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Behavioral Finance at JP Behavioral Finance at JP MorganMorgan
Managerial Finance Presentation
Presented by
Hussein Elgarhy
&
Fouad Ellaithy
Supervised by
Prof. Dr. Mustafa Eldewany
April, 2010
AgendaAgenda
Behavioral Finance * Why/What is BF
BF Characteristics Over Confidence / Loss aversion
Prospect Theory
The Weighting Function
JP Morgan **
BF At JP Morgan Over Confidence / Loss aversion
BF Implementation
JPM Branded BF Fund
Top JPM BF Funds Updated Status
* Behavioral Finance: BF** JP Morgan: JPM
Slide 1
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Why Behavioral Finance?
If we always behaved rationally…
Nobody would ever sell stocks in a panic at the first sign of trouble
Nobody would ever buy stocks (or other investments) based on hunches,
hot tips or media hype
Nobody would ever keep money in the bank instead of using it to pay off
high-interest credit card balances
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Behavioral Finance Behavioral Finance provides an ‘overlay’ to the Standard Theory.
Theory It provides a framework to understand ‘non-rational’ investor and market behaviors…
Investors
Are not totally rational
Often act based on imperfect information
Make “non-rational” decisions in predictable ways
Markets
May be difficult to beat in the long term
In the short term, there are anomalies and excesses
The two aspects of behavioral finance are:
The behavior of investors
The behavior of markets© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Our Brains affect on Financial Decisions
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
•Fear Vs Greed •Dough Vs Gain
Behavioral Finance Cont’
Behavioral Finance is a reflection to extremes we see in Efficient Market Theory or in Mathematical Finance.
It is not just Behavioral Psychology applied to finance but also includes more broad social aspects which are not related to anything fundamental.
Stocks Market Price
Stocks Dividends
1880 1900 1920 2000
Behavioral Characteristics
Loss aversion
Media response
Disposition effect
Herding
Narrow framing
Optimism
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Mental accounting
Overconfidence
Regret
Anchoring
Hindsight bias
Recency
Behavioral Characteristics “ JP Morgan focus “
Loss aversion
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Overconfidence
Over Confidence
What is the weight of Status of Liberty -in Tons- ?
Population of Turkey -2008- ?
Size of Sahara Desert -Sq meter- ?
Over Confidence
What is the weight of Status of Liberty -in Tons- ? 252 Tons
Over Confidence
What is the weight of Status of Liberty -in Tons- ? 252 Tons
Population of Turkey -2008- ? 73,914,260
Over Confidence
What is the weight of Status of Liberty -in Tons- ? 252 Tons
Population of Turkey -2008- ? 73,914,260
Size of Sahara Desert -Sq meter- ? 3.5 Million Sq meter
In year 1979 Daniel Kahneman & Amos Tversky published there article about Prospect Theory as a psychologically realistic alternative to Expected Utility Theory.
There is a discontinuity in slope which means we value losses more than we value gains given an equal probability for both. In contrary to EUF, here we are always at the reference point exaggerate in our minds the importance of deviations from where we are. This is not rational! So losses tend to dominate so you don’t want to take the bet.
Expected Utility Function Value Function
Prospect Theory
The Weighting Function
Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory:
Given these two prospects
Which one you choose?
Probability Gain
25% $3000
20% $4000
The Weighting Function Cont’
Named after the French economist Charles Allais, the Allais paradox illustrates thinking that violates the Expected Utility Theory:
Given these two prospects
Which one you choose?
Most people would choose the 20% & $4000
Probability Gain
25% $3000
20% $4000
What if you have
Which one you choose ?
Probability Gain
100% $3000
80% $4000
The Weighting Function Cont’
What if you have
Which one you choose ?
Most people would choose the 100% & $3000 because we prefer certainty. This contradict with the EUF theory.
Probability Gain
100% $3000
80% $4000
The Weighting Function Cont’
The Weighting Function Cont’
Kahneman & Tversky said we weight probabilities in our minds in a distortion way. They stated that we emotionally minimize the differences between probabilities if they are close.
JP Morgan
J.P. Morgan Chase & Co. is one of the oldest financial services firms in the world. It has operations in 60 countries. It is a leader in financial services with assets of $2 trillion.
J.P Morgan manages clients’ assets through three key business units:
Private Bank High net worth individual (26 counties)
Private Client Services (PCS) Client with < $ 25M in Assets
Asset Management Developing financial products for retail and institutional investors
JPM was the seventh largest asset management company in the world in 2005
Behavioral Finance at JP Morgan They emphasis on two behavioral Biases:
Over confidence JPM funds systematically overweight value stocks, means that our
investment behavior is changed. We are forced to focus on out of fashion stocks that we wouldn’t naturally have bothered with and that means that we cannot fall into the same overconfidence trap.
Loss Aversion Our approach requires a systematic tilt to momentum, forcing us to run
our winners and cut our losers. It also forces our investors to re-evaluate stocks which have done well for a long time but are now starting to disappoint
The implementation of the BF investment philosophy had three parts:
Stock selection A quantitative stock selection model is used to rank stocks based on behavioral
characteristics
Portfolio construction Portfolio construction involved maximizing exposure to stocks with value and
momentum, while controlling other risk exposures, such as overall risk, sector exposures
Execution. In our portfolios, stocks are systematically combined in such a way as to produce a
barbell portfolio which is cheaper than the market and has better momentum than the market - a kind of “super-stock.”
Behavioral Finance Implementation
JPM Branded BF Fund Intrepid Funds
Intrepid America
Intrepid Growth
Intrepid Value
Intrepid Multi Cap
They Capitalize on the emotions that often cause people to make poor investment decisions
Their performance had been impressive Example: Intrepid Value was ranked first of 400 funds since its release in
2003
Top JPM BF Funds Updated Status
QUESTIONSQUESTIONS
Back up
Loss Aversion: Pop Quiz
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
A friend wants to make a bet with you. If accept the bet you will have a 50% chance of losing $10,000 and a 50% chance of winning $_______.
How much would you want to have a chance of winning before you would take the bet?
Please right down your number
Loss Aversion: The Disproportion of Gain & Loss
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Most people want to gain between 2 and 2.5 times as much as they put at risk. So most people will want a chance to win $20,000 before they will play.
Practical Example: Between 1926 and 2000
Stocks returned 8% (real) Bonds returned 2% (real)
The answer is loss aversion: The less frequently you evaluate stocks, the less risky they appear. People tend to evaluate stocks as if they had a short time horizon.
Question: Why would anyone
invest in bonds?
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Anticipation of gain (greed) is more satisfying than the actual gain Pain of loss has a larger emotional impact than the pleasure of
gain Investors lose confidence in markets due to the media response,
herding, and anchoring effects Excessive conservatism and aversion to risk is exacerbated by
narrow framing, mental accounting and short time horizons Investor overconfidence, optimism and minimization of
uncertainties create inflated egos Investors often repeat predictable, destructive behaviors and
don’t learn from past mistakes
Bottom line: These behaviors and reacting to ‘recency’ events leads to lower overall returns over the long-term.
Behavioral Finance: Key points
© Hussein Elgarhy and Fouad Ellaithy, MsM-RITI-Cairo Outreach Program, 2010.
Recognize that behavioral issues affect us all—including financial advisors, institutional money managers, and individual investors
Do a self-assessment to determine what behaviors you’ve exhibited and how it may impact the advice you provide clients or the advice your clients have clients—or received from other advisors
Challenge the financial advisors you work with—see with see if their advice and recommendations are influenced by latent behavioral biases
Conclusion