financial advisors are well aware of the herd mentality of humans, which sometimes leads individual investors to buy high and sell low, by plunging into rising markets and fleeing when markets fall (Bikhchandani et al., 1992; Galbraith, 1993). But there are other psychological issues at play in the behavior of individual investors, beyond fear and greed, impulses that flow from the intuitive mind. Overconfidence is as strong an urge in humans as the herd instinct. It leads people to believe they can outperform the market, and seduces them to trade stocks at an irrationally high rate. It s a costly path to follow. One study of 66,465 individual investors over a six-year period in the United States found that the average investor turned over 75 percent of his/her portfolio each year. Transaction costs associated with this excessive trading reduced net performance by 3.7 percent compared with the market as a whole. Investors who traded most (in the top quintile) did even worse: these people turned over their portfolios more than twice each year, and as a result suffered a 10.3 percent reduction in net performance (Barber and Odean, 2000; see also Daniel et al.,1998). This is the expenses trap that Buffett mentioned in his letter. Behavioral Finance in Action 1

3 A separate study of transactions in 19 major international stock markets produced equally salutary warnings against the urge to beat the market by too frequently buying and selling securities. Between 1973 and 2004, the average penalty for repeated buying and selling as opposed to a buy-and-hold strategy in these markets was 1.5 percent (Dichev, 2007). Faced with thousands of possibilities, individual investors are ill-equipped to make rational decisions about which stocks to buy. Most people simply don t have the time or expertise to find fairly valued stocks or under-valued stocks. As a substitute for appropriate analysis, many people unconsciously fall back on a simple rule of thumb, or heuristic: What stocks are in the news? Buy them. Stock markets often move in response to many factors unrelated to true value. Shlomo Benartzi, UCLA Anderson School of Management Apparently, it matters not at all why a company happens to be in the news the launch of a new product, large one-day moves on the market (up or down), even a scandal involving the CEO these stocks are bought disproportionately by individual investors (Barber and Odean, 2008). This is the intuitive mind taking the easy way to making a choice, one that, if fully engaged, the reflective mind might reject. Inevitably, attention-driven buying pushes prices beyond true value, and investors once again do less well than they expect. The intuitive mind is at work in the very common mistakes people make in selling stocks they already own. The rational investor would sell losers and hold on to winners. But this is not what individual investors commonly do: They sell winners too early and losers too late. This error is called the disposition effect. This is how it works for investors. An individual who owns a stock that has appreciated significantly faces a choice: hold or sell. If they sell, they lock in a gain, and they feel good about that. But by selling they forfeit any possibility of further price appreciation and accept the certainty of paying taxes on their profit. If a stock has lost value, however, the investor faces the prospect of admitting a loss if they sell, and that feels very bad. Loss aversion kicks in and most investors choose instead to hold on to the stock. They now face the possibility of further deterioration in price, and the certainty of passing up tax advantages if they were to sell, which is what they perhaps should do. The disposition effect is the result of mental accounting. The rational investor would be interested in the overall return of their portfolio, and be content to say, You win some, you lose some, but overall it s doing well. Instead, the typical investor treats the portfolio as a series of investing episodes. A winning stock offers the opportunity to sell, and so lock in a gain, and the investor experiences the pleasure of that gain. They sell. This is a positive investing episode. A losing stock offers the prospect of incurring a loss, and experiencing the pain that goes with it. They hold, and in so doing avoid a negative investing episode (Barberis and Xiong, 2010). Behavioral Finance in Action 2

4 Stock markets often move in response to many factors unrelated to true value. For instance, a commercial plane crash in the United States that kills 75 people or more typically causes the NYSE briefly to shed around $60 billion in value. This reduction in market value contrasts with the actual economic cost of such incidents (incurred by the airline and insurance companies) of around $1 billion (Kaplanski and Levy, 2010). In countries where soccer is a major sport, a loss by the national team leads to a significant decline in that country s stock market (Edmans et al., 2007). And weather gloom or shine has been found variously to affect stock markets, too (Laughran and Schultz, 2004; Hirshleifer and Shumway, 2003). becoming overwhelming. No less a figure than former Fed chairman Alan Greenspan admitted as much while appearing before the House Committee on Oversight and Government Reform in October He said of the idea of self-correcting markets: The whole intellectual edifice collapsed in the summer last year. The challenge for behavioral finance is to find ways to help people not go with the crowd, and not be susceptible to the errors of the intuitive mind. Here we offer such a solution. The Ulysses Strategy The evidence that investor emotions are influencing prices of securities is becoming overwhelming. Kent Daniel, Graduate School of Business, Columbia University Investor mood associated with irrational fear of plane crashes or the ignominy of one s national team losing, is apparently at work here. The resulting dark mood causes investors to view future economic conditions more pessimistically, so they favor selling rather than buying. As you have seen here, and as Columbia School of Business professor Kent Daniel 1 observes, The evidence that investor emotions are influencing prices of securities is The phrase Ulysses contract refers to a decision made in the present to bind oneself to a particular course of action in the future. It derives from a strategy that Ulysses adopted on his journey home from the Trojan wars, which took him and his ship s crew close to the Sirenusian islands. The islands were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the waters, in an attempt to reach the Sirens. No seaman ever survived, so no living human knew the nature of the Sirens songs. Ulysses wanted to be the first human to hear the songs, and survive. He instructed his crew to fill their ears with beeswax, to block out the sound, and then tie him securely to the mast and to ignore his pleas to be released, should he do so. The plan worked. Ulysses heard the Sirens songs, the crewmen ignored his entreaties to be untied and when they were out of earshot, he gave a pre-arranged signal to 1 Kent Daniel is a member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance. Behavioral Finance in Action 3

5 take out the ear plugs and release him. Ulysses had committed himself to a rational course of action at a neutral time, that is before he could hear the Sirens songs, and ensured that he stuck with his decision. This action of pre-commitment is the work of the reflective mind. In the same way, financial advisors could invite their clients to engage their reflective mind to pre-commit to a rational investment strategy in advance of movements of the market that might otherwise trigger irrational responses of the intuitive mind. This kind of Ulysses Strategy has been shown to work with the Save More Tomorrow program (Thaler and Benartzi, 2004), in a pilot savings product in the Philippines (Ashraf et al., 2006) and in a program to help smokers quit, which involved participants depositing a sum of money in an account that they would forfeit if they relapsed (Giné et al., 2008). Pre-commitment to a rational investment plan is important, because the intuitive impulse to act otherwise is strong. The first step in the process is to help your clients understand the psychology of trading by individual investors that can lead to poor decisions. Help them understand that these misguided impulses of the intuitive mind are quite natural, but that there is another, better path to follow, one that is guided by the reflective mind. The second step is to agree on an investment strategy, which would include an acceptable balance between risky and conservative instruments. As financial advisors, you are already very familiar with this. What would be novel for most advisors, however, is to commit to a specific contingency plan. This is an agreement made in advance about what action will be taken should a certain event or condition occur: for example, if the market goes up 25 percent or if the market goes down 25 percent. The third component of the Ulysses Strategy is to formalize these agreements in a commitment memorandum, to which both the client and the financial advisor are parties (see Appendix A for a sample memorandum). Although research shows that financial professionals are less affected by the impulses of the intuitive mind, they are not completely immune to them (Barber and Odean, 2000). And by being co-signatories to the memorandum, financial advisors put themselves on the same footing as their clients. This memorandum is not binding, in the sense of a legal contract. But the act of writing down the agreements and putting one s signature to it helps people resist the siren call of the intuitive mind. It helps clients stick with the plan when changes in market conditions might tempt them to go with the herd, and make unwise decisions. And it helps financial advisors honor the agreement, too. The Ulysses Strategy BeFi-in-Action: 1. Help clients understand the sometimes impulsive nature of investment decisions. 2. Discuss and agree upon what action would be taken when, for example, the markets move 25 percent up or down. 3. Draw up a commitment memorandum, with both client and advisor as signatories. (See sample memorandum, appendix A page 6.) Behavioral Finance in Action 4

6 References Nava Ashraf et al., Tying Ulysses to the Mast: Evidence from a commitment savings product in the Philippines, The Quarterly Journal of Economics, pp , May Nicholas Barberis and Wei Xiong, Realization Utility, 2010, faculty/ncb25/rg40d.pdf Kent Daniel et al., Investor Psychology and Security Market Under- and Over-Reactions, The Journal of Finance, vol LIII, no. 6, pp (1998). Ilia D. Dichev, What Are Stock Investors Actual Historical Returns? The American Economic Review, vol 97, no. 1, pp (2007). Daniel Kahneman and Amos Tversky, Prospect Theory: An Analysis of Decisions Under Risk, Econometrica, vol 47, no. 2, pp (1979). Guy Kaplanski and Haim Levy, Sentiment and Stock Prices: The Case of Aviation Disasters, Journal of Financial Economics, vol 95, pp (2010). S. Bikhchandani et al., A theory of fads, fashion, custom, and cultural change as informational cascades, Journal of Political Economy, vol 100, no. 5, pp (1992). Brad M. Barber and Terrance Odean, Trading Is Hazardous to Your Wealth: The common stock investment performance of individual investors, The Journal of Finance, vol LV, no. 2, pp (2000). Brad M. Barber and Terrance Odean, All that Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors, The Review of Financial Studies, vol 21, no. 2, pp (2008). A. Edmans et al., Sports Sentiment and Stock Returns, Journal of Finance, vol 62, pp (2007). John Galbraith, A Short History of Financial Euphoria, Whittle Books in association with Viking, New York, Xavier Giné et al., Put Your Money Where Your Butt Is: A commitment savings account for smoking cessation, American Economics Journal, vol 2, no. 4, pp (2010). David Hirshleifer and Tyler Shumway, Good Day Sunshine: Stock returns and the weather, The Journal of Finance, vol 58, no. 3, pp (2003). T. Loughran and P. Schultz, Weather, Stock Returns, and the Impact of Localized trading, Journal of Financial and Quantitative Analysis, vol 39, no. 2, pp (2004). Behavioral Finance in Action 5

7 Appendix A Sample Commitment Memorandum A commitment memorandum drawn up between a financial advisor and his/her client can help the client avoid making unwise investment decisions. A sample memorandum might read something like this: Behavioral Finance in Action 6

8 About the Author The Behavioral Finance in Action series was written by Shlomo Benartzi, Ph.D., Professor, UCLA Anderson School of Management, and Chief Behavioral Economist of the Allianz Global Investors Center for Behavioral Finance. Professor Benartzi is a leading authority on behavioral finance with a special interest in personal finance and participant behavior in defined contribution plans. He received his Ph.D. from Cornell University s Johnson Graduate School of Management, and he is currently co-chair of the Behavioral Decision-Making Group at The Anderson School at UCLA. Professor Benartzi is also co-founder of the Behavioral Finance Forum ( a collective of 40 prominent academics and 40 major financial institutions from around the globe. The Forum helps consumers make better financial decisions by fostering collaborative research efforts between academics and industry leaders. Professor Benartzi s most significant research contribution is the development of Save More Tomorrow (SMarT), a behavioral prescription designed to help employees increase their savings rates gradually over time. Along with Richard Thaler of the University of Chicago, he was recognized by Money as one of 2004 s Class Acts for SMarT s success increasing savings rates in one plan from 3.5% to 13.6%. The SMarT program is now offered by approximately half of the large retirement plans in the U.S. and a growing number of plans in Australia and the U.K. Professor Benartzi has supplemented his academic research with practical experience, serving on the advisory boards of the Alaska State Pension, Fuller and Thaler Asset Management, Guggenheim Partners, Morningstar and the U.S. Department of Labor. Behavioral Finance in Action 7

9 Acknowledgements We would like to thank the following experts in behavioral finance for their input to the intellectual content of the Behavioral Finance in Action series. Each of them is a member or past member of the Academic Advisory Board of the Allianz Global Investors Center for Behavioral Finance. Richard H. Thaler The University of Chicago Booth School of Business Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics aspx?person_id= Daniel G. Goldstein Yahoo Research, Research Scientist London Business School, Assistant Professor of Marketing faculty/search. do?uid=dgoldstein Nicholas Barberis Yale School of Management Stephen & Camille Schramm Professor of Finance Noah Goldstein UCLA Anderson School of Management Assistant Professor of Human Resources and Organizational Behavior Kent Daniel Graduate School of Business, Columbia University Professor of Finance John Payne Duke University, The Fuqua School of Business, Joseph J. Ruvane, Jr. Professor of Business Administration Director, Center for Decision Studies, Fuqua School of Business We would also like to thank the financial advisors who provided feedback on the Behavioral Finance in Action series. And we welcome further comments from our readers. us at [email protected]. Behavioral Finance in Action 8

10 The Allianz Global Investors Center for Behavioral Finance is committed to empowering clients to make better financial decisions by offering them actionable insights and practical tools. We developed Behavioral Finance in Action to present potential solutions to some of the key challenges financial advisors are facing. We consider this a work in progress. Our goal is to build on what we ve begun, to improve and expand upon the contents. We can do this most effectively in partnership with you. We therefore invite you to give us your feedback. To do so, please [email protected]. befi.allianzgi.com Allianz Global Investors is the asset management arm of Allianz SE. The Center for Behavioral Finance is sponsored by Allianz Global Investors Capital and Allianz Global Investors Distributors LLC. The principles and strategies suggested do not constitute legal advice and do not address the legal issues associated with implementing any recommendations, or associated with establishing or amending employee benefit plans. There are many legal and other considerations plan sponsors and plan fiduciaries should consider prior to adopting any of the recommendations herein, and legal counsel should be consulted to ensure compliance with the law. Any adoption of these general recommendations must be considered in light of the particular facts and circumstances of each retirement plan and its participants, and the authors of the program and Allianz Global Investors provide no advice regarding, and are not responsible for, implementation of these concepts by any particular plan. AGI Behavioral Finance in Action