 Hello and welcome to the session. This is Professor Farhad in which we would look at behavioral finance. This topic is covered in essential of investment scores. As always, I would like to remind you to connect with me only then. If you haven't done so, YouTube is where I have 1,800 plus accounting, auditing, finance, tax, as well as Excel tutorial. If you like my lectures, please like them and share them. If they benefit you, it means they might benefit other people. And on my website, farhadlectures.com, you will find additional resources, the complement and supplement discourse, as well as your other courses. Let's go ahead and start by looking at the conventional theories. What are the conventional theories? The efficient market hypothesis is a conventional theory. And basically it makes 2 important prediction based on the body of research. That implies that security prices, basically stock prices, reflect all information available to investors. And active traders will find difficult to outperform passive strategies such as holding market indexes. Now, this conventional theory, as along with other theories like the modern portfolio theories, ignore how people make decisions. What they assume, they assume that people are rational. That's what they do. So whether it's the efficient market hypothesis or the modern portfolio theory, they always tell you, we are assuming here that people are rational. Behavioral finance, which is the topic of this session, is different. This type of studies takes into account the psychology factor. In other words, people behavior, how they affect investors behavior. So the conventional, they only look at actual numbers and theories. The behavioral finance, they look at how people react to certain situations. And under those circumstances, people are not rational. People are not rational. I'm going to give you an example that I experienced this morning. I was talking to one of my subscribers and this subscriber, he purchased a CPA prep course, CPA prep course. And he paid for this course. Actually, it's this conversation this morning today. He paid for the course 1700. Now, he is also a member of my website and he paid, he pays $30 a month. That's how much is my membership? And here's what happened. He's complaining to me. He's just kind of, he kind of hit a wall that he's finding hard time with the CPA prep course. So I told him, well, my membership, my $30 membership will help supplement your course. So if you go through my membership, it will help supplement your course. And his answer was, you know, I, he said he felt guilty because he paid 1700 for the course and he's not using it that much and he's paying $30 for my course. So he felt guilty that because he paid 1700, he should focus on the course, on the CPA prep course. That's not delivering what it's, what is supposed to deliver. He admitted to me that when he uses my material, I'm sorry, this is kind of, I don't assume I'm making an ad. This is a real story. It's actually, I was speaking to this, to this CPA candidate a couple of hours ago. The fact that he only paid $30, he doesn't want to use it as much because the prep course he paid, he paid more for it. So this individual is not acting rationally. Okay. He paid the $17. It's a sunk cost move on because the $30, my $30 will help complement his course, but he's kind of stuck to stuck at that. So it doesn't matter. Let's move on. So these irrationalities based on behavioral finance, they fall into two categories. One is called process information, process information. Investors do not always process information correctly. And therefore they infer incorrect probabilities. Distribution about future rate of return. So this is called information processing. They have one of the issues is information processing. Well, they get the probabilities, but they're not absorbent correctly. And the second category of this behavioral finance is even if you get the probability distribution of return correctly, let's assume you, you were able to read the numbers correctly, you often make inconsistent and systematically suboptimal decision. Why would you do that? Because your behavioral biases, you have certain biases, although the numbers are accurate, you absorb them accurately, you are reading them accurately, but you're making the wrong decision. Therefore, our behavioral finance will, all of them, they will fall under those two categories. And under those two categories under information processing, we're going to look at forecasting errors over confidence, conservatism, simple side, simple size neglect and representative. And under the behavioral biases, we're going to look at framing, mental accounting, regret avoidance and effect. And every time I have a list, that means I'm going to go over each one of those lists. Let's start with forecasting errors. What does it mean forecasting errors? It means you are making a prediction and it's incorrect. Why? Well, people overvalue recent experience compared to prior belief when forecasting. What does that mean? It means they have a memory bias. They only remember the good stuff, especially if it happened with them recently. They don't remember the bad experience. A case in point is Tesla or the dot com when the dot com crash, but Tesla basically as soon as Tesla and again, I'm going to be using Tesla and this recording more than once. I don't want you to think anything about Tesla. I'm not against or with Tesla. I'm just, you know, using Tesla as an example. So when during the quarter that Tesla deliver good numbers, for example, there are four quarters in a year, maybe Tesla would with with the report good numbers, good deliveries in one quarter and three quarters. They miss. Well, people remember if the most recent one is a good one, people would remember that most recent one and they will build their forecast based on that ignoring the three, the three prior forecast that they missed. Also, during the dot com, people fell into that into that into that problem where they overestimated the dot com companies that many of them went bust because they assume it's a dot com. The sky is the limit, but that's not what actually happened. So you tend to make forecast that are too extreme given the uncertainty inherent in their information. As long as they have some good information, they will forecast very high. See, perhaps do the favorable recent performance. So that's why you do that. You only remember the recent good stuff and you forget all the bad numbers. So this result in a high valuation, high P ratio due to optimism built into the stock price. So now you're bidding the stock price up and eventually what happened when the new data came comes in and you have a poor subsequent performance, then that then then the investors would realize their error. A case in point as Tesla, you know, Tesla, sometimes they perform one and one quarter and they bid the stock price up as soon as they cannot deliver, the stock price goes down. So high PE firms, high price to earnings first tend to tend to be poor investments, not old, but why high PE when we have a high PE, it means the future looks really bright. It means you are making a forecasting errors. You are looking into the future. When a company has price to earning, it means their price. What is price to earning? So it's very important to explain this. Let's assume the stock price is $100. And the company is earning $1 per share. Well, the PE is 100. Let's let's look at another company where they where the price is $50 and they earn $1 per share. The PE is 50. Now, what does what does this 100 means and what does this $50 and $50 mean? It's important to understand this concept to apply it mathematically. It means you are paying for this company. You are paying $100. That's how much you are paying for $1 in earnings. Now, why would you do that? You would do that because in the future, you think the company is going to do better. So this one has a high PE ratio. In comparison to this company, in this company, you're only paying $50 per share, $50 per share for a company that's earning $1 per share. It has a lower PE ratio. So companies with high PE ratio tend to be poor investments, not always. For example, Amazon had a high PE ratio. I mean Tesla has a high PE ratio. Well, when they make a profit because PE only works if you have earnings. So when a company has earnings and if they have high PE ratio, it means that you have to deliver a lot into the future. So you might be making a forecasting error over confidence and who's not guilty of that, right? People tend to overestimate the precision of their belief or forecast and they tend to overestimate their ability. Well, that's obvious. We are overconfident. Well, the clearest example and finance is when you compare active management in the face of passive. What happened is this generally the active managers, they disappoint relative to relative to people who put their money in the S&P 500 or in an index. So active managers, why are they active? They are active because they believe they believe they can perform better than the S&P 500. That's why you are overestimating your ability and research shows that active managers don't always actually the underperformed passive investments. Why would they do that? Because they're overconfident. They think they can do it. Another interesting example of overconfidence in the financial market and this is from Barber and Odin 2001 is when they compare activity and average return in brokerage accounts of man and woman and what they find out is they find out that men, especially when they are single, they trade far more actively than woman, consisting with the generally greater overconfidence among men documented in the psychology literature. And I can testify to this myself. I have my own portfolio. My wife has her own portfolio and we trade actually not we I trade. She doesn't trade that much. And over the past five, six years, my wife always overperform, outperform, outperform my portfolio. Why? Well, because she doesn't trade as much as I do. I do trade. So I am guilty of that as well. They also find that trading activity is highly predictive of poor investment performance. When you keep trading, what are you simply put when you trade? What statements are you making? What single you are? What signal you are sending? What I'm sending is I know what I'm doing. When I sell, oh, this is the top. I'm going to sell it at the top. When I buy, I believe I'm buying it at the bottom. So this is over overconfidence and research shows you have a poor investments. So here's what research shows the top 20 accounts ranked by portfolio turnover had an average return. Seven percentage point lower than the 20% of the account with the lowest turnover rates. What does that mean? It means don't don't have a high turnover. Why? Because as you buy and sell constantly, you are not doing well. Simply put, trading is hazardous to your account, to your wealth. Simply put, when you trade a lot, because when you trade a lot, it's a it's a signal of overconfidence. Okay. And you may not be as good as let the market let the market, maybe it's you're not as good as the S&P 500 performance conservatism. Again, here I'm going to talk about Tesla, but I'm going to put it in a positive light means that when investors are too slow and updating their belief and the response to new evidence. And I have to tell you those biases, those issues, it's not only for common investors. A lot of famous investors like Warren Buffett, they fall into they they they fail those biases. This means that they might initially underrated underact to a news about a firm so that prices will fully reflect the new information only gradually. So when there's good news, you don't jump in. You think, you know, it's too good to be true or it's not going to be sustainable. Then you will adjust slowly. A case in point is Warren Buffett. Warren Buffett always did not like technology companies and eventually he bought Apple. So for example, why did he did not like Apple company and technology companies? Because by nature, he's conservative. He would like to he would like to take a look at five to seven years of constant earnings. He believed technology is as a fast-paced industry that he does not understand. But Apple proved to be a really strong company. So when he came into Apple, he came in a little bit late. So even famous the famous Warren Buffett also fall into those biases. Okay. Also, Tesla, many people don't believe in Tesla because they don't think they think it's a risky investment. So I'm going to be conservative. Well, people who buy Tesla believe in maybe 10 to 15 years, most of the cars on the road will be Tesla. So you better get on right now because that's the future. Well, if you're conservative, you don't want to make this bet. You don't want to make this bet. Otherwise, if you believe that, if you're not conservative and you believe that bet and you should buy Tesla today and don't wait. Okay, you have to be simply put open-minded and don't have any prior, prior belief that no, Tesla is not good or you have to look at the data and act accordingly. Sample size neglect and representative. That's another thing that we can always relate to. People are too prone to believe that a small sample is representative of a broad population. And what you do is you'll take that small sample and you infer pattern too quickly and you make conclusion, even though it's a small sample. So a short-lived run of good earning report or high stock return, which lead to investors to revise the assessment of the likely future performance and they bid the price up. So if the company have a good, a good quarter, you will jump in and you would assume that they're going to have good quarter in the near and in the foreseeable future and you bid their price up and it's only one quarter. Eventually the gap between the price and the true value becomes too glaring because you bid the price too high and the price falls. So research shows that stock with the best recent performance suffer reversal precisely in few days, few days surrounding management earning forecast. Why? Because initially you bid the price up too high, then you find out later that it's not as good, then it goes back to, it goes down lower or actual earning announcement suggesting that the correction occur just as investors learned that their initial believe were too extreme. So initially you'd look at this one quarter, you bid the price up, you want to get in, then you'll find out later two or three days later. Maybe there are new information that it's not as good and the price would reverse. That's an example of it. Now these are all what we looked at now because remember we broke those biases into two categories. One we call them information processing. So those are the four errors of information processing. Now we're going to look at behavioral biases. Basically behavioral biases is biases that we have, biases that we have. So even though you might get the information processing perfectly, you absorb the numbers. The numbers are good. Many studies conclude that individual would tend to make less than fully rational decision using this information. So you have the information, you have the correct information, but you would still act in a biased way. These behavioral biases largely affect how investors frame questions of risk versus return and therefore make risk return tradeoff. Again here we're going back to how you look at things, how do you frame things, how do you, how do you look at things? Although you have it correctly, but the way you, it's framed to you or the way you frame it to yourself will make a difference. Decisions are affected by how choices are presented to you. For example, an individual may reject the bet when it's presented to them in term of risk surrounding possible gain, but they may accept the same bet when described in terms of risk surrounding potential losses. Simply put, individuals, they want to avoid losses. Let's take a look at an actual example. Let's assume you're presented 100% chance you will win $500, or an 80% chance you will win $1,000, but there's a 20% chance you won't win anything. Guess what? Most people will go with the 500 guarantee, not because it has a higher value. This option could have a, mathematically this option has higher value than the first option, but since we like to avoid losses, we would select the first option. So it's the way it's framed to us. So would you rather get a 5% discount or avoid a 5% surcharge? Basically, you want to avoid the loss. You think, oh, I want to avoid the loss. They're the same thing, but 5% discount, you think you have a gain and with a 5% surcharge, you think you have a loss. Simply put, losing $100 also, it's not the same as winning. So losing and winning from a personal perspective, you don't care. They don't have the same linear effect on us. They don't have the same lasting effect. Any day, if you lose $100, it may ruin your day. It may ruin your week. But if you win $100, it does not have a lasting effect. It will go away. So there's a non-linear, non-linearity between gains and losses as far as individuals are concerned. Simply put, a price increases has twice the impact of a price decrease. So if a price went up, we feel we lost a lot versus if it went down by the same amount. Another behavioral bias is mental accounting. And what does that mean? It means a specific form of framing, presenting in which people segregate certain decisions. How we look at things, how we look at things, just looking at things, framing it, keeping it in a box. Something like this. Okay. Chevron and statement argue that behavioral motives are consistent with two things. Some investors irrationally prefer stock with high cash dividend. Now, why would they prefer the stock with high cash dividend? Because they believe they're going to get the dividend, they're going to get the cash dividend, and they're not touching their original investments. And they can spend this money. So they feel it's a gain for them. Although maybe the stock price that's generating the dividend is losing, they believe because they're getting the dividend. And a tendency to ride losing stock positions for too long. That's another one. We tend, let's assume we have a stock. It went up 10%, we'll sell it. If it went down 10%, we don't sell it. Why? Because we want to not realize loss. We want to avoid losses because losses are hurtful. Losses are hurtful. So investors are more likely to sell stocks with gains than those with losses. Precisely, it's contrary to a tax minimization strategy. Because remember, if you have losses, you can deduct up to 3,000 per year. So you would reduce your taxable income. This reluctance to realize the losses, to sell the losses is known as the disposition effect. The term you need to do, you need to know the reluctance of investors to sell shares that have fallen in prices. Although it went down in price, you don't sell it. I am guilty of that myself. I'm guilty of that. And you can ask yourself whether you are guilty or not. You sell when it's a gain, but when it's a loss, you prefer not to sell, okay? Mental accounting also affect, mental accounting effect also can help explain momentum and stock prices. What happened in momentum and stock prices? We have something called the house money effect. Refer to the gamblers greater willingness to accept new bet as they are currently ahead. Very similar to the cash dividend. The house money effect is you made money from the stock market. Now you have this extra profit. And what you do with that money, you make higher bet. Why? Because it's not really my money. It's really my gain. Okay, they think they frame it to themselves, although it's the same money, whether it's the original money or the gain. It's your money. They think that the bets are being made with the winning account. There's no such thing as winning account. It's the same amount of money, okay? So that is with the casino's money and not their own money. And thus will make more, are more willing to accept risk. And this is what's been happening lately. This is one explanation why the market ran up recently. Now we are in September 26. For the past two months, stock went up substantially, especially technology stocks. And part of the reason is because we have this Robin Hood accounts, this company, and people, they are younger investors, and now they make a profit. And as they make the profit, they take this profit and they keep bidding the price up. Why? Because they don't think it's the same amount of money. It's not their money. They're playing with the casino's money. So they bid the price up, okay? So after a stock price run up, individuals may view investments as largely funded out of capital gain account became more risk tolerant and discount future cash flow at a lower rate and thus further push the prices up. So the more profit you make, the more capital gains you make, you'll take this money and you buy more stocks. Then your capital gain increase and it will keep on going up. But eventually what's gonna happen when the market crash, then you're gonna lose everything all at once. So this is called mental accounting. This is part of, this is not really my money. It's the casino's money. It's not my money. Regret avoidance is another bias that we need to be aware of. Psychologists have found individual who make decision that turn out badly have more regret when that decision was more unconventional. So you try, and I do this as well, you try to blame something else for your losses. For example, if you buy a blue chip portfolio like the Dow Jones, really good names and that portfolio goes down in value, it's not as hurtful as if you bought startup firms. So if you bought at the Dow, if you bought companies from the Dow, Apple, Microsoft, well-known blue chip companies, what's gonna happen is, and the market goes down. He said, well, that's not my fault. There's nothing I can do. The market went down, even the best investors, buy those blue chips. Therefore, I should not blame myself. But if you buy a startup company, a company unheard of and you lose money, you will regret it much more. Why would you not do it with the blue chip? Because you are following the herd. You're following the herd. Any losses on the blue chip stocks can more easily attribute it to bad luck rather than bad decision. It's just bad luck. I made the right decision and I'm gonna have less regret. And I remember when I bought the Global Crossing in 2000, I blamed myself a lot because it was not a startup company but was fairly, I was better off buying IBM or Apple, more established companies, but I bought a company called Global Crossing. And if you lose when you make those fats, it feels worse. But it's not worse. It's the same money. You lost the same amount of money. It's the way we frame things to ourselves. Effect is deals with what? Well, conventional models, such as the efficient market hypothesis, focuses on asset risk return. So we look at the asset, the amount of the risk and the amount of the return that we are making versus behavioral finance. We focus on effect. What is an effect? It's the feeling of good or bad that consumers may attach to potential purchase or investors to a stock. So simply put, I feel to think about it from a example perspective, firm with reputation for socially responsible policies or attractive working conditions or those producing popular product may generate higher effect and public perception because that's the case. Investors will favor them. They will favor them. If investors favor those stocks with their effect, that will drive the stock price up and return, drive their average rate to return down because once your stock price is up on you buy it, you're going to earn a lower average. And there's a body of evidence that shows for statement Fisher and Engner in 2008, look for evidence that effect influence security pricing. And what they find out, they find that stocks ranked high in a fortune survey of most admired companies tended to have lower average risk adjusted return then least admired, least admired firm. What did that research suggest? Suggest that prices have been bidding up relatively to their underlying profitability. So the prices of those companies that we like, they went up in price as a return went down. Therefore their expected future flow, expected future return are lower because we already bid them up for reasons other than their profitability because we like them. They are, they have an effect on us. They have an effect on us. In the next session we would look at technical analysis and little bit more how behavior effect technical analysis. As always I'm gonna invite you to like this recording, share it, put it in playlist and visit my website farhatlectures.com for additional resources. Good luck, study hard and stay safe.