Post on 02-Apr-2022
transcript
Question
If you could increase your chances of having a more comfortable retirement by taking more risk, would you:
a. Be wiling to take a little more riskwith all your money?
b. Be willing to take a lot more risk with some of your money?
If you could increase you chances of improving your returns by taking more risk, would you:
=xA lot more risk
Some of your money
Addition to portfolio risk
Risk Money
=x All of your money
A little more risk
Addition to portfolio risk
a.
b.
The plan for this session
Compare
Mean-variance portfolio theory to
Behavioral portfolio theory
Provide tools to implement behavioral portfolio theory
Standard Finance and Behavioral Finance
Standard Finance – Investors are rational.
Behavioral Finance – Investors are normal.
Behavioral Finance
First Lesson
Know YourselfMake yourself your ally
Know your goals
Know your emotions
Know your cognitive biases
Behavioral Finance
Second Lesson
Protect YourselfMake science your ally
Know the science of financial markets.
Know the science of human behavior.
Use the tools of science to overcome cognitive biases and emotions
Mean-variance portfolio theory
Investors consider portfolios as a whole.
Investors care only about expected returns and risk (standard deviation)
of the overall portfolio.
Investors are always averse to risk.
Individual investors care about reaching ultimate goals (retirement, education, travel, charity)
Institutional investors care about reaching ultimate goals. (Pensions, health care, surplus)
(Expected returns and standard deviations are only intermediate goals)
Investors consider their portfolios not as a whole but as a pyramid of distinct mental accounting layers, arranged by
goals
Investors are not always averse to risk
(Investors buy both insurance policies and lottery tickets)
Behavioral Portfolio Theory
Behavioral Portfolio TheoryPyramids of mental accounts
arranged by goal
Pensions
Health Care
Surplus
Behavioral Portfolio Theory
Low risk vs. high risk? (Risk budget)
Diversified vs. concentrated?
Passive vs. active?
Downside protection vs. Upside potential?
Satellite
Core
Mean-Variance Portfolio TheoryIt all mixes in the stomach
Investors want highly nourishing and low cost meals.
Behavioral Portfolios TheoryPortfolios from the perspective of the palate as well as the perspective of the stomach. Investors want highly
nourishing and low cost meals. But they also want palatable meals.
Mean-variance portfolio theoryEfficient frontier and optimal choice
The one and only question to investors.
What is your utility function?
Or, more intelligibly, which of the combinations of
expected return and standard deviation for
your overall portfolio is optimal for you?
Expected Return
Standard Deviation
5% 3%
6% 5%
7% 10%
12% 18%
14% 20%
Have you ever seen a question like this in any investor questionnaire?
Generally, I prefer investments with little or no fluctuations in value, and I’m willing to accept the
lower return associated with these investments
o Strongly disagreeo Disagreeo Somewhat agreeo Agreeo Strongly agree
Insights from investment questionnairesWhat you are likely to see is a question like this in the
Vanguard questionnaire:
Does the question guide you to the right portfolios on the efficient frontier?
Is it about the portfolio as a whole?Unintelligible questions lead to unintelligble
Behavioral portfolio theoryHow much of your portfolio would you
allocate to each goal
Downside protection
Full Funding
Upside potential 10%
90%
Surplus
Behavioral portfolio theory What is the probability of reaching this
goal?
Different probabilities for different goals
Risk is the probability of not
reaching a goal
I’m virtually sure that my downside is protected
(Almost 100% chance to reach the goal)
I have some chance of upside potential
(20% chance to reach the goal)
Efficient frontier in behavioral portfolio theory
Link between behavioral portfolio theory and value-at-risk (VaR)
Expected return (Aspiration level)
Risk (Probability of failing to achieve this expected return)
When your aspiration level (expected
return) is high, the probability of failing
to reach it is high. This is a version of Value-at-Risk (VaR)
Behavioral portfolio theory Goals are liabilities
Full funding Surplus
Proportion allocated to the goal
90% 10%
Desired probability of reaching the goal
100% 20%
1
2
Outflows minus inflows in each period
3
Behavioral Portfolio Theory
Use Monte Carlo Simulation to find the best sub-portfolio for each goal.
The overall portfolio is the sum of the sub-portfolios
Is that overall portfolio on the mean-variance efficient frontier?
Committee Work Analysis of 13 Investment Committees
Size of committee: 3-12 with 6 as a median
Managing $20 million to $15 billion
Decisions include:• Investment policy• Asset allocation
• Hiring and managing money managers• Market discussion
• Specific investment options
Payne and Wood
Committee Work
Intellectual tasksThere is a demonstrably correct answer
Judgmental tasksNo clear correct answer
Preferences matterStrength in numbers is often used as the
decision rule
Committee WorkHow committees reach good decisions.
• More information – What are the likely inflows and outflows?– What are likely returns?
• Checking errors in facts and reasoning• Incorporation all preferences• Generating feelings of participation and
acceptance of decisions
Committee WorkHow committees reach poor decisions
Poor information sharingAmplification of cognitive biases and emotions
Social loafingConformity pressures
Polarization of attitudes
The tools of science– The science of financial markets– The science of human behavior
Game
1. I have just given you $20. We will play 20 rounds of a game.
2. You have to choose if you play each round. If you play you have a 50-50 chance to lose $1 or win $1.5.
Do we have stable expectations of returns and attitudes toward risk?
What were our expectations of returns and risk tolerance in late 1999?
What were our expectations of returns and risk tolerance in early 2003?
The role of fear and exuberance (lack of fear) in expectations of returns and risk
tolerance.
Fear decreases our expectations of returns
Fear increases our aversion to risk
Do we have stable expectations of returns and attitudes toward risk?
Do you think that now is a good time to invest in the financial markets?
Percent of investors who said Yes
0
10
20
30
40
50
60
70
80
90
Jun-98 Jun-02 Jun-06
July 07 - 63%
March 03 - 41%
Feb 00 - 78%
Percent
Source: UBS Index of Investor Optimism
From August 31, 2000, through March 31, 2001, stocks lost more than 25%. If I
owned a stock investment that fell more than 35% in 7 months, I would
o Sell all of the remaining investmento Sell a portion of the remaining investmento Hold on to the investment and sell nothingo Buy more of the investment
Insights from investment questionnaires
From the Vanguard questionnaire
Question
Please rate your level of agreement with the following statement on a scale
ranging from “Strongly Disagree” to “Strongly Agree”
“Now is a good time to invest in stocks”
1 2 7 8 9 1063 4 5Strongly Disagree
Strongly Agree
We need to calibrate our level of fear (or exuberance) when we estimate expected returns,
inflows, and outflows.
QuestionnaireReturn
Please circle the number that reflects your perception of the expected return of a broad index of stocks of each country in the following 12 months, from 1 for a low expected return to 10 for a high expected return.
Low Return High Return
Albania 1 2 3 4 5 6 7 8 9 10
Canada 1 2 3 4 5 6 7 8 9 10
Iraq 1 2 3 4 5 6 7 8 9 10
United States 1 2 3 4 5 6 7 8 9 10
QuestionnaireRisk
Please circle the number that reflects your perception of the risk of a broad index of stocks of each country in the following 12 months, from 1 for a low risk to 10 for a high risk.
Low Risk High Risk
Albania 1 2 3 4 5 6 7 8 9 10
Canada 1 2 3 4 5 6 7 8 9 10
Iraq 1 2 3 4 5 6 7 8 9 10
United States 1 2 3 4 5 6 7 8 9 10
The relationship between assessments of expected returns and assessment of risk of
210 companies
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0
Risk score
Exp
ecte
d re
turn
sco
re
Expected return score = 8.6 - 0.5 Risk score (24.4) (-7.2)
R2 = 0.2n = 210
Expectations about future returns and realized past returns
UBS Index of Investor OptimismWhat overall rate of return do you expect to get on your portfolio in the NEXT twelve
months?
02468
101214161820
-40.0 -30.0 -20.0 -10.0 0.0 10.0 20.0 30.0 40.0 50.0
Realized stock return in the past 12-months
Expe
cted
retu
rn in
the
next
12-
mon
ths
Expected future return = 10.6 + 0.1 Realized past return (49.9) (8.4)
r2 = 41.2n = 102
Returns are of the CRSP 1-10 Index
Expectations about future returns and realized future returns
UBS Index of Investor Optimism What overall rate of return do you expect to get on your portfolio in the
NEXT twelve months?
-40.0
-30.0
-20.0
-10.0
0.0
10.0
20.0
30.0
40.0
50.0
0 2 4 6 8 10 12 14 16 18 20
Expected return in the next 12 months
Real
ized
sto
ck re
turn
in th
e ne
xt 1
2 m
onth
s
Realized future return = 21.4 - 1.5 Expected future return (2.9) (-2.3)
r2 = 5.7n = 90
Revising portfoliosRebalancing
After the market has gone up we are tempted to transfer funds to the
“surplus” mental account.
After a particular asset has gone up we are tempted to increase its proportion in
the portfolio (Private equity? Hedge funds? REITs?
Use the tools of science
Behavioral portfolios
Compare
Mean-variance portfolio theory to
Behavioral portfolio theory
Provide tools to implement behavioral portfolio theory