Behavioral Finance Notes

Announcements

• Late assignment submissions are accepted until Wednesday at noon to avoid work during finals.

• Self-control projects are being graded, and individualized grade updates will be sent.

• Nudge votes: Group five's recycling bin design was the class favorite, with plans to potentially implement it on campus.

Disclaimer

• The instructor is not a licensed investment advisor;

• Information provided is based on current knowledge and research but should not be taken as financial advice.

• Investment decisions based on the lecture are at your own risk.

Behavioral Finance

• Traditional finance relies on two assumptions:

  • Rational Expectations: Beliefs about the future are unbiased, and investors, on average, hold correct expectations given current information.

  • Expected Utility Maximizers: Investors aim to maximize total returns over time.

• Behavioral finance acknowledges that humans have biased beliefs (e.g., overconfidence) and make choices inconsistent with expected utility, such as prospect theory and mental accounting.

• These behaviors can lead to investment decisions that deviate from optimal financial strategies.

• Richard Thaler, known as the father of behavioral finance, won a Nobel Prize for his contributions to behavioral economics.

• In the movie "The Big Short," Selena Gomez spoke with Thaler, asking if he could invent his own field of study; she felt insecure, adding that she sold 30,000,000 albums.

• Three financial economists won the Nobel Prize in economics for their work in finance before 2017, including Eugene Fama (efficient market hypothesis) and Bob Shiller (behavioral impacts on markets).

Personal Financial Literacy

• A survey assessed students' financial literacy, revealing self-evaluations that were not high.

• The average score in the class was eight out of 13, slightly above the worldwide average.

• Some students scored perfectly (13/13), but none were finance majors.

• Students underestimated how many questions they answered correctly, suggesting a lack of confidence about financial knowledge.

• Finance professors created a personal finance course due to the lack of financial literacy among students.

Financial Definitions

• Security: A tradable financial instrument.

• Debt Securities (Bonds): Lending money to a company or government, which is repaid with interest. Average return on a ten-year bond is approximately 5% per year.

• Equities (Stocks): Owning a part of a company and having claims to its assets, where the stock price reflects the company's value.

• The presenter recommends against investing in Bitcoin, saying that it is more like gambling due to the lack of fundamental value.

• Historically, the average real return on stocks is about 10% per year, potentially doubling your money every seven years (Rule of 72).

Stock Market Volatility

• Stocks experience fluctuations; the stock market can either double or halve in a year.

• Over 35 to 50-year periods, the average gain ranges from 6% to 14%.

• If investing for the long-term, the risk from stocks diminishes.

• Young people with long investment horizons should invest in stocks rather than bonds.

• Derivatives: complex investment that are recommended against unless one has a strong knowledge about the same.

• Mutual Funds: Professionally managed investments where investors pool their money together.

• Hedge Funds: Similar to mutual funds but typically open to wealthy or institutional investors.

• Diversification: Reducing risk by holding a variety of investments.

Financial Literacy Questions Analysis

• 40% of students did not know that stocks historically yield more than bonds.

• The compounding question: Investing $100 with a 20% annual return results in 250 after five years.

• The most incorrectly answered question involved credit card debt: Owing 3,000 with a 12% APR and paying only the minimum of 30 each month means the debt will never be eliminated because the minimum payment only covers the interest.

• It is crucial to pay off credit cards in full each month to avoid accruing interest.

Topics for the day

• Whether to invest at all.

• How people trade securities.

• What people choose to invest in.

• How people diversify or not.

• Finally, how to use class concepts to help people.

Investing and 401(k)s

• A 401(k) is a tax-deferred retirement savings plan commonly offered by employers.

• With a 401(k), when you put money in, let's suppose that you make 100,000, you save 10,000. The government only sees 90,000 in. The rest of that 10,000 goes into your account, and it's it's to grow tax free.

• Too many choices in 401(k) plans can deter people from investing due to choice overload.

• Automatic enrollment increases participation rates significantly (50% to almost 90%).

• Defaults are powerful, and inertia often leads people to stick with initial choices.

• Many individuals fail to update beneficiaries; for example listing their mothers as beneficiaries instead of listing their spouses.

Retirement Planning

• The median planned retirement age in the class is 62, while some plan to retire much earlier or later.

• The average retirement age in the US is 65 for men and 63 for women.

• Full Social Security retirement age is typically 67, but the presenter expects an increase of 68-70.

• Retirement requires substantial savings to maintain a comparable quality of life.

• Conditional life expectancy for a 21-year-old woman is 65 years and 60 years for a man.

• College education adds about eight years to life expectancy.

• The median savings goal in the class ranged from $1,000,000 to $2,500,000.

• The average 401(k) balance for those near retirement is only $53,000, insufficient for a comfortable retirement.

• A general rule of thumb is to save 16 to 20 times your salary to maintain your retirement lifestyle.

Social Security

• Saving 12 to 15% of pretax income per year in the stock market can lead to adequate retirement savings.

• Social Security may not be sufficient, as it provides a limited income.

Emergency Savings and Financial Cushion

• 27% of students couldn't readily cover a $2,000 emergency expense.

• Median unemployment duration is 10 weeks, with 24% taking six months or more to finds jobs.

• Having a financial cushion is cruical.

Trading Securities

• Financial markets exhibit a high volume of trade that traditional economics struggles to explain.

• The Groucho Marx theory: rationality suggests minimal trade because you wouldn't want to participate in any trade that someone is willing to take the other side.

• Overconfidence drives trading volume; most investors think they are above average.

• Traders tend to trade less near the end of the year if they have hit their targets.

• The speaker introduces the concept of target which means setting a reference point.

• Afternoon risk-taking behavior relates to the house money effect (more risk after gains) and break-even effect (more risk after losses).

• The disposition effect: Selling winners too early and holding on to losers for too long.

• Realized tax benefit exists when selling losing stock.

• People tend to be more risk seeking in games and risk averse in losses.

• Data shows people sell gains 50% more frequently than losses.

• Winning stocks outperform losing stocks by 4% over two years.

Investment Choices and Equity Premium Puzzle

• The equity premium puzzle: Stocks return 6% higher than risk-free rates, which is more than enough compensation for the riskiness of the market.

• Frequent portfolio checking leads to seeing more frequent losses because the stock market is a random walk.

• Myopic loss aversion makes people not invest in the stock market exactly because sometimes the stock market goes down.

• People chase returns, investing in current top-performing stocks and not holding for the long term.

• 98% of active investors fail to beat the market over the long term.

• Men are more overconfident and trade 45% more than women, leading to poorer performance.

• Men tend to invest in crypto more frequently than women.

• There is a company called Lvest that helps women get involved in trading since women tend to be less involved in trading.

Professional vs. Passive Investing

• Jack Bogle's 30-year study showed that only a small fraction of actively managed mutual funds beat the S&P 500.

• In 2014, 86% of fund managers underperformed the index which they are managing.

• Alternative: Index funds that passively mirror a broad market index with average returns of 10% per year.

• Actively managed mutual funds average an 8% return per year.

• Investing in a hedge fund averages at 6% premium.

• During the .com bubble, a chimpanzee outperformed 6,000 professional portfolios by randomly selecting stocks with darts.

Warren Buffet

• Warren Buffett recommends investing in an S&P 500 index fund.

• He made a $1,000,000,000 bet with the hedge fund industry that passive investment would outperform them over the next decade.

• A hedge fund lost the bet to S&P five hundred.

Vanguard

• Vanguard was created by Charles Bogle to allow people to more easily invest passively in the stock market.

• Vanguard's expense ratios are significantly lower (0.09%) compared to the industry average (0.73%), adding up to huge long-term gains.

• The entire mutual fund industry received about $97,000,000,000 of new investments compared to $800,000,000,000

• Vanguard, as of 2022, had $8,000,000,000,000 under management.

More Biases and Pitfalls

• Jim Cramer has had an accuracy rate of 44% with the stocks that he chooses.

• The number game (tea beauty contest) shows how people guess what other people guess, related to speculation in the stock market.

Investment Biases

• Investors tend to invest in what they know, deviating from optimal diversification, in a form of country bias or local bias.

• USA Investors invest 93% in US stocks.

• Home bias: Employees often over-invest in their own company stock.

• Employees should not invest with someone that is a primary source of their income.

• The company stockholder sacrifice, on average, 42% of returns compared to holding a diversified portfolio.

• People make decisions based on what is easier rather than what is right.

• One over N is another form of Bias which states that investments should simply split evenly.

Improving Investment Decisions

• Provide good defaults.

• Actively circumvent biases.

• Provide decision-making aids. People don't save enough for retirement, so save more.

• Make the pain less problematic:

  • By asking people to save more money next year.

  • Offer a raise every year.

• The save more tomorrow plan found that savings rates tripled from 3.5% to 11.6% within two years.

Retirement Savings

• Provide people with good default options, as defaults are powerful and inertia often leads people to stick with initial choices. Good defaults can significantly increase participation rates and improve investment outcomes.

• When Swedes were encouraged to actively choose between 450 mutual funds, the default option of 65% non-Swedish stock and 70% Swedish stock mutual fund investments outpaced active choices by 10%. This illustrates the impact of defaults, as most people stuck with the pre-selected funds, leading to better overall performance compared to those who actively chose their investments.

• Target date funds are a good investment technique/instrument. They automatically adjust the asset allocation over time, becoming more conservative as the target date (retirement) approaches. This simplifies investment decisions and helps individuals align their investments with their risk tolerance and time horizon.

• When Swedes were encouraged to actively choose between 450 mutual funds, the default 65% non-Swedish stock, 70% percent Swedish stock mutual fund investment outpaced active choices by 10%.

• Target date funds are a good investment technique/instrument.

Other Options

• Algorithmic investing has been shown to be quite useful and can be found in Betterment Wealthfront.

• Micro-investing apps exist that make this available in Acorns.