The Implications of Behavioral Finance

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
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ghariton
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Post by ghariton »

Norbert Schlenker wrote: Predictably Irrational by Dan Ariely
If you like that kind of stuff, you might also look at Sway, by Ori and Rom Brafman, and Nudge by Richard Thaler and Cass Sunstein. The last was far and away the best, in my opinion. But even there, you won't learn anything new -- you'll just get the old truths retold in a different (and more striking) way.

But then most of the finance literature for non-academics seems to be mere repetition of old truths.

As for "free", that was probably Arieli's best insight. But even there, I wonder. For example, big cities in Canada now offer a free twelve or sixteen page tabloid along with daily newspapers that cost upwards of a dollar. Yet I see lots of people passing up the free paper only to buy one of the more expensive ones. (I'm too lazy to look up the circulations, but I bet that the paid papers beat the free ones.)

My most striking experience with "free" was while I was on vacation in Delaware in August 1984. Our daily paper there was the Washington Post, and it reported on the experience of a new start-up airline, flying between Washington and Norfolk. For its first week, the new airline was offering free trips. The first day, they filled barely 20% of their seats, despite a publicity blitz. Meanwhile, at the next gate, US Air (as I recall) was 80% full with passengers paying $59 for a trip. Both were flying at about the same time, and would arrive at about the same time. What was going on?

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Post by scomac »

Norbert Schlenker wrote: I was especially struck by the chapter which discussed the "power of free" as it affects decision making. Google for the term AND ariely to get an online hint of the phenomenon. Once you see the results of experiments that show how different people are when offered something free, you are unlikely to ever be surprised again that the cost of financial advice gets buried.
Thanks for bringing this up, Norbert. It was very interesting. With respect to your comment above, I ran across a blog comment where a private school administrator doubled enrollment by making tuition free yet charging double for everything else. It was a wash on a cost per student basis between the old and the new. When you see just how powerful "free" is, there is really no hope for a change in the way financial advice is delivered.
"On what principle is it, that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?"
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Bylo Selhi
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Post by Bylo Selhi »

Then there are the people who gladly sign up for 3-year cellphone contracts that bind them to paying $50/month (or more) in order to get a "free" cellphone. Instead they could buy a new, unlocked phone for as little as $40 then pay 10¢/minute on a pay-as-you-go basis with no contract.

The common-sense-blinding power of "free" becomes even more apparent when these folks try to terminate their contract early and discover that the carrier wants to charge them as much as $20/month to complete the amortization of that "free" phone.
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Brix
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Post by Brix »

Bylo Selhi wrote:The common-sense-blinding power of "free"
...might have something to do with the seductive equivalence in English of "free"/gratis and "free"/libre. How could a freebie indenture us, and why should we pay for liberties?
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Post by DanielCarrera »

ghariton wrote:[
As for "free", that was probably Arieli's best insight. But even there, I wonder. For example, big cities in Canada now offer a free twelve or sixteen page tabloid along with daily newspapers that cost upwards of a dollar. Yet I see lots of people passing up the free paper only to buy one of the more expensive ones.
Perhaps the "free" effect only applies when it's something that you feel you might not get again. You know, feeling you lost an opportunity. Air and sunlight are free, and we don't go nuts over those. You can find free water to drink in some places, and you don't go nuts about that. My school residence offered free garbage bags and we didn't hoard them because we could always get another one.

Someone should try the following experiment. Give out free chocolate at a booth someplace where the same group of people normally frequent (e.g. the math faculty at a university campus). I suspect that as people get used to the idea of free chocolate in that location and it stops being a one-time special, people will be less nuts about the chocolate.

Anyways, that's just a hypothesis of mine.
My most striking experience with "free" was while I was on vacation in Delaware in August 1984. Our daily paper there was the Washington Post, and it reported on the experience of a new start-up airline, flying between Washington and Norfolk. For its first week, the new airline was offering free trips. The first day, they filled barely 20% of their seats, despite a publicity blitz. Meanwhile, at the next gate, US Air (as I recall) was 80% full with passengers paying $59 for a trip. Both were flying at about the same time, and would arrive at about the same time. What was going on?
Perhaps people booked the flights earlier an the new airline was not ofered in the catalogue. I have bought many plane tickets. I am never interested in flyers or other ads advertising great travel deals. When I travel I do a search for airlines and pick the lowest price I find, whatever the airline is. So, in my case, I would only have gotten the free ticket if a deliberate search for a trip between those destinations would have turned up that opportunity.
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Post by DanielCarrera »

Bylo Selhi wrote:Then there are the people who gladly sign up for 3-year cellphone contracts that bind them to paying $50/month (or more) in order to get a "free" cellphone. Instead they could buy a new, unlocked phone for as little as $40 then pay 10¢/minute on a pay-as-you-go basis with no contract.
Indeed. Some times I feel like I am the only sane person on Earth. Or the only one that can do algebra.
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Post by NormR »

ghariton wrote:As for "free", that was probably Arieli's best insight. But even there, I wonder. For example, big cities in Canada now offer a free twelve or sixteen page tabloid along with daily newspapers that cost upwards of a dollar. Yet I see lots of people passing up the free paper only to buy one of the more expensive ones. (I'm too lazy to look up the circulations, but I bet that the paid papers beat the free ones.)

My most striking experience with "free" was while I was on vacation in Delaware in August 1984. Our daily paper there was the Washington Post, and it reported on the experience of a new start-up airline, flying between Washington and Norfolk. For its first week, the new airline was offering free trips. The first day, they filled barely 20% of their seats, despite a publicity blitz. Meanwhile, at the next gate, US Air (as I recall) was 80% full with passengers paying $59 for a trip. Both were flying at about the same time, and would arrive at about the same time. What was going on?
Ah, but price is often an indicator of quality.

Charlie munger tells a tale of a firm that makes complicated oil pumps. An item that is put at the bottom of a well for which there is a very low tolerance for failure. The firm that had the best tech and made the best pumps wasn't doing so well by underpricing their competitors. It all changed when they boosted prices and began to offer a 'premium product'. Of course, only the prices changed, the pumps were the same, but now they sold like hotcakes.

You might think that air travel can suffer from similar notions. You don't want to fall out of the sky after all.

As to free newspapers, I rarely bother. They seem to be mostly filled with AP copy around these parts. (i.e. free but crappy quality.) But I have a stack of magazines that are usually waiting for me. So, I'm not wanting for reading material on the train.
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Post by Bylo Selhi »

Brix wrote:...might have something to do with the seductive equivalence in English of "free"/gratis and "free"/libre
It occurs to me there are more distinctions within the "free"/gratis model...

1. $0, no strings attached
2. no monetary value but some strings attached, e.g. the laws of the land, license restrictions on some types of open source software
3. no implicit charge, voluntary payment expected, e.g. free pretzels at a bar, street entertainers
4. no implicit charge but it's buried in the price, e.g. (once upon a time) free pretzels (and even beer) on airplane flights, buy-one-get-one-free
5. no upfront charge but involuntary repayment via (usually hidden) fees, e.g. DSC mutual funds, cellphones
6. ...
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ghariton
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Post by ghariton »

DanielCarrera wrote:Someone should try the following experiment. Give out free chocolate at a booth someplace where the same group of people normally frequent (e.g. the math faculty at a university campus). I suspect that as people get used to the idea of free chocolate in that location and it stops being a one-time special, people will be less nuts about the chocolate.
When I worked at Bell Northern Research, management cleverly placed free coffee machines at strategic locations throughout the labs. I suppose the purpose was to cut down on employee trips to the cafeteria for coffee. Yet the cafeteria was still full at around 10 am and around 3 pm, of people consuming just coffee, for which presumably they had just paid. (It was better quality than the stuff in the coffee machines, but still... Of course, there was the benefit of taking a justified break from work, although I noticed that many of the cafeteria coffee-drinkers were talking shop.)

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Post by Peculiar_Investor »

ghariton wrote: When I worked at Bell Northern Research,

George
BNR :D is an echo from my past also. I thought that name had disappeared, never to be seen again.
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Post by kcowan »

Bylo Selhi wrote:
Brix wrote:...might have something to do with the seductive equivalence in English of "free"/gratis and "free"/libre
It occurs to me there are more distinctions within the "free"/gratis model....
Also the notion of scarcity works well to motivate immediate action. Limited Time Offer
Good until midnight
New price next month...

Consumer Reports once studied these and found that the "new" price was often lower than the previous one...

Dutch auctions use the same sense of urgency. Not free but cheaper than tomorrow because the "deal" will be gone. Similar to buying stocks on weakness.
For the fun of it...Keith
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Post by Bylo Selhi »

kcowan wrote:Also the notion of scarcity works well to motivate immediate action.
Yup. Also "limited quantities available," "bonus gift if you call in the next 10 minutes or are one of the first 100 to call," "only 10 coins per customer at this price"... ;)
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Post by augustabound »

NormR wrote: Ah, but price is often an indicator of quality.
Exactly. I remember when I first started contracting I was told by some more experienced contractors to charge what I was worth. If you charge then $15/hr they expect mediocre work from a handy man type not a professional contractor whose capable of good workmanship.
Same goes for the free papers, I don't expect much from them at all except short insignificant stories only meant to hold the readers attention until they get to Union Station. I'll pay $1.25 for the Globe over the free Metro any day.
As for a free flight, I think I would be all over that one, not sure why anyone would turn that down. :?
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Post by WishingWealth »

Just got this in my e-mail.

FWIW.
A SHORT COURSE IN BEHAVIORAL ECONOMICS
Edge Master Class 08


http://www.edge.org/documents/archive/edge253.html

WW
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What is Stupid

Post by Dark Bear »

Do we really know what is stupid in today's market.

Some say buy value but most of the time it is a value trap.

Some say buy low but you get cut by a knife.

Some say sell high only to see it go alot higher.

Gold is a stupid investment which you keep telling yourself as it outperforms while your great picks underperform.

Cash doesn't pay enough so you lose great amounts in the stock market.

What I have learned is nothing is stupid only those who think it is within reason.
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Post by Dark Bear »

I suppose if I bought a stock just because it was recommended on the internet that would be stupid. I also heard that land banking and giving money to someone who e-mailed from Nigeria to unlock a large sum of money would be stupid.
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Post by DenisD »

Behavioral Finance Does Not Pay By Larry Swedroe
authors of the study “Behavioral Finance: Are the Disciples Profiting from the Doctrine?” analyzed 16 behavioral funds to determine whether they successfully attract investment dollars and earn abnormal returns. Here’s what they found:

...

Behavioral mutual funds are tantamount to value investing and not much more.
:wink:
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Post by NormR »

DenisD wrote:Behavioral Finance Does Not Pay By Larry Swedroe
authors of the study “Behavioral Finance: Are the Disciples Profiting from the Doctrine?” analyzed 16 behavioral funds to determine whether they successfully attract investment dollars and earn abnormal returns. Here’s what they found:

...

Behavioral mutual funds are tantamount to value investing and not much more.
:wink:
While the funds do outperform S&P 500 Index funds, they have significant exposure to value stocks, which have historically provided a higher risk premium. Thus, after accounting for risk, they do not earn abnormal returns.
:lol:
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Post by George$ »

Methinks a useful reminder..
Overconfidence and Over Optimism
Behavioural Biases (1): Overconfidence and Over Optimism
Most of us are way too confident about our ability to foresee the future and overwhelmingly too optimistic in our forecasts. This finding holds across all disciplines, for both professionals and non-professionals with the exceptions of weather forecasters and horse handicappers.

To add the problems it also turns out that the executives running the companies we invest in so hopefully suffer from the same problems. Overconfident, over optimistic investors investing in companies run by overconfident, over optimistic executives. What could possibly go wrong?
and a related academic publication in 1999 of
Unskilled and Unaware of It: How Difficulties in Recognizing One's Own
Incompetence Lead to Inflated Self-Assessments
“The search for truth is more precious than its possession.” Albert Einstein
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Post by Norbert Schlenker »

Nothing can protect people who want to buy the Brooklyn Bridge.
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ghariton
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Re: The Implications of Behavioral Finance

Post by ghariton »

Abstract of an article by a Richard Thaler and a bunch of other "names":
The average nominal share prices of common stocks traded on the New York Stock Exchange have remained constant at approximately $35 per share since the Great Depression as a result of stock splits. It is surprising that U.S. firms actively maintained constant nominal prices for their shares while general prices in the economy went up more than tenfold. This is especially puzzling given that commissions paid by investors on trading ten $35 shares are about ten times those paid on a single $350 share. We review potential explanations including signaling and optimal trading ranges and find that none of the existing theories are able to explain the observed constant nominal prices. We suggest that the evidence is consistent with the idea that customs and norms can explain the nominal price puzzle.
From the conclusion of the article:
Tradition may also explain other aspectsd of corporate behavior. For example: Why do some firms have almost no debt? When and why do firms initiate dividend payments (which are also irrelevant in a Millar and Modigliani world)? Why are some firms sensitive to cash flows while others are not? Why do spin-offs behave like their parents? Norms provide a parsimonious explanation for all these phenomena: this is the way things have always been done.
(a bunch of references omitted)

I find that intriguing. Why do dividends matter for share valuation? Answer: Because we expect them to matter.

In other words, paying a premium for stocks with growing dividends may be irrational, but while everyone else is doing it, we are well advised to do it too.

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Re: The Implications of Behavioral Finance

Post by scomac »

ghariton wrote:
I find that intriguing. Why do dividends matter for share valuation? Answer: Because we expect them to matter.
Wrong. This is a simple time value of money concept. When a portion of your return is derived from an on-going cash payment, there is greater value in this instrument due to the fact that a current cash payment is worth more than a future cash payment. Paying a premium for investments that return an on-going cash payment is not irrational, it is simply reflecting the greater discount applied to any investment that must rely on its terminal value to generate the entire return for the investor.
"On what principle is it, that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?"
Thomas Babington Macaulay in 1830
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Re: The Implications of Behavioral Finance

Post by Brix »

scomac wrote:When a portion of your return is derived from an on-going cash payment, there is greater value in this instrument due to the fact that a current cash payment is worth more than a future cash payment.
What is it about a time-series of scheduled payments that seems less "future" than a delayed accumulation of indeterminate date? Mere return of capital could provide me with a series of ongoing cash payments up to some future point, compared with which not making the investment in the first place would be more rational for the time-value reason.
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Re: The Implications of Behavioral Finance

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Brix wrote:
scomac wrote:When a portion of your return is derived from an on-going cash payment, there is greater value in this instrument due to the fact that a current cash payment is worth more than a future cash payment.
What is it about a time-series of scheduled payments that seems less "future" than a delayed accumulation of indeterminate date?
Quite simply it is the discounting effect to risk free; the further out the time line, the greater the discounting effect must be when bringing future dollars forward. It is mathematically quantifiable.
Mere return of capital could provide me with a series of ongoing cash payments up to some future point, compared with which not making the investment in the first place would be more rational for the time-value reason
It would be if you ignore the discount rate. That is why the cumulative total of annuity payments from a term certain annuity will be greater than the lump sum present value of the cash flow stream -- the impact of discounting the future payments to present day.
"On what principle is it, that when we see nothing but improvement behind us, we are to expect nothing but deterioration before us?"
Thomas Babington Macaulay in 1830
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Re: The Implications of Behavioral Finance

Post by MaxFax »

I'm with Brix. There is no difference between a cash flow draw made up of distributions and a cash flow draw made up of capital gains realized (or even not). Plus, consider that those dividend cash flows must be immediately reinvested back into the market by anyone in accumulation mode. So the cash flow is just a figment of your imagination... like the true DRIP where the cash never leaves the company's coffers.
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