The traditional model of the "rational economic man" has dominated economics for decades along with the efficient market hy[othesis and capital asset pricing model, both of which rely on the rational economic man. The model states that economic actors make decisions by gathering available information and then rationally choosing the path most likely to maximize their goal. Because information is widely available to all market participants, the implication of the model is that it is virtually impossible to outperform the market without access to non-public information. In recent decades, a field of economics known as behavioral finance or behavioral economics radically revises the rational economic man model. It finds that decisions are actually made not by rational analysis but rather by emotions, instincts, cognitive biases, and primitive fears and desires. The result is financial decision-making that leads to "irrational" decisions -- think financial bubbles, panics, etc. By analyzing the decisions of others and finding the faults, it is possible to develop strategies that gain from these faults. This presentation presents a detailed explanation of behavioral finance and its implications for decision-making and financial markets and then describes strategies that may profit from the knowledge.

1. How to Profit From
Behavioral Finance Investing
A GUIDE TO PROFITING FROM THE OTHER GUYS’ MISTAKES

2. Course Contents and Takeaway
What is Behavioral Finance?
Theory of the mind and how we make decisions
How do emotions and biases effect investment decisions?
How can we mitigate irrational investment biases?
oNarrative fallacy and the Narrative Audit™
How can we profit from other peoples’ mistakes?
The trader’s worst problem – and even his worst enemy – is likely to be himself … Benjamin Graham

3. Emotional Investing

4. Efficient Market Hypothesis (EMH)
Market prices reflect all relevant information
New information is immediately incorporated into
security price
Stocks always trade at their fair value
“Random Walk” and Efficient Markets
Impossible to buy undervalued or sell overvalued
stocks

5. EMH Assumptions
Homo Economicus (Economic Man) is a fully
rational Investor who maximize his/her wealth
Market movement only with new information
Any deviation from efficient market is quickly
arbitraged away
Irrational (“noise”) investors cancel each other out

6. What Modern Economics Can’t Explain
Market prices different from fair value
oBubbles and Crashes
Equity risk premium
◦ Returns on equities higher than warranted by their risk
Price momentum and autocorrelation
◦ Today’s price is based on previous prices
Investments biased toward home countries

7. Behavioral Finance
Emotional and cognitive biases influence investment
decisions
Decisions are based on both irrational and rational factors
Market prices are outcome of rational and irrational
investors
Market participants have varying goals and objectives
Markets have inefficiencies that can be exploited for profit

8. Satisficing
People do not maximize their goals
◦ Cost of collecting information
◦ Impossible to calculate all future outcomes
◦ Uncertainty of future events
◦ Presence of multiple and conflicting goals
Settle for “satisficing” using “bounded rationality” …
(Hebert Simon)

9. Our Flawed Decision Making
Emotions, mood, sentiment
oRisk aversion – we hold on to losers and sell winners
Cognitive biases
o“Heuristics” – rules we follow without rational analysis
◦ Overconfidence – we think we are better than we are
◦ Framing – response to information depends on how it is framed

10. Human Evolution and Financial Choice
Homo Sapiens evolved to cope with the dangers and
opportunities on the plains of East Africa
Emotions and thinking evolved to survive and thrive
in the face of uncertainty and risk
Humans did not evolve to make financial decisions

11. How Does Our Mind
Work?
REASON, EMOTIONS, COGNITION AND SOCIETY

12. System 1 and System 2 Processing

13. System I:
Instincts and
Emotions
Fast, automatic,
emotional,
unconscious
Associations, past
events, patterns
Instincts such as
fight or flight, risk
aversion

14. Emotions
Happiness, sadness, fear, anger, greed, trust
Different from cognitive state
Rise spontaneously without conscious effort
Part of every decision making process
Accompanied by physiological symptoms

15. System II: Cognition and Heuristics
Slower, conscious, logical part of the brain
Evolved later in human development
Takes time, effort and energy
Collect and analyze information, then decide
Includes short cuts or heuristics

16. Heuristics
Rules of thumb, shortcuts
Decisions when faced with complexity and
uncertainty
Learned or hard-coded by evolution
Hitting brake when we see a red light
Can lead to irrational decisions

17. Emotional Markets
Markets are depressed, exuberant, bi-
polar, euphoric
Market sentiment
Market comprised of rational and
irrational participants
Irrational investors are not “noise”

18. Cognitive
Dissonance
Contradictory
beliefs or actions
People will do
anything to avoid
dissonance
o Change one of more of
the beliefs or behavior
o Acquire new information
o Discount conflicting
information

19. Neuro-Economics
Testosterone provides a surge of energy and optimism;
causes risky behavior
Dopamine provides pleasure and excitement;
overoptimism and overtrading
Serotonin associated with anxiety, fear, fight or flight
Cortisol result of long term stress; causes anxiety,
excessive risk taking

20. A Note on Mood
Emotion attached to specific issues; stock, market
Mood is a feeling that touches on everything
Mood can effect information and decisions
◦ Good mood takes in optimistic information
◦ Good mood more likely to risk taking and trading

21. Emotional and Cognitive
Biases

22. Overconfidence
Excessive faith in one’s beliefs and abilities
Overoptimistic about the future
Attribute good outcome to own abilities and bad outcomes to external events
(Hindsight Bias)
Causes Illusion of Control
“Lake Woebegone where all the women are strong, all the men are good
looking, and all the children are above average”…Garrison Keillor

23. Implications for Trading and Investing
Replace market reality with own views
Leads to overtrading
◦ Overtrading leads to poorer results
Hindsight bias prevents learning from mistakes
Hindsight bias and overconfidence cause illusion of control

24. Prospect Theory
(Loss Aversion;
Regret Aversion)
 Greater pain from a
financial loss than
pleasure from
equivalent gain
 One would need a
gain of $112.50 to
offset the negative
feeling of a $50 loss
 Go to great lengths to
avoid feeling regret
 Realized gains or losses
are felt more strongly

25. Implication for Trading and Investing
Miss investment opportunities
Take early profit on a winning position
Allow losses to accumulate
“Close out winners; let losers ride”
Hold on to paper losses

26. Endowment (Disposition) Bias
Psychic pain caused by loss of securities in our
portfolio
Place a higher value on securities that we own
True for recent acquisition
True for items are of equal value
Hold on to investments even if irrational

27. Implication for Trading and Investing
Keep securities we own, even if they are above intrinsic worth
Prevents sale of inferior investment or purchase of superior
investment
Adds non-economic, emotional value to the value of an investment
Susceptible to advertising
Decision based on like or dislike (environmentally friendly)

28. Anchoring
Focus on one piece of information – usually the purchase price or
the first number given
Subsequent decisions made with reference to the anchor
Stock purchased at $50 becomes the anchor
◦ If the stock goes to $30, the decision to sell or not is made by reference to the
$50
◦ Forecast of the future price of the stock is based on the anchor

29. Implication for Trading and Investing
Buy/sell decision based on anchor price
Price seen as gain or loss compared to anchor
◦New price may come from economic conditions or
company fundamentals
Tendency to block out new information or new
anchor

30. Confirmation Bias
Only information that confirms a belief is legitimate
Contradictory information is minimized
Escaping pain of cognitive dissonance
With 24/7 information, escaping becomes more
difficult

31. Implications for Trading and Investing
Selective intake of information to support
one’s position
Holding on to poor investments
Foregoing potentially profitable
investments

32. Availability and
Familiarity Biases

decisions made on
the availability of
familiar information
decisions based on
non-objective factors
poor trading and
investment decisions
available information
may be latest
information

33. Implications for Trading and Investing
Purchase or invest in known, familiar stocks
In calm markets, the available image is one of low
volatility
Manipulated by advertisers and brands
◦Repeated, loud advertising of stock names, mutual funds
◦Trusted brand names

34. Mental Accounting
Mentally separate money into accounts
◦Based on subjective criteria
◦Accounts by source of money or intent of each account
We think of a dollar as being more valuable in one
context than in another

35. Implications for Trading and Investing
money from bonus used differently than
money from salary
◦Bonus money for large acquisitions salary for day-to-day
expenses
◦Earn minimal interest while paying 25% for credit card
Profits may be treated differently from losses

36. Gamblers’ (Monte Carlo) Fallacy
3 reds in a row gives information about the
outcome of the next roll
See pattern where none exist
We are terrible at calculating probabilities
The fact that the market has gone up for three days
in a row is seen as proof that it will rise the next day
or revert to the mean

37. Implications for Trading and Investing
“Law of small numbers” -- rely on data samples that are
too small, very recent or very different
◦ Short track record be taken to imply future outperformance
Take funds with the best recent track record
Leads to ignoring reversion to mean.
◦ Take outliers as the norm rather than outliers

38. Framing Bias
Information is always presented in a frame or
context
Decisions are based on this information
React positively to an investment that is presented
in a positive frame
Something presented as having a 95% chance
of success vs. 5% chance of failure

39. Implications for Trading and Investing
Framing present in almost every situation
 Influenced by the manner in which
information is presented
Leads to purchase or sale of securities
based on bias

40. Crowd (Herd) Behavior
Wherever there is a market there is crowd behavior
Crowd behavior can result in market bubbles or
panic selloffs.
Distinction between “herding” and “crowding”
◦Crowding when a number of actors purchase same stock

41. Implications for Trading and Investing
Generate a self-reinforcing market movement which can
cause bubbles
Invest in fund with good recent track record or good
management
The more people in crowd the more pressure to join
Factor in Ponzi schemes where investments made because
others have invested

42. Measuring Market
Mood and Sentiment

43. Measuring Financial Market Sentiment
“Ben Graham …described the mental attitude toward market
fluctuations … imagine market quotations as coming from … Mr.
Market who appears daily and names a price at which he will either
buy your interest or sell you his shares…Even though the business
may be stable, Mr. Market’s quotations will be anything but. For
the poor fellow has incurable emotional problems. At times he
feels euphoric. When in that mood, he names a very high buy-sell
price….At other times he is depressed….On these occasions he will
name a very low price….”
Warren Buffet

44. Risk On Risk Off (RORO)
Investors switch between riskier and less risky assets
oSwitch follows economic and political events in the global markets
Risk on markets favor commodities, high yield and
emerging market bonds, NASDAQ, commodity currencies
(i.e., Australian and Canadian dollars) and the Europe and
British Pound
Risk off markets favor U.S. Government bonds, U.S. dollar,
Swiss Franc, Gold

45. Sentiment Surveys
Attempts to measure sentiment of market participants
Some measure consumer others measure professionals
sentiments
◦ American Association of Individual Investors (AAII)
◦ CBOE Volatility Index (VIX)
◦ CBOE put-to-call ratio
◦ Conference Board Consumer Confidence
◦ New York Stock Exchange New High to New Low Ratio

46. News and Social Network Measures of
Market Sentiment
Massive data and algorithms to measure market sentiment
Google Trends
◦ Number of web searches on key words
Thomson Reuters News Analytics
◦ Real-time linguistic and sentiment analytics on financial news
RavenPack News Analytics
◦ “real-time structured sentiment, relevance and novelty data for entities and event detected
in the unstructured text published by reliable sources.”

47. Investor Sentiment
and Business Cycle
market participants
experience longer term
moods
Graph shows range of
emotions and moods during
a business cycle
euphoria at peak and
depression at trough
As the mood changes over
time, investment decisions
will vary as well.

48. Momentum and Technical Analysis
Central tenet of the Efficient Market Hypothesis: security
prices are random and independent
Technical analysis is a methodology for forecasting the
direction of prices through the study of past market data,
primarily price and volume.
Momentum, moving average and charting
Serial autocorrelation used to measure price direction

49. Technical Analysis

50. Financial Bubbles
A sharp movement in market prices and widespread participation.
Prices detached from fundamentals and fair value
Financial bubbles occur in stocks, commodities, real estate and
bonds.
Every 5-10 years as memory of the previous bubble fades
Tend to occur during periods of “easy money” when credit is widely
available

51. Bubble Examples
The Dot Com and House Price bubbles burst in 2001
and 2008 respectively
The charts for the equity and bond markets show a
spike in prices, but have not had the steep decline

52. Dot Com (Internet Bubble)

53. Stock Market Bubble (?)

54. Housing Market Bubble

55. Bond Market Bubble (?)

56. Apple Stock Bubble?
Apple stocks has shown attributes of a bubble,
◦Stock values having less to do with any changes in
fundamentals and more with investors’ greed and fear.
Different outlook of owners and non-owners of their
stocks. (Disposition Effect)
◦Owners of the stock place a much higher valuation than
non-owners.

57. Apple Stock Bubble (?)

58. Narrative Fallacy and
Narrative Audit

59. Investment Narratives
Wired to think in terms of stories or narratives
Bring order to events that may be random.
Narrative elements are linked together
All is explained and causality rules
Random events or ambiguous elements are excluded

60. Narrative Fallacy
A story is economical for our brain to process.
◦ Run out of space and energy if we tried to remember every aspect
◦ A few salient facts that can be recalled quickly
It doesn't matter if the narrative resembles the real world
Nassim Taleb “narrative fallacy” — looking backward and
creating a pattern to fit events and causation

61. Narratives in the Investment World
Types of narratives in the investment world:
◦ Company Narrative
◦ Stock Narrative
◦ Investment Theme Narrative
◦ Economic Narratives
◦ Political Narratives
◦ Strategy Narratives
◦ Product Narratives

62. Narrative Audit
Special effort to overcome narrative bias
“Narrative Audit” ™ -- stripping down a story and separating it into
its factual and narrative components
Narrative Audit of the recent rise and fall of mortgage backed
securities.

63. Subprime Mortgage and Mortgage
Backed Securities
Mortgage backed securities (MBS) were sold in the 2005-8 years. The narrative
was as follows:
◦ Subprime MBS are an excellent investment because of their high yield and their low risk.
◦ They are backed by mortgages on houses whose prices have been rising and will continue to
rise in the future
◦ The creditworthiness of the mortgage holders largely irrelevant.
◦ MBS had built in features such as “waterfalls” that protect investors
◦ Preferred investors purchased securities rated as AAA by the major rating agencies
The key elements of this narrative include “high yield,” “continued rise of
housing prices,” “investor protection in case of defaults.”
The Narrative Audit requires that each of these be examined to separate fact
from story, appeal to logic and appeal to emotion.

64. High Yield
By 2006 the spread between AAA rated subprime mortgage backed securities and U.S. treasuries
had narrowed to well under 1%.

65. Rise of Housing Prices
The increase in the price of houses leading up to the credit crisis of 2007-8.

66. Waterfall Structure
Another risk protection mechanism was the structure of the underlying securities and the
protection they afforded to security holders, especially those holding higher rated securities.

67. Mitigation of Biases

68. Know Thyself
Admit we have biases, no matter how disciplined we are
This is not a sign of weakness; integral part of being human
Explore where biases influence trading and investing
Both emotions and cognitive biases
Understanding self is critical to profiting from others’
behavioral mistakes.

69. Mindfulness
Meditation focusing awareness on the present moment, while
acknowledging and accepting feelings, thoughts, bodily sensations
Mindfulness accomplishes two goals
oA clear knowledge of the emotional and cognitive biases that impede success
oCalming of animal spirits, allowing for more rational analysis and decision
Mindfulness has now entered the boardrooms and trading room
Manuals and courses teach this method and how it can be applied
to investments and trading.

70. Physical Fitness
A strong link exists between body and mind
Tiredness inhibits clear logical thoughts and rational
decision making
Exercise releases chemicals that provide energy and focus,
as well as aiding in memory and task completion.
Diet is a key for chemical balance in your mind and body

71. Always Play Devil’s Advocate
Look for information and opinions that contradict your
decisions
◦ Forces you to defend your decisions on a rational, rather than
emotional level.
Develop methodology for gaining new information
◦ Following new publications and Internet sites
◦ Reaching out to colleagues and friends to share their views.
A methodology for critically reviewing your positions

72. Emotions and Biases Checklist
Keep a checklist similar to the way that pilots to go through a
comprehensive checklist prior to flying
View comprehensive checklist on: www.emotionalmarkets.com)
Checklist should list some of the most common biases and
behavioral errors:
Are you using today’s market price for the valuation of investments
rather than historical or other prices?
Are we viewing our investments in the proper time-frame?

73. Keep a Journal
A detailed record of all trading and investment decisions
◦ The reasons for making these decisions
◦ Exit plan for when to reverse the decision
◦ Understand decisions that turned out to be mistakes.
Discipline for uncovering the biases in your decisions
◦ A plan for keeping our emotions in check.
Keep journal of forecasts

74. Establish Targets and Benchmarks
Clear targets and benchmarks and a course of
action if these targets or benchmarks are achieved.
Targets that can only be changed under a formal
procedure
Only changed if there is a change in the fundamentals or in your
own goals or objectives.
Useful in overcoming the disposition bias and
prospect theory

75. Learn the Basic Rules of Probability
Overcome biases that confuse random events or luck with patterns
Antidote to the Gambler’s Dilemma
“in the case of independent events (i.e., each toss of the dice),
the odds of any specific outcome on the next event
remains the same regardless of what preceded it.”
In a large group of funds, some will show superior performance
purely by random chance
Law of small numbers –you cannot extrapolate the future on the
basis of a small sampling of past patterns.

76. Avoid Herd Behavior
Check emotions and decisions for signs that you
have abandoned your own rational decision making
process and given into our social emotions.
Herd behavior common when a topic becomes the
subject of widespread discussion in the media or
among people
Keep a critical detachment and independence
Keep a focus on the intrinsic value of an investment

77. Conclusion
People are a bundle of contradictions when it comes to making investment or trading decisions.
On the one hand, we are capable of the most rational and logical analysis of our decisions. On
the other hand, we are blind to a wide range of emotions and biases that seriously undermine
our ability to make logical decisions.
It is only by understanding this dichotomy and taking steps to mitigate its pernicious effects that
we become better at financial decision making.
Fortunately for us, the journey is rewarding not only in terms of our financial selves, but for
other aspects of our lives as well.
Updates, case studies, resource lists and guest articles are continuously posted on the course’s
website
Handouts in pdf form are available on the website
www.investmenteducationforum.com