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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yielder
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Post by yielder »

NormR wrote:
yielder wrote:Using PE bands does more or less the same thing.
A supplementary link.

So you have a free/cheap source for such graphs?
TDWaterhouse. For research, TDW is light years ahead of any other brokerage in Canada.

Thanks for the reference. I'd completetely forgotten about it. Complementary evidence to the S&P rankings study.
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Norbert Schlenker
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Post by Norbert Schlenker »

I've been a little distracted lately but finally had a look at PE bands and the Ford studies. To me, that looks suspiciously like - I'm very sorry for using curse words - technical analysis.

Take Bollinger bands as an example, which are acknowledged by all to be technical indicators. IIRC they're one or two standard deviations bands around prices. Is putting a standard deviation band around PEs inside of prices so different?

I'm also skeptical about documents that show off a dozen or so instances where the indicators work. That's statistically invalid, as we all know. Are there any published academic studies of this technique?

P.S. What's this got to do with behavioural finance?
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NormR
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Post by NormR »

Norbert Schlenker wrote:I've been a little distracted lately but finally had a look at PE bands and the Ford studies. To me, that looks suspiciously like - I'm very sorry for using curse words - technical analysis.
I'm sure you'll correct me if I'm wrong, but I thought that technical analysis relied on past/current prices (and volumes) alone. Basically it has to come out of the ticker machine to count. :wink:
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Post by NormR »

yielder wrote:TDWaterhouse. For research, TDW is light years ahead of any other brokerage in Canada.
Any idea of what a Summary of Annual Trading Activity fee $50.00 is?
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yielder
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Post by yielder »

Norbert Schlenker wrote:To me, that looks suspiciously like - I'm very sorry for using curse words - technical analysis.
They sure do IF you take them out of the context of the discussion here. The SD aspect is eyeballing masquerading as scientific technique. I suppose it's OK as long as one doesn't forget to eyeball think about the information being presented with such statistical rigour. I think they're interesting to demonstrate that the prices of good quality stocks tend to oscillate within fairly narrow bands, PE and yield if they pay a dividend, especially if they have lowish PEs. Should you pick stocks based on the bands? Absolutely not. In fact, I'd be more than a tad scepitcal of PE bands because of E especially where no div is paid I'd be far less sceptical about yield bands because the dollar in my pocket tells me the dividend is real.
I'm also skeptical about documents that show off a dozen or so instances where the indicators work. That's statistically invalid, as we all know. Are there any published academic studies of this technique?
What I've uncovered is more or less what you see in this thread - the S&P and Ford material. A lot of research is under lock and key so it's difficult to go digging. Some of the research doesn't seem to show up at SSRN. Yes, there's some academic research also upthread that examines the S&P study. As for statistical validity, I think you have to also consider the data universe being used.
P.S. What's this got to do with behavioural finance?
Everything. It's a pretty short thread from where I fire it up again.
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yielder
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Post by yielder »

NormR wrote:
yielder wrote:TDWaterhouse. For research, TDW is light years ahead of any other brokerage in Canada.
Any idea of what a Summary of Annual Trading Activity fee $50.00 is?
Not the faintest. Didn't even know it existed.
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Post by twa2w »

Any idea of what a Summary of Annual Trading Activity fee $50.00 is
Just what it sounds like. You aks for a summary of all your trading activity for a year. they press a button, it is printed and mailed to you,. $50.00 gets dinged from your account. -- For people who don't keep good track of trades and paperwork. Order one of these each year, check for accuracy and get rid of all your other paperwork. :shock:
Cheers.
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Post by NormR »

twa2w wrote:
Any idea of what a Summary of Annual Trading Activity fee $50.00 is
Just what it sounds like. You aks for a summary of all your trading activity for a year. they press a button, it is printed and mailed to you,. $50.00 gets dinged from your account. -- For people who don't keep good track of trades and paperwork. Order one of these each year, check for accuracy and get rid of all your other paperwork. :shock:
Cheers.
J
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Post by WishingWealth »

One more on the subject.

Why say no to free money? It's neuro-economics, stupid
In Times on Line
IMAGINE that you are sitting next to a complete stranger who has been given £10 to share between the two of you. He must choose how much to keep for himself and how much to give to you.

He can be as selfish or as generous as he likes, with one proviso: if you refuse his offer, neither of you gets any money at all. What would it take for you to turn him down?

This is the scenario known to economists as the ultimatum game. Now the way we play it is generating remarkable insights into how the human brain drives financial decisionmaking, social interactions and even the supremely irrational behaviour of suicide bombers and gangland killers.

According to standard economic theory, you should cheerfully accept anything you are given. People are assumed to be motivated chiefly by rational self-interest, and refusing any offer, however low, is tantamount to cutting off your nose to spite your face.

Yet in practice derisory offers are declined all the time. Indeed, if the sum is less than £2.50, four out of five of us tell the selfish so-and-so to get lost. We get so angry at his deliberate unfairness that we are prepared to incur a cost to ourselves, purely to punish him.

Homo sapiens is clearly not Homo economicus, the ultra-rational being imagined by many professional economists. ...
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Post by Bylo Selhi »

The Voices in My Head Say ‘Buy It!’ Why Argue?
Now that scientists have spotted the pain and pleasure centers in the brain, they’ve moved on to more expensive real estate: the brain’s shopping center. They have been asking the big questions:

What is the difference between a tightwad’s brain and a spendthrift’s brain?

What neurological circuits stop you from buying a George Foreman grill but not a Discovery Channel color-changing mood clock?

Why is there a $2,178.23 balance on my January Visa bill?...
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NormR
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Post by NormR »

Bylo Selhi wrote:The Voices in My Head Say ‘Buy It!’ Why Argue?
Now that scientists have spotted the pain and pleasure centers in the brain, they’ve moved on to more expensive real estate: the brain’s shopping center. They have been asking the big questions:

What is the difference between a tightwad’s brain and a spendthrift’s brain?

What neurological circuits stop you from buying a George Foreman grill but not a Discovery Channel color-changing mood clock?

Why is there a $2,178.23 balance on my January Visa bill?...
Count me as an irrational tightwad. Better get some shopping therapy. :)
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Post by parvus »

I suppose I should title this: bringing real life back into economics:
Mr. Akerlof is facing considerable criticism for his view that standard economics leaves out too much actual human motivation. What Mr. Akerlof sees as missing content, Mark Gertler, a New York University economist, describes as “frictions” that distort accurate theory.

“What Akerlof is doing is stepping out of line,” said Mr. Gertler... “A lot of people are correctly taking rational behavior as a baseline and are adding frictions, such as constraints on borrowing, that can lead to temporarily inefficient markets.” ...

In his speech, he encourages others to follow his lead, rejecting the focus on what he calls “parsimonious modeling” inspired by Friedman. Everyday experience and observation must be returned to a prominent place in the profession, he argues.

“The early Keynesians got a great deal of the workings of the economic system right in ways that are now denied,” Mr. Akerlof said in a study newly posted on the Internet that closely tracks the text of his speech. “They based their models, as Keynes put it, on ‘our knowledge of human nature and from the detailed facts of experience.’ ”

A lot of what Mr. Akerlof advocates in his speech is already under way, with Mr. Akerlof himself a major contributor. He shared a Nobel in economics in 2001 for his work on imperfect information... He was an early participant in behavioral economics, another assault on the rational, fully-informed behavior that Mr. Friedman counted on to make markets work efficiently without regulation or intervention.

People often do not behave rationally, the behaviorists found in their experiments. Most do not bother to sign up for a voluntary 401(k) plan, for example, but do not pull out of such a plan if an employer signs them up automatically.

Now Mr. Akerlof is taking a big step on his own. His ... research, much of it done with Rachel Kranton, a University of Maryland economist. They are trying to incorporate into theory, as Keynes once did, the great variety of “norms” that determine human behavior.

What Mr. Akerlof is trying to do, with Ms. Kranton’s help, is to reflect the variety of motivations that come from the sense people have of “what they are and how they should behave,” as Ms. Kranton put it.

Among the examples they cite:

A teacher in good standing among the parents of her students puts the preservation of that reputation ahead of attempts to maximize her pay. ...

Workers resist wage cuts even when unemployment is rising, despite standard theory that they will accept less pay to save their jobs.

The variations in norms and behavior are numerous and Mr. Akerlof, in his speech, calls on economists to incorporate this diversity into standard economic theory.

“If there is a difference between real behavior and behavior derived from abstract preferences, New Classical economics has no way to pick up those preferences,” Mr. Akerlof asserts. “A macroeconomics that incorporates observations regarding how people think they should behave combines the best of the two approaches.”
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Post by martingale »

WishingWealth wrote:According to standard economic theory, you should cheerfully accept anything you are given. People are assumed to be motivated chiefly by rational self-interest, and refusing any offer, however low, is tantamount to cutting off your nose to spite your face.
Game theory is part of standard economics, and explains this result well enough. The issue is that people play this game every day, not just one round, but over and over again. They punish those who are unfair because they are looking at time horizons beyond the current game--they're looking at the likelihood that they'll be treated unfairly in the next game (even if it's a different game, with a different researcher, in a different university). As such it *is* entirely rational behavior, and those who turn down highly unfair amounts ARE acting as homo economicus.
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Post by FinEcon »

It is my understanding that game theory does not provide an explanation of the sub optimal player, the irrational player or the aloof player.

In a one-shot game there is only one round and some of these games (ultimatum game) will not be played as predicted by economics in academic tests.

Game theory makes several assumptions that are easily shown not to be true in the real world in many cases:

1) player knows/understands the rules of the game
2) player knows/understands the entire set of (sub)strategies
3) player knows/understands the entire set of outcomes
4) player is able to make the optimal decision 100% of the time (at a given decision point)
5) player(s) can accurately determine probabilities when there is imperfect information

Don't get me wrong, I have found game theory to be interesting area of ECON but it is quite limited IMO, particularly in cases of modelling non-trivial 'games' of the real world. Essentially, I take Nassim Taleb's argument that the only games which can be accurately modelled are useless ones like those found in a casino. Type II randomness and off model risk/behavior is no captured.

A person need only watch someone play Blackjack at a local casino to see an agent playing a game in a sub-optimal way which violates at least one of the assumptions of rationality.
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Post by martingale »

FinEcon wrote:It is my understanding that game theory does not provide an explanation of the sub optimal player, the irrational player or the aloof player.

In a one-shot game there is only one round and some of these games (ultimatum game) will not be played as predicted by economics in academic tests.
The issue is that while you (and the study authors) may think they are "one shot" games the players may not see it that way. They may see it as part of their continuing, ongoing interaction with other people. Your one shot game does not represent the last time they'll ever be involved in negotiating a settlement with another person, and in that larger context, punishing an unfair negotiating partner may be near optimal behavior.

As for misjudging probabilities and rules it's clear that the very mathematical game theory models are gross simplifications of reality. That doesn't necessarily mean they aren't useful ways of analyzing a situation, it just means that their results won't perfectly match real observations. If all they need, though, is the addition of some statistical noise, then they're pretty good models--and that would be the case if people are equally likely to under- or over- judge a probability, or misunderstand rules in ways that cancel out over large numbers.

Even if there are behavioral biases that cause people to systematically err in one direction, say always over-estimtating a probability, the simple model can still wind up being your starting point in whatever correct model you wind up coming up with. The academic way to discuss this is to talk about what percentage of the observed behavior is explained by the model--so maybe 80% of what you observe is explained by the simple model, and the 20% that varies from it can be explained by some 2nd level behavioral or other analysis.

No-one really doubts that the simple abstractions used in economic models are not quite like real people--the question really is whether they are close enough to what real people do that, despite some error, they overall do predict a substantial portion of observed behavior. If they do, then the simple models will only be discarded when some other model comes along that predicts even more of the behavior--even though, in the meantime, we know that the model we've got is less than 100%. There is always room for improvement in any science--the soft sciences generally have much more room to improve than the hard ones, but it's true across the board that all scientific models are ultimately over-simplifications--even the theory of gravity.
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Post by Bylo Selhi »

Gimme more
The more money we have, the less we want to share with other people Few of us like to think of ourselves as being greedy, although we might describe ourselves as being self-sufficient or financially independent. And many of us like to think that if we suddenly received a windfall, we'd share the wealth. Yeah, sure. The trouble is that self-perception is often very different from reality...
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Post by Bylo Selhi »

We Hear Just What We Want to Hear
Jonathan Clements wrote:Think you're immune to confirmation bias? If you are a regular reader of this column, ask yourself this question: Why do you keep reading my articles?...

On the other hand, investing a little of your ego isn't such a bad idea. If you're going to stick with your portfolio at times of market turmoil, you need unflinching commitment. My advice: Develop a sense of conviction -- about your profound ignorance...

Faced with this sort of uncertainty and our own ignorance, it makes sense to focus on controlling those things that we truly can control. Hold down investment costs. Diversify to reduce investment risk. Minimize taxes. Save aggressively. This may not sound terribly exciting. But it should be reasonably profitable. An added bonus: If we build our investment strategy around the notion that we're pretty darn ignorant, we probably won't have to wait very long for confirmation.
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Norbert Schlenker
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Post by Norbert Schlenker »

An attempt at a heartfelt questioning of one's own beliefs, eh? But go on to read the last section and he retreats to the same old comfy chair.

Appropriately published on a day of resurrection. ;)
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Post by ghariton »

I thought that was an excellent article.

I stopped reading Jonathan Clements some years ago because, while what he has to say is useful and insightful, he does repeat himself. But then, I think that repetition of valid insights is inevitable -- there are so few of them.

Diversification, low costs, tax efficiency, and patience: I learned those on the predecessor forum years ago. What else is there?

And yes, the world is a lot more random than most of us think.

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Carnegie Mellon Survey on Spending Habits

Post by svt »

Are you a spendthrift or a tightwad. The survey for the NYT article linked aboved.

here
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Post by WishingWealth »

In the NYT.
More Expensive Placebos Bring More Relief.
In marketing as in medicine, perception can be everything. A higher price can create the impression of higher value, just as a placebo pill can reduce pain.

Now researchers have combined the two effects. A $2.50 placebo, they have found, works better [than] one that costs 10 cents.

The finding may explain the popularity of some high-cost drugs over cheaper alternatives, the authors conclude. It may also help account for patients’ reports that generic drugs are less effective than brand-name ones, though their active ingredients are identical.

...

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Post by Brix »

A higher price can create the impression of higher value, just as a placebo pill can reduce pain.

Now researchers have combined the two effects. A $2.50 placebo, they have found, works better [than] one that costs 10 cents.
Needs testing for a third effect:

Does the more expensive placebo work better when patients are paying for it with cash from their pockets than when it's supplied by a private insurer or government program?
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Post by Bylo Selhi »

July/August issue of Journal of Indexes: Money and Your Mind includes...
• Your Money & Your Brain
By Jason Zweig

• An Interview With Jason Zweig
By Journal of Indexes Staff

• Behavioral Finance And Indexing
By Ed McRedmond, William Bernstein, John Prestbo, Ross Miller, Terrance Odean, Francis Kinniry and David Blitzer

• The Frontier From Different Views
By Craig Israelsen

• ETFs, Spreads And Liquidity
By Matthew Hougan

• Why ETFs And 401(k)s Will Never Match
By David Blanchett and Gregory Kasten

• The ABCs Of ETFs
By Richard Ferri

• Talking Indexes - Inside The Home Price Indices
By David Blitzer
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Good summary of the insights provided by the talking heads

Post by kcowan »

Good summary of the insights provided by the talking heads:
Markets explained
Why does this sound so familiar?! :lol:
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Post by Norbert Schlenker »

On the road, I blitzed through a borrowed copy of Predictably Irrational by Dan Ariely. Very worthwhile although it covers much of the ground that readers of behavioural finance literature would have seen before: framing, anchoring, etc.

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.
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