Behavioral Theory

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Behavioral Portfolio Theory

Behavioral portfolio theory, introduced by Shefrin and Statman (2000), is a goal
based theory. In that theory, investors divide their money into many mental
account layers of a portfolio pyramid corresponding to goals such as having a
secure retirement, paying for a college education, or being rich enough to hop on a
cruise ship whenever they please.

A central feature in behavioral portfolio theory is the observation that
investors view their portfolios not as a whole, as prescribed by mean-variance
portfolio theory, but as distinct mental account layers in a pyramid of assets, where
mental account layers are associated with particular goals and where attitudes
toward risk vary across layers.

Behavioral Portfolio Theory

BPT emphasizes the role of behavioral preferences in portfolio selection and
proposes that individual investors’ portfolio choices and consequently return
performance reflect characteristics such as aspirations, hope, fear, and narrow
framing. In this respect, BPT helps to explain why some investors simultaneously
buy bonds and lottery tickets by investigating multiple objectives (e.g., protection
from poverty at retirement and potential for a shot at riches) as well as aspirations
(Statman, 2002).we contribute to the literature in several ways. We (1) characterize
some of the key ways in which individual investors differ from each other in terms
of both preferences and beliefs, (2) develop a stylized dynamic behavioral portfolio
selection model to explain how
differences in preferences and beliefs lead to differences in investors’ portfolio
decisions, (3) develop a series of hypotheses based on predictions stemming from
the model, and (4) present a series of empirical findings, some of which serve to
test our hypotheses, and some of which strike us as surprising and at odds with
conventional wisdom. Our most striking result is that overtrading does not
necessarily result in underperformance. Rather, underperformance depends on the
circumstances. Investors with strong beliefs that stem from using fundamental
analysis trade more frequently but still outperform investors using other strategies.


C. Beliefs: Biases, Framing and Probability Weighting
The behavioral approach emphasizes the importance of both preferences and
beliefs. In shifting the emphasis from preferences to beliefs, we identify three key
issues. First, investors typically have erroneous beliefs stemming from behavioral
biases. Examples of biases are excessive optimism and overconfidence. Excessive
optimism can lead investors to overestimate expected returns (De Bondt and
Thaler, 1985), whereas overconfidence can lead them to underestimate risk (Barber
and Odean, 2000; Odean, 1998). In conjunction, this can lead to forecasts which
are too bold (cf. Kahneman and Lovallo, 1993).

Second, because of framing effects, behavioral investors ignore information
relating to return covariance. Instead, we follow the approach of prospect theory
with narrow framing and assume that investors’ beliefs consist of marginal
distributions for each security, which are applied to (2) on a security by security
basis. In particular, investors are assumed to ignore covariance when choosing
their portfolios.

Investor’s preferences & strategy’s:
First, compare investors who rely on fundamental analysis as a strategy with those
who rely on technical analysis. Investors using fundamental analysis examine all
underlying conditions relevant for future stock price developments. Besides
financial statements, these include economic, demographic, and geopolitical
factors. In contrast, investors relying on technical analysis only study the stock
price movements themselves, believing that historical data provides indicators for
future stock price developments.
To us, this suggests that fundamental analysis typically involves more information
than technical analysis (cf. Shleifer and Summers, 1990). Investors relying on
fundamental analysis are therefore more likely to become more familiar with the
firms they follow than investors relying on technical analysis.

Hypothesis
H1: Relative to investors relying on technical analysis, investors relying on
fundamental analysis will form bolder beliefs, and their greater overconfidence
will induce them to trade more frequently.

Apart from a very small segment of highly skilled investors who hold concentrated
portfolios (Barber, Lee, Liu, and Odean, 2009; Goetzmann and Kumar, 2008),
overtrading typically leads to underperformance due to the accumulation of
transaction costs (Barber and Odean, 2000). As there is no a priori reason to expect
that investors using fundamental analysis are more skilled than investors using
other strategies, we expect:

H2: Relative to investors relying on technical analysis, investors relying on
fundamental analysis will earn lower risk and style adjusted returns.
Second, compare investors who rely on fundamental analysis with those relying on
their intuition. In the behavioral framework, investors do not place high intrinsic
value on diversification. In the spirit of prospect theory’s isolation effect (mental
accounting, narrow framing) (Kahneman and Tversky, 1979), investors act as if
they implement condition (2) on a security-by-security basis, rather than as part of
an integrated optimization.10 As a result, status quo bias will typically lead to
underdiversification. Ceteris paribus, (2) implies that investors
holding more securities will tend to be those with stronger convictions in their
stock picking skills and in possession of better and more information which leads
them to make bolder forecasts (Kahneman and Lovallo, 1993). Only in these cases,
will investors be able to overcome status quo bias and be willing to invest in
multiple stocks and thus make less timid choices.
Investor’s Objective:
H3: Investors relying on fundamental analysis will hold a larger number of
different stocks in their portfolio than investors relying on intuition.
Investment objectives are imbedded in investors’ preferences. Aspiration levels
constitute an important component of objectives. A key implication of behavioral
portfolio theory is that investors whose goals involve high aspirations act as if they
have a high tolerance for risk, implying that investors, who set high aspiration
levels in combination with an associated high probability of achieving those levels,
will tend to choose risky portfolios (Shefrin and Statman, 2000). Risky portfolios
are portfolios that are more exposed to market risk and overweight small firms
(Barber and Odean, 2001). Hence we hypothesize:

H4: Investors with higher aspiration levels have higher risk profiles than
investors with lower aspiration levels.

H5: Investors with higher risk profiles will hold riskier portfolios (i.e. with higher
exposure to the market and small-firm factors) than investors with lower risk
profiles.

As previously discussed, because of familiarity bias, investors who rely on
fundamental analysis are likely to have high conviction in their stock picking
skills. In addition to leading them to make bold forecasts, we suggest that
familiarity also leads them to be more ambitious than investor whose beliefs
feature more ambiguity. This is because ambiguity involves uncertainty about
P(A), the probability of achieving the aspiration level. In turn, ambiguity aversion
induces pessimism about P(A), which results in less risk taking. This leads to the
following hypothesis:

H6: Investors relying on fundamental analysis will have the highest aspirations and
risk profiles.

The behavioral framework links investments objectives to trading behavior. In this
regard, investors saving for retirement or building a financial buffer and investors
who invest to speculate or exercise a hobby lie at opposite ends of a continuum.
For investors who mainly invest as a hobby or to speculate, the second and third
term in (2) loom large, as these relate to the benefits from (anticipated) evaluation
utility (Barberis and Xiong, 2008) and thrill seeking (Grinblatt and Keloharju,
2006). To experience these positive emotions such investors will trade more
frequently than other investors. Hence we hypothesize:

H7: Investors who invest primarily as a hobby or to speculate will trade more
frequently than investors whose primary investment objective is to build a financial
buffer or save for retirement.

Additionally, investors who mainly invest as a hobby or to speculate might have
very high conviction, make bold forecasts, tolerate risk, and set ambitious targets.
Indeed, recent literature shows that investors who trade to entertain themselves
(Dorn and Sengmueller, 2009) or to speculate – essentially seeing stocks as a
lottery ticket providing a shot at riches (Statman, 2002) – have higher aspirations
and take more risk relative to investors who do not associate investing with
gambling (Kumar, 2009). In contrast, investors whose primary investment
objective is to build a financial buffer or save for retirement are likely to have
lower aspirations and choose more conservative portfolios. In short:

H8: Investors whose primary investment objective is to build a financial buffer or
save for retirement have lower aspirations and take less risk than investors who
invest primarily as a hobby or to speculate.

Examples
Prospect theory:
If there are two circumstances firstly, Investor gains $50 on investment of equal
amount and secondly Investor gains $100 dollars on investment of $50 but suffer a
loss of $50 latter.
In both the cases the overall gains are $50 however most of the investor prefers the
first option.
Regret theory:
If investor decides to choose the investment destination which has bad image and
his decision goes against his desired result than it is harder to rationalize.
Anchoring theory:
If the share price of ABC Corporation is rising than investor may try to link its
price movement with its past performance. And the basic fundamentals may
become more irrelevance in the emergence of the new trends.


Investors often do not participate in all asset and security classes:
As per Kent et al. (2001), investors incline to emphasis only in stocks that are ‘on
their radar screens’. Investor might choose from the assets class which they are
more familiar with and neglects the assets like bond, equity, commodities.
Investors use historical data as an indicator of future movement in stock
purchase decisions:
Often it is found that the investor try to judge the future price movement in stock
price based on past performance which can be termed as technical analysis. This
advocates that investors will on occasion infer past price trends naively.
Investors trade too aggressively:
Kent et al. (2001) found that investors are overconfident in their decision making
process. And due to this overconfidence they don’t emphasize on information and
action of others and they are also believed to overreact to unreliable information
than to reliable information. According to the findings of Barber and Odean(1999).
Investor who has an experience of greatest success in past in trading will trade
more in the future. This evidence is consistent with self-attributing bias which
means investor has largely attributed their success to their skill rather than luck.



Investors are influenced by historical high or low trading stocks:
Daniel, Hirshleifer, Teoh (2002) suggested that investors may form theories or
concept of market functionality based on unrelated historical prices, somewhat
similar to making choices built upon mental accounting with respect to arbitrary
reference points. Tvernsky and Karneman (1974) also relate the idea of anchoring,
where investors set a primary value for future price.
Investors behave parallel to other investor:
This occurrence is called herding, where investors is consistent with the rational
response to any new information coming into the market. Kent et al. (2001), says
people tends to behave in similar or a parallel way with one another, irrespective of
whether the choices are smart enough or not.
Investor depending on fundamental analysis tends to hold larger numbers of
stocks in their portfolio:
Fundamental analysis studies all underlying condition of firms future prospects
which maybe internal or external. Shleifer and Summers. (1990), says that investor
relying on fundamentals are likely to be familiar to firm they follow than technical
analysis and as a result investor may find different alternatives backed by strong
beliefs and diversify their portfolio.


Investors exhibit loss-averse Behavior:
In the study of Odean (1998), he showed that investor are more likely to sell stocks
which are making profits and they hesitate to sell stocks which are making losses.
According to Tversky and Kahneman, (1991), this psychological tendency explains
the disposition effect; even various studies on investor behavior have found that
investors are more inclined to realizing gains than losses.
Trading as entertainment:
Recent literature has revealed that some investor do trading as it hobby and to
entertain themselves (Dorn and Sengmueller, 2009) or speculate on certain stock
seeing them as a lottery ticket which can make them rich in one shot (statman,
2002). These types of investors have a high convection and a very ambitious target
to achieve with high degree of risk tolerance. In contrast investors whose objective
is to plan for retirement and financial buffer are more likely to have lower
aspiration and their portfolio are likely to be conservative.






References for above three pages:
Daniel, K., Hirshleifer, D., & Teoh, S. H. (2002). Investor psychology in capital markets:
Evidence and policy implications. Journal of Monetary Economics,49(1), 139-209.

Daniel, K. D., Hirshleifer, D., & Subrahmanyam, A. (2001). Overconfidence, arbitrage, and
equilibrium asset pricing. The Journal of Finance, 56(3), 921-965.

Odean, T. (1998). Volume, volatility, price, and profit when all traders are above average. The
Journal of Finance, 53(6), 1887-1934.

Hirshleifer, D. (2001). Investor psychology and asset pricing. The Journal of Finance, 56(4),
1533-1597.

Tversky, A., & Kahneman, D. (1974). Judgment under uncertainty: Heuristics and
biases. science, 185(4157), 1124-1131.

Shleifer, A., & Summers, L. H. (1990). The noise trader approach to finance.Journal of
Economic perspectives, 4(2), 19-33.

Dorn, D., & Sengmueller, P. (2009). Trading as entertainment?. Management Science, 55(4),
591-603.





Other References:
Hoffmann, A. O., Shefrin, H., & Pennings, J. (2010). Behavioral portfolio analysis of individual
investors. June, 24, 2010.

Ferri, R. A. (2010). The Power of Passive Investing: More Wealth with Less Work. John Wiley & Sons.

Chong, J., & Phillips, G. M. (2013). Portfolio Size Revisited. The Journal of Wealth Management, 15(4),
49-60.

Alexeev, V., & Tapon, F. (2013). Equity Portfolio Diversification: How Many Stocks are Enough? Evidence
from Five Developed Markets.

Statman, M. (2008). What Is Behavioral Finance?. Handbook of Finance.



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