Flashcards in behavioural finance and financial planning Deck (42):
The field of behavioural finance looks at how
a variety of mental biases and decision-making errors affect financial decisions. It relates to the psychology that underlies and drives financial decision-making behaviour.
Although traditional economic theory assumes that individuals and investors always act rationally, which usually means with the aim of maximising some interpretation of expected utility, experimental and actual evidence suggests that this may not always be entirely the case.
Much of the work to date has concentrated on the impact on prices in capital markets (indeed, some “contrarian” investment funds are run on the basis of taking advantage of errors made by other investors).
contrarian fund is one that
Atends to take the opposite view to the rest of the market – ie it will tend to buy shares when most people in the market are recommending sell and vice versa. For example, it might sell shares when the market is “high” or rising on the basis that the market tends to overreact to positive news and so is likely to be overvalued.
In investment consultancy, behavioural arguments
can be applied to trustees and used to justify proposed investment management structures.
In practice, the management of an investment portfolio in accordance with an investment objective will require both:
an investment strategy
a choice of investment management structure.
Once these have been determined, the implementation of the chosen investment strategy will then require the selection of the individual investments and investment managers.
If it is recognised that the trustees responsible for the direction of investment policy are subject to the types of mental bias identified by behavioural finance,
then the recommended investment management structure may be chosen to reflect those biases.
if capital markets are indeed influenced by behavioural factors, then
those investors who recognise this may be able to exploit this knowledge to the disadvantage of investors who don’t.
Common themes found in research on behavioural finance include:
anchoring and adjustment
framing (and question wording)
myopic loss aversion
the effect of options.
Anchoring and adjustment
Anchoring is a term used to explain how people will produce estimates. They start with an initial idea of the answer (“the anchor”). They then adjust away from this initial anchor to arrive at their final judgement.
Thus, people base perceptions on past experience or “expert” opinion, which they amend to allow for evident differences to the current conditions. The effects of anchoring are pervasive and robust and are extremely difficult to ignore, even when people are aware of the effect and aware that the anchor is ridiculous. The effect of anchoring and adjustment grows with the size of the difference between the anchor value – the original estimate provided – and the pre-anchor estimate – the mean estimate people make before being exposed to an explicit anchor. In other words, the bigger this difference, the greater the influence of the anchor value on the post-anchor estimate. The effects of anchoring are pervasive and robust and are extremely difficult to ignore, even when people are aware of the effect and aware that the anchor is ridiculous. Even patently ridiculous anchor values have been shown to influence post- anchor estimates.
Prospect theory is a theory of
how people make decisions when faced with risk and uncertainty. It replaces the conventional risk-averse / risk-seeking decreasing marginal utility theory based on total wealth with a concept of value defined in terms of gains and losses relative to a reference point. This generates utility curves with a point of inflexion at the chosen reference point.
Prospect theory attempts to explain why people may make asymmetric choices when faced with similar possible gains and losses.
evidence suggests that rather than being risk-averse, people may actually become risk-seeking when facing losses. prospect theory assumes that:
value is based on gains and losses relative to some reference point
people are typically risk-averse when considering gains relative to the reference
point and risk-seeking when considering losses relative to the reference point.
Prospect theory suggests that
the decision made depends on how a problem is presented or “framed”, ie whether the available choices are presented as gains or losses relative to the chosen reference point. If the alternative choices are presented as possible gains, then the value function is concave, reflecting the risk-averse nature of individuals. Conversely if they are presented as possible losses, then the value function is convex reflecting the risk-seeking nature of individuals. So, the value function will be as shown on the diagram above.
The way a choice is presented (“framed”)
particularly, the wording of a question in terms of gains and losses, can have an enormous impact on the answer given or the decision made. Changes in the way a question is framed of only a word or two can have a profound effect. In the same way, “structured response” questions are found to convey an implicit range of acceptable answers.
Myopic loss aversion is:
This is similar to prospect theory, but considers repeated choices rather than a single “gamble”. It may therefore be relevant when considering investment choices, which can often be thought of as a series of repeated gambles. For example, if an investor reviews and possibly changes its investment strategy on an annual basis, then the investment strategy decision can be thought of as a series of repeated one-year gambles.
Research suggests that investors are less “risk-averse” when faced with a multi- period series of “gambles”, and that the frequency of choice / length of reporting period will also be influential.
As its name suggests, myopic loss aversion relates to investors’ aversion to short-term losses. The basic idea is that investors have been shown to be less “risk-averse” when faced with a repeated series of “gambles” than when faced with a single gamble. Thus, if the investor recognises that the investment strategy decision is in fact a series of repeated short-term gambles and consequently takes a long-term view when determining strategy, then they are likely to be less risk-averse than if they instead consider only the immediate short-term gamble and so take too short-term a view. In this latter case, they will tend to focus more on the short-term risk of loss than is necessarily in their best interests, the consequence being that their resulting portfolio ends up being overweight in less risky assets.
In addition, the extent of investors’ short-sightedness may be influenced by the frequency with which they review their investment choices and/or the length of the reporting period. For example, a pension fund that has to report its financial position every year may be more averse to very short-term investment losses than one that has to report only every three years.
What might be the consequence on its investment strategy of requiring a pension fund to report its financial position annually rather than triennially?
investors’ estimates OF PROBABILITIES may be influenced by a number of biases.
Dislike of “negative” events – the “valence” of an outcome (the degree to which it is considered as negative or positive) has an enormous influence on the probability estimates of its likely occurrence.
In particular, experiments suggest that individuals are prone to underestimate the probability that a negative event may occur.
Representative heuristics – people find more probable that which they find easier to imagine. As the amount of detail increases, its apparent likelihood may increase (although the true probability can only decrease steadily).
As the amount of detail increases, the more specific (less generalised) the event becomes and the less probable the occurrence of such a specific event must become.
Availability – people are influenced by the ease with which something can be brought to mind. This can lead to biased judgements when examples of one event are inherently more difficult to imagine than examples of another.
An example here concerns the incidences of deaths due to car crashes and cancer. When asked to estimate the relative numbers of deaths due to each, people tend to overestimate the numbers of deaths due to car crashes perhaps because they receive more publicity and are easier to imagine.
People tend to overestimate their own abilities, knowledge and skills. For example, if you ask 100 people if they are better than average drivers, then you might not be surprised if more than 50% of them reply “yes”!
Moreover, studies show that the discrepancy between accuracy and overconfidence increases (in all but the simplest tasks) as the respondent is more knowledgeable! (Accuracy increases to a modest degree but confidence increases to a much larger degree. ) If this is true then it may not be wise to pass the Subject F105 exam!
Overconfidence could therefore be a potentially serious problem in fields such as investment where most of the participants are likely to be highly knowledgeable. Moreover, the available evidence suggests that
even when people are aware that they are overconfident they remain so, due to:
Hindsight bias – events that happen will be thought of as having been predictable prior to the event; events that do not happen will be thought of as having been unlikely prior to the event.
A possible example of the first type of event was the dot. com crash that followed the dot. com bubble of 1999/2000. A possible example of the second type of event is when an underdog is heavily beaten in a sporting event. Although supporters may have had high hopes of an upset prior to the event, after the event a heavy defeat will always have seemed inevitable.
Confirmation bias – people will tend to look for evidence that confirms their point of view (and will tend to dismiss evidence that does not justify it).
For example, failing an exam might reinforce an existing preconception that the exam system is a lottery – even if the real reason for failure was a lack of preparation. In contrast, passing an exam might reinforce a view of the exam system as a lottery, even if it was in fact due reward for months of long, hard study!
a tendency to separate related events and decisions and find it difficult to aggregate events. Thus, rather than netting out all gains and losses (as standard financial economic theory would suggest) people set up a series of “mental accounts” and view individual decisions as relating to one or another of these accounts.
An example of when mental accounting might be of relevance relates to t
he paying off of a mortgage early. Consider the following two situations:
1. have a 100k mortgage and 10k of savings in the bank
2. use 5k of savings to pay off part of your mortgage, so that you end up with a 95k
mortgage and 5k of savings in the bank.
In theory (ie ignoring issues such as tax and the interest rates applicable) you should be indifferent between these two situations because either way you have a net indebtedness of 90k (and somewhere to live!).
In practice, however, this may not be the case. Some people may actually feel happier in the second situation because they feel that a smaller mortgage means that they have less debt. This will be the case if they use separate mental accounts for savings and debt.
In practice, of course, the choice of course of action will be driven to some extent by issues such as tax, the interest rates applicable and the need to hold some liquid assets.
the range of options or choices presented to people may influence their choices.
the primary effect – people are more likely to choose the first option presented
the recency effect – in some instances, the final option that is discussed may be preferred! The gap in time between the presentation of the options and the decision may influence this dichotomy.
More specifically, the sooner/later the decision is made, the more likely it is that the first/last option will be chosen.
other research suggesting that people are more likely to choose an intermediate option than one at either end!
a greater range of options tends to discourage decision-making. On the other hand, a higher probability is attributed to options explicitly stated than when included in a broader category.
status quo bias – people have a marked preference for keeping things as they are.
regret aversion – by retaining the existing arrangements, people minimise the possibility of regret (the pain associated with feeling responsible for a loss).
ambiguity aversion – people are prepared to pay a premium for rules.
uch standard financial economic theory (such as portfolio theory) assumes that investors know
the actual distribution of future investment returns when making their investment choices – although they don’t know what the actual investment return will turn out to be in any future period. The terms ambiguity and uncertainty are both used to refer to a situation in which the investor is uncertain about the distribution of future investment returns. A investor who dislikes such ambiguity will tend to err on the side of caution when making a investment choice. The investor will also be prepared to pay for further information that reduces the degree of uncertainty faced.
List the eight common themes found in research on behavioural finance.
Financial planning can be undertaken on
a long-term (capital budgeting) or a short-term (cash management) basis.
Long-term financial planning is concerned with
a company’s long-term investment decisions and capital requirements – ie long-term loans, debt and equity – whereas short-term financial planning is concerned with the management of short-term or working capital requirements.
Long-term planning is primarily a responsibility of
the finance function within the organisation, liaising with senior management to ensure consistency with business plans. Short-term planning is more closely associated with operational issues, since it will involve consideration of credit policy and possible deferment of settling accounts payable
Credit policy relates to
the trade credit a company gives to its customers. For each particular customer the company will need to determine:
how much credit to advance (including none at all)
over what period to advance the credit
the rate of interest to be charged for that credit, which could be zero.
In determining its credit policy, the company will need to assess the short-term creditworthiness of the particular customer.
“Long-term” planning commonly looks
3 to 5 years ahead (although for capital projects 10 or 12 years would not be unusual). It assesses the company’s requirements for capital to finance its business operations over the long term.
The development of financial plans should begin by
consideration of an organisation’s business plans – its anticipated product development and sales objectives. Whereas business plans relate to the business operations of the company, financial plans relate to how those business operations are to be financed. These will typically need to consider the organic development of existing activities, and also plans for new developments (whether expansion or retrenchment). Sensitivity analysis should begin at this stage, by exploring business plans under a range of scenarios – as it is never possible to predict future trading conditions with certainty. You may recall the discussion in Subject A103 on how to use probability trees for this purpose.
Once the business plans have been developed, they can be converted into financial plans starting with the forecast of future cashflows. Analysis of the anticipated need for working capital and growth in fixed assets, together with considerations of tax, dividend and interest payments, will enable the financial manager to plan for capital budgeting and structure. Whereas capital budgeting decisions relate to the total amount of capital required, capital structure decisions relate to the mix of the capital raised between the different possible types of debt and equity.
Once again, sensitivity analysis will be needed in order to allow for possible changes in the financial environment – changes which again cannot be predicted with certainty in advance.
Given that a company’s operations can be characterised as a portfolio of projects, the approaches and methods used here are likely to be similar to those discussed in the appraisal of capital projects, as discussed in Subjects A103 and A301.
Financial planning therefore focuses on the sources and uses of funds as well as the implications for borrowing and financial structure. Clearly, an iterative process will be involved as the implications of the business plan are explored.
The financial plan will also have to consider non-operational issues such as the possibility of breaching financial covenants and the impact of additional borrowing on credit ratings.
Likewise the level of gearing reported on the company’s balance sheet may also be a consideration.
Short-term” planning often takes the form of
“ a 12-month “rolling” plan. Short-term financial planning revolves around the analysis of working capital
requirements. Current assets and liabilities are collectively known as working capital.
Key elements of Short term planning
In addition to consideration of credit management, there is also the need to determine stock (inventory) policy, both as regards raw materials and finished goods. The operational advantages of holding buffer stocks will need to be balanced against the implications for cashflow and the opportunity cost of capital. Seasonal factors may be of considerable importance in many industries.
Credit management refers to the collection of revenues in respect of goods and services supplied, ie from trade creditors. Ideally, the company would like to receive these revenues as quickly as possible. However, an excessively strict credit policy could adversely affect relations with key customers. Conversely, the company would prefer to delay payments to its suppliers, again in so far as this doesn’t adversely affect its relations with those suppliers.
Holding sufficient buffer stocks helps ensure that the firm will be always able to manufacture and supply goods promptly in response to unforeseen increases in demand. It may also be worthwhile if it enables the company to obtain lower raw material prices on orders from suppliers. The main disadvantage is the opportunity cost of the capital tied up in the stocks – given that the money tied up in stocks could otherwise be invested in other assets that are either more liquid (eg cash) or that generate investment returns (eg short-term securities).
A key element in short-term financial planning is the translation of the sales and production plans (underlying the long-term projections) into cashflow projections, allowing for the settlement policies adopted in respect of accounts payable and receivable. In other words, allowing for the fact that cash normally changes hands sometime after the good or service is actually bought or sold.
List the main classes of current assets and liabilities.
What other possible costs are involved in holding buffer stocks?
Attention must also be given to the non-cash elements in projected accounts,
such as the need to add back depreciation provisions, and the delays before tax, interest and dividend payments have to be made. Short-term financial plans will allow for such factors, and will seek to establish a minimum operating cash balance with which the organisation wishes to operate (in order to allow for unexpected eventualities).
What is the main advantage and disadvantage for the company of holding cash?
Working capital usually refers to
the company’s short-term assets and short-term liabilities. In practice, it is sometimes interpreted as the difference between short-term assets (cash, short-term securities, stocks and trade receivables or debtors) and short- term liabilities (trade payables or creditors, tax and dividends due).
Agency costs are incurred when:
managers (as agents) do not attempt to maximise the value of the company
shareholders (as principals) incur costs monitoring the managers and attempting to influence their actions.
Economies of scale refers to the situation in which
long-run average costs decrease with the level of output. Economies of scale may arise from factors such as the spreading of fixed costs (eg research, marketing), specialisation in the production process and the ability of larger enterprises to obtain finance more cheaply.
Economies of scale may arise if a merger
enables the two companies to share some common functions that are common to all types of enterprise, such as general management, accounting and marketing.
It might be argued that a company definitely shouldn’t merge purely to achieve diversification on behalf of its shareholders.
This is because the divisibility of financial securities means that it will usually be much quicker, easier and cheaper for the shareholders to obtain diversification within their share portfolios than it is for the company to diversify via a series of possibly lengthy and costly merger processes.
The consequence of requiring a pension fund to report its financial position annually rather than triennially might be to
force the fund to invest in less volatile assets in order to reduce the risk of having to report a poor financial position. It might therefore force the fund to invest less heavily in equities, and possibly also less heavily in long-term bonds.
This assumes that assets are valued using market values.
financial covenants are
restrictions placed on a borrower, typically an issuer of long- term debt, which require that the borrower meets specified financial criteria, eg with regard to interest and asset cover on that debt
Other possible costs involved in holding buffer stocks include:
spoilage costs – due to physical deterioration in the raw materials or finished or unfinished goods
obsolescence – of the raw materials or finished or unfinished goods.