DANIEL KAHNEMAN - Behavioral Finance

I'm actually not an economist at all I never had a course in economics I am a psychologist and involved in behavioral finance because behavioral finance which is a branch of behavior economics is strongly influenced by psychology the main difference between behavioral economics and economics and between behavioral finance and finance is in the assumptions that are made at the basis of the theory and the major assumption of economics as everybody knows there are two big assumptions wanted that people are rational and the other that they are selfish psychologically both of these assumptions make very little sense

and that is really the origin of behavioral finance and behavior economics there are economic agents who make Lourdes mistakes large and predictable mistakes and what I would like to begin with is an example of such a mistake individuals who invest on their own characteristically make large and expensive mistakes and the research on that possibly still the best research was done a long time ago by tario Dean earlier than that was a student of mine and he studied the individual investors who had large accounts or accounts in a brokerage house and he studied every transaction that

they made over a period of several years and he focused in particular on days in which the individual both sold one stock and bought another now those days you know that this is not a liquidity issue this is the determinant of the individuals behavior is some belief about the two stocks and the stocks they buy is going to do better than the stock they sell and now modern technology makes the analysis possible and this analysis is straightforward you can look a year later and you can see which does better the stock that individuals buy or

the stock they sell and the result is actually very striking one might even say astonishing on average the stock that people saw did better than the stock they bought but it's not only that it did better it did better by a large amount the average is three point four percent that is huge and it's been replicated many times the very solid results I I keep wondering why it isn't better known in the world of Finance because many it is known but it's not quite as widely known as I think it deserves to be the idea

is that there is an average cost to having an idea for an investor and the average cost is above three percent which is quite a lot so having ideas cost people money and they have lots of ideas individual investors tend to churn their accounts they tend to trade too much and clearly they trade too much that must express some kind of overconfidence they believe they know something that they do not know and this is one essential characteristic of human beings which makes them different from rational beings Theriault team also showed among many other things that

women investors for example do better than many investors as individual investors and the reason is again completely straightforward it is that they it's not that they have fewer ideas they may have as many ideas but they act on fewer of these ideas they just trade less and by trading less there she's significantly better results than many investors so that is one main example of what happens to individual investors in the market clearly there are people on the other side of these transactions the other people are professionals not that the professionals know so much but the

professionals clearly know better than the individual investors and clearly take advantage of them and it's because the market consists both of professionals and of individuals and these days also of computers it is quite difficult to make money from psychological assumptions but it is useful to know something about individual investors what is an important aspect of the psychology of investiture of decision-makers all together is confidence and expertise and where did the origin of confidence and most of the time we feel considerable confidence in our opinions and in our beliefs and in fact we feel too much

confidence in our opinions in our beliefs according to tario Dean this is what causes excessive trading and it clearly causes a lot of trading in general and and it is really quite important to know that psychological research I think is fairly unequivocal that confidence is not a very good indicator of accuracy that as you can have a great deal of confidence in opinions that are not accurate at all confidence is primarily feeling and it's a feeling about the coherence of a story that you're telling yourself if the story that you're telling yourself makes sense and

it makes subjective sense is internally consistent then you feel confident in it it has very little to do with the quality of the information on which the story is based expertise and true confidence of valid confidence is really something quite different and expertise is something we know actually the conditions under which expertise develops and expertise there are several conditions a few conditions and they are quite clear one is you cannot develop expertise unless the environment is regular unless there are regularities to be picked up so you can develop expertise in driving you can develop expertise

in press play you can develop expertise in poker because although there is a larger element of chance there are also regularities whether you can develop expertise in picking stuff this is very doubtful in fact it probably is not the case because the this is a highly irregular environment so the first condition is regularity the second condition is a vast amount of practice and vast amount of practice with immediate feedback you have to know the consequences of the action the feedback has to be clear it has to be rapid it has to be unequivocal and in

the absence of these conditions you do not have expertise and confidence that you experience when these conditions are not fulfilled is not good confidence it is not confidence that one should act on so in general if you want to know whether to trust somebody's expertise or to trust somebody's experience you should treat that as we treat a work of art the primary information is nothing what looks like the primary information is in its provenance how can you where does it come from does it come from true expertise or does it come from what many of

us call judgment heuristics which are very different processes which also give rise to confidence but are not based in the same way now the essence of rationality is what I will call broad framing the essence of rationality is a broad view and I will try to give you some examples of this this is the essence of rationality and this is probably the primary way in which individuals including individual investors deviate from rationality a fully rational agent is supposed to have a comprehensive view he views consequences in global terms and one of the major differences between

behavior economics and standard economics is that in standard economics the individual agent is supposed to be driven or motivated by the utility of future wealth or by the utility of discounted future wealth at present well in behavioral economics and this is really the primary difference between behavioral and standard his agents are supposed to be motivated by something else by gains and losses and notice the difference between gains and losses on one side and wealth on the other gains and losses are temporary their events wealth is a state it is a broader way of looking at

things but in fact what dominates our behavior is much more immediate than consideration that wealth it has considerations of gains and losses and that is the essential idea of both behavioral economics and behavioral finance a fully rational agent has a broad view in another meaning it has gives a long horizon but a basic finding well replicated in psychology decision theory and so on is that people are myopic and that they weigh immediate consequences much more than delayed there is in fact brain research that indicates that there are special brain circuits that respond to relatively immediate

as consequences as against other brain circuits that react to more delay consequences and we tend to be more rational about the more delayed consequences they're about the immediate ones a fully rational agent has a comprehensive view narrow framing which is a characteristic of most investors thinking has many manifestations one of them and one of the more important ones in that people find it unnatural to take a portfolio of you and here I'm talking of the knot of professionals but of the clients of professionals of investors they tend to follow each stock the performance of each

stock separately many people know the price at which they bought the stock and then week the price at which you bought the stock is actually a bad idea you are much better off if you didn't know the price at which you bought the stock because it turns out that people's when they have to sell a stock from their portfolio they are not neutral between winners and losers people tend to sell winners and hang on to their losers the psychology of that is quite straightforward when you sell a stock on which you made money because you

sell it for more than you bought it for then in effect you score yourself a success when you sell a stock for less than you bought it for you acknowledge a failure and so people in some sense by deciding which stock they will buy out of their portfolio they they have control over whether to give themselves pleasure to give themselves pain and they tend to give themselves pleasure and to sell winners and hang on to losers turns out to be a bad idea this is a significant difference this is called the disposition effect that's a

significant part of the three point four percent of the costs of individual ideas is there in any portfolio that a diversified portfolio will include both winners and losers and the consideration that should determine which you should lose which you should sell if any are certainly not the price at which you cost it right which you bought it originally so a rational investors trades less would trade much less than real investors do and would also trade differently would buy different stocks and would sell different stocks and professionals are on their way in those respects they are

on their way relative to their closer to rationality than individual investors are now the major psychological discovery makes a strange thing to call it a discovery because it's so obvious but it was a discovery in its time the major discovery that distinguishes rational from standard economics is that not only do people respond to gains and losses but they respond differentially to gains and losses and the main result the main feature is something that is called loss aversion the pain of loss seems to be more intense than the pressure of gain and most of us have

an asymmetric reaction to the two to appreciate how our loss of us you are personally imagine that I offer you a gamble and and the gamble will toss a coin if it shows tails you lose 1,000 euros if it shows heads you win X euros and my question to you and you might as well spend a few seconds figuring out your answer my question to you is what does X have to be before the gambler becomes attractive and the answer is actually surprising from on average it's over 2,000 euros that is it's actually much better

than most investment and yet when you just have to make that naked choice about a gamble between a loss and again the gain that is needed to compensate for the possibility of the loss is about twice as large a little more than twice as Lord on the average that's been verified in many contexts and in many different countries there is that that distinction the pain of losing appears to be greater than the pleasure of winning by a factor of about two to one and this causes many mistakes in import and that may be the more

important result the loss aversion is the major cause of risk aversion people are in fact it turns out not averse to risks there are many conditions and it would they like risks but they are averse to losing and the possibility of loss plays a very significant result a very significant part in their decision let me quickly show you that the normal reaction to the gamble rejecting a gamble who say with possibility of losing a thousand and the possibility of winning 1500 which is not attractive this is really quite irrational in a way and there is

a classic demonstration by the economist Paul Samuelson he did something else with it then I'm going to do but you'll see he suggested to a friend of his in my dream that I offer you a gamble just a gambler's I mentioned before equal probabilities to lose a thousand to win two thousand in his case he did it with hundreds lose a hundred when two hundred and his friend said he was not interested but then Samuelson says suppose I offered you ten such Gamble's so you'll toss ten times and after each time you will win two

hundred or lose 100 and of course the friend said of course I will accept then indeed it would be crazy not to accept them because the probability of winning overall is overwhelming and the expected value is very large so what happens there the question that I want to raise is the following I want to ask if you reject if you accept 10 Gamble's should you really be allowed to reject the one and the reason I'm asking this question in the following you are really not on your deathbed you are going to face many opportunities to

make decisions you are going to face many Gamble's they're not going to be exactly the same on the toss of a coin with two-to-one but in effect you will have many opportunities to make decisions very much like the present one it seems completely absurd when you're not on your deathbed to reject one gamble if you would accept ten of them when in fact life is very likely to offer you 10 of them what you should have and that's what a rational individual would have is not a preference for individual Gamble's for this particular gamble a

preference for an individual gamble is a prime example of narrow framing to look at problems in isolation in fact a fully rational individual would have a policy for how do you decide among Gamble's and the policy would probably be quite close to risk neutral for Gamble's with small stakes in fact it could be rescued row for gandules more stakes so if you managed to and and of course the expected value of the policy is vastly higher than the expected value of considering one decision at a time and making loss averse decisions about each decision at

a time so when I spoke earlier of gains and losses the narrow framing in terms of gain and losses is very costly this was what I was referring to individuals who managed to overcome this are going to end up they're going to end up Richard and they're going to be emotionally much calmer because they are not thinking and they are not reacting to losses as they occur to immediate losses but they have that long view and they evaluate the wealth of a collect but there is there is a phrase in American business you win a

few you lose a few and in a way this phrase at the essence of practical rationality having that having that particular attitude which is the attitude of many professional traders they show little aversion for losses and this is because they manage to frame consequences in this manner and this framing produces better decision and a much more comfortable emotional life I will spend a few minutes the last few minutes in talking about a third manifestation of the human mind the characteristic of the human mind and I will talk about hindsight hindsight and you probably can recognize

it in your surface that when a surprising event happens surprise is very brief and immediately after the surprise people make sense of the event and in a way they are no longer surprised by it they have learned something from the event so there were two football teams that you considered equally matched one of them trounced the other five to male now they're no longer equally strong in your mind one of them is clearly better than the other this makes sense of their victory it also makes it virtually impossible for you to reconstruct that earlier you

thought they were equal you now think that the team that actually won had to win and why did it have to win it had to win because it was stronger how do you know it was stronger because at one this is hindsight it has a huge effect on our thinking it has a huge effect on investing behavior and and it has a very pernicious effect in that we it teaches us something quite wrong about the nature of reality because for example you know the victory of Donald Trump was considered unthinkable and probably Donald Trump himself

did not expect to win but now the Donald Trump has won every day it makes more sense why he won every day it is less surprising now an example of that of course is the Great Recession there are many people who predicted the Great Recession there many more now than they were then and the film the big shorts was the book was written by Michael Lewis was a friend of mine but the book is really invites you to him to hindsight there are a few people they're obviously very clever people and they knew the market

was going to crash and you can't help but get the feeling that the people who didn't know the market was going to crash were either fools or knaves they were taking people who are planning to take advantage of it intelligent people saw the recession coming but in fact and that's well known fact many highly intelligent and well-informed people did not anticipate the crash and my conclusion from it in that the crash was in fact not quite as predictable as it now appears it now appears highly predictable in hindsight so the the pernicious effect of hindsight

that I mentioned earlier it was we get the sense after the fact that an event was predictable so we get a sense that the world is predictable we get a sense that the world makes sense and that exaggeration of the coherence consistency predictability of the world means that we deny the real uncertainty with which we are faced in existence and this denial of uncertainty by itself produces irrational action so I had 25 minutes to introduce you to to the psychology of behavioral finance I picked I picked a few topics one topic in the origin of

confidence and I told you that it's coherence and not accuracy the other topic is broad framing and narrow framing from which follows loss aversion and the final is hindsight and an individual decision maker who is affected by all of these and all of us are affected by all of these is going to make decisions that deviate in a predictable way from the decisions predicted by economic standard economic theory and standard economic finance thank you please join me we'll have a discussion now with our audience people have been sending questions and it'll be really fascinating to

hear your response as we deep dive into some audience questions the first one what tips do you have for us to be successful investment advisor slash partners to Millennials and next generations well I don't know specifically about Millennials advisors in effect have to build on the sort of thing that I discussed earlier the role of advisors is to press people towards rationality up to a point by encouraging broad framing primarily and by encouraging broad framing they will cause people in principle to trade less to churn less to check and one very important aspect to check

their results less frequently frequent tracking of results causes people to want to change what they're doing and people do poorly when they change what they're doing so by and lord you know everybody all professionals know that they're a good policy is a stable policy and the more you change it the worse you are and so the best advice is going to be advice to resist changes but I will add one other thing an adviser who merely preaches rationality to people is not going to be a good adviser an adviser has to recognize that their effect

on investors therapeutic educational call it what you will their effect on investors is limited the investor is going to remain low suppose the investor is going to remain with some hindsight the investor is going to remain to regret when things are going badly regret is a terrible guide to to decision making but 'progress is a frequent guide to decision-making and the role of the advisor is going to be multiple here first of all to recognize individuals who are prone to regret because they need a different policy and they need a different approach second to discuss

and anticipate regret because anticipating losses and anticipating volatility and anticipating regret is like a vaccine it is an inoculation by preparing people in advance you can reduce the severity of rate you can eliminate or reduce catastrophic responses to bad events and responses to bad events are the main reason actually responses delayed response to events are the main reason that investors typically do less well than the funds that they invest in they buy - they buy at the wrong time they sell at the wrong time and a lot of that is done because they keep changing

their policy okay next question from the audience is there a utility in having an advisor if we assume that experts do not have meaningful skills in picking investments I guess the utility is elsewhere it's a psychological support as you would say I would think that you know the main utility of an advisor is and I think that therapeutic and educational role and they do have a role in that respect but I do not you know I do not much believe that advisors are going to know to be able to give tips on the market very

few people can do that here's the one I guess it ties back into the part about Millennials because you didn't really answer the question about what it means for younger people but somebody here asks does the culture or age have an impact on investment behavior more generally is the investment behavior homogeneous or are there clusters and if yes what criteria shaped behavior style well it's not a topic about which I know much which is the reason that I avoided it there are there are clearly large individual differences in in investment style some people are much

more optimistic than others there are differences between men and women as I mentioned in there are differences in the level of our confidence and and in the wish to trade there differences in the anxiety level there are differences in the ability to tolerate regret of two kinds both the regret the catastrophic regret applause --is and another kind of regret that I haven't spoken about but I'll spend a minute on it if you think of which gamble you would rather have a gamble in which you are guaranteed a gain of a large gain and then you

have a small chance to win a very large gain or another gamble in which you are guaranteed an even larger gain but with a small chance to win to lose a very large amount people very clearly prefer the first to the second so we always prefer positively skewed gamble to negatively skewed gamble but if you have to live with these two Gamble's for a long period of time then for a long period of time the people who have taken the gamble with a small probability of a big loss every day they do better than the

others that creates regret for some people it's a different type of regret and it's a very peculiar thing that people that the gamble that people prefer in advance they find it harder to live with in reality so there are differences there how to detect those differences and whether there are tests and ways of indicating that is a very subtle topic my guess is that most of the tests that we have for people reaction people's reaction to risk and to volatility I'm not very useful thank you that's all we have time for that was fascinating thank

you very much [Music] you