Tag Archives: behavioral economics

If You Love Something, Set it Free: Avoiding Loss Aversion

Today Mark Hulbert ran an intriguing post in the Weekend Investor section of the Wall Street Journal suggesting that investors should take the opportunity to do some spring-cleaning of their asset portfolios.  Hulbert outlines a very common problem that both lovers and investors face: both are often afraid to end bad relationships. From a romantic context this is ancient wisdom, but to economic and financial researchers, understanding the aversion many investors have to selling their stocks is a relatively new development.

Terrance Odeon, a professor of finance at New York University and principal at AQR Capital Management, describes this concept very succinctly: “for most investors, buying is a forward-looking activity and selling is a backward-looking activity.” Odeon maintains that there are a lot of strange things investors do when they’re faced with selling a stock they own, especially when faced with realizing a loss. For instance, in his article Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold, Odeon and Michal Ann Strahilevitz explain that investor’s previous experiences with a stock affect their willingness to repurchase a stock. After surveying the trading records of several tens of thousands of individual investors, Odeon and Strahilevitz found that investors are reluctant to repurchase two types of stocks: those that they sold for a loss, and those that had risen in price soon after their sale. This phenomenon appears to occur regardless of whether these stocks are reasonably good investments after the initial sale. The reason for this behavior, according to the authors, is the cognitive dissonance, or negative and disappointed emotions, that investors feel when reflecting on their previous investing actions. Many investors are easily manipulated by these emotions, and as a result often tend to follow reinforcing behavior in which they purchase stocks associated with positive emotions and avoid those that inspire negative emotions.

This behavior seems consistent with Amos Tversky and Daniel Kahneman’s research in their article The Framing of Decisions and the Psychology of Choice. In their article, Tversky and Kahneman describe how individuals tend to switch from risk aversive behavior to risk taking behavior depending on how a problem was phrased. For instance, when presented with a hypothetical problem in which a flu outbreak is expected to kill 600 people, with a choice between solutions A: “saving 200 people with 100% probability” and B: “saving 600 people with 33% probability” (which has the same expected value as the other option: 600 people * 33% = 200 people saved), individuals tend to choose option A. In this case, the bias of the participants towards picking the “most positive sounding” answer seems consistent with the Odeon paper where investors tend to choose stocks that they have the most “positive emotions” towards. On the other hand, when participants in the Kahnemann study are presented with the same question but are offered equivalent “negative sounding answers,” they tend to switch their preferences. Here, participants are more likely to choose option B: where there is a 1/3 probability that no one will die (same as the option B in the previous question, since 600 people * 33% = 200 people not dying is equivalent to 600 people * 33% = 200 people saved) over the option A: where 400 people will die for sure (equivalent to option A in the previous question in which 200 people will for sure be saved). In this case, much like in the Odeon paper, individuals tend to avoid the options that inspire negative emotions (the “negative sounding “option where 400 people are certain to die, and the “negative sounding” option to avoid a stock on which they had previously lost money), and tend to choose those that appear “more positive.”

In order to combat these mental biases and to identify stocks to sell, Hulbert offers a few tips to investors. First, he suggests that investors pay attention to the companies  financial analysts have given “sell” ratings to. This is because even financial analysts are reluctant to tell investors to “sell” stocks, so the logic is that if they actually do muster up the courage to give a stock a “sell” rating then the stock likely deserves it.  Along these same lines, Adam Reed, a finance professor at UNC-Chapel Hill, suggests to look at short-interest data (number of people who are “shorting” the stock and hope to profit from a fall in its price) as an indicator of whether or not you should sell a stock. Despite all of the tips offered in Hulbert’s article, it’s probable that the best advice is to take a tip from Tversky, Kahneman, and Odeon: don’t be afraid to cut your losses; the only thing that you should avoid is loss aversion.

Overall, what holds true in love appears to hold true in investing as well: if things are truly not working out, it’s often better to end your love affair (with a stock) than to prolong your suffering.

 

Irrationality

Based on Adam Smith’s rational choice theory, individuals will always make the best choice in terms of maximizing their interests. However, it is only an assumption, and I think that one-day it will become a “special case”.

Think about what choices will you made under situation below:

– Would you rather take $100 now, or take a 50/50 bet in which you will win nothing or win $200?

– Would you rather give us $100 from your pocket now, or take a 50/50 bet in which you will lose nothing or lose $200?

In this example given in the article Human? Then You Might Have These Issues With Trading, people are not indifferent between two choices that might bring them equally expectation of gain/loss. What we care more is to increase the possibility of getting something that’s better for us. In the first case, I will choose &100 because I have higher possibility for win something, in the second case, I prefer to take the bet because I know that I have higher chance to loss nothing. This suggests that people sometimes care more about possibility than quantity.

In one of my classes this semester, we played the OPEC game introduced by UC Berkeley. The rule of the game is simple: 7 countries of are members of OPEC, they will decide what amount of oil to produce and the aggregate production determines the world oil price. If every country produces its capacity amount, then the oil price will be too low to be profitable for all nations. All of us knew that collusion outcome is definitely better then cheating and it’s also better to cheat a lot than just cheat a little. But it comes out that no country followed the optimal plan and none cheated a lot, countries just increase their production by a little bit.

In my mind, there are some factors that stop people from making rational decisions. First is the imperfect information. People may not know others’ choice and it’s hard to predict your rivals’ behaviors, so some decisions are based on guess or imperfect information. And second is loss aversion, which refers to the preference of avoiding loss then obtaining gain. In the OPEC game, even though we want to believe in other countries, the possibility of being betrayed still exists, and human nature is against such possibility. Third is the opportunity cost. Doing the calculation and predict rivals’ production waste a lot of time, so people tend to risk the loss in score than the loss of time and energy.

Overall, the irrationality do exist widely in our world, actually it is more common than rationality. According to Harriet, the study of irrationality is becoming more and more popular among managers. Hedge fund managers turned to study behavioral finance to have a better understanding of how psychology affects decision and profits.

(Revised) Will Online Grocery Shopping Replace Supermarkets?

Since the start of the internet, online purchasing has become a huge convenience for customers. With having all the information at the tip of your fingers, customers are now able to price compare across stores and shop for the best deal. Although this type of shopping is most common in the electronic, clothing, toy, and jewelry industries, it is now starting to make a larger appearance in the grocer industry. Companies like Safeway, Walmart, and AmazonFresh—Amazon’s expanding grocery service—are now starting to run their tests in select cities.

But why would customers prefer to online shop rather than go to their local grocery store? Some people actually like shopping at the supermarket. Here, they can find out what’s in season and what’s not as well as be able to pick out their own quality of meat and fresh fruit on their own. Allowing someone else to pick out their groceries takes away the shopping experience and exploration, as well as the enjoyment of getting out of the house. In contrast, however, there are a lot of conveniences you can get out of shopping online for your groceries. For example, online grocers have become more convenient in the sense of allowing you to use filters—for things such as food allergies and recipes. But, more importantly, the internet allows you to price compare across stores. Online, you can quickly see which vendor has the best price, something you cannot easily do by visiting the grocery store.

So, if the U.S. starts gearing towards online grocery shopping, what will happen to local supermarkets? As stated in a Forbes article, since there are already low profit-margins in the grocer industry, they are not at all worried about online competition. And, with this low profit industry, Amazon is not looking to make money by selling groceries; they are more geared towards connecting with their customers more frequently. As Bomberowitz says, “most Amazon customers tend to make small purchases, one or two items at a time. But, if Amazon can bundle your bananas with your books and batteries, it can make that stop at your door all the more profitable.”

This type of strategy that Amazon is pushing towards can be linked to behavioral economics. They are observing how their customers make market decisions and they are using these mechanisms to drive public choice. In an IBTimes article, retail consultant Burt Flickinger points out that Amazon has already targeted families with children. These families tend to shop Amazon specifically for bulk items such as laundry detergent and diapers. With AmazonFresh, Amazon intends to reel in these customers even more. By targeting big cities with families of multiple children, generally both spouses work and they have so many errands to take care of that a trip to the supermarket turns out to be a burden. If Amazon can get these customers to start buying their groceries online as well, their push towards producing a more loyal and profitable customer base demonstrates the effects of behavioral economics.

Seeing Amazon’s strategy, it’s not likely that Amazon or other online grocers will replace the well-known supermarkets such as Meijer and Walmart. Shopping at your local grocery store has become a part of people’s daily routine and for many, minimum-order quotas, membership fees, and delivery charges that come with online shopping will continue to keep customers away.

U.S. Markets Tumble, Fear and Irrationality to Set In?

After a roaring year in 2013, the S&P 500 index has dropped more than 2.5% so far in 2014, prompting many investors to question whether the U.S. stock market is headed for a “correction” in which investor exuberance eases and stock prices return to more realistic levels. The Dow Industrial Average also fell more than 3.5% this week as investors expect the Fed to reduce its monthly bond purchases very soon. The taper of the Fed’s current policy of Quantitative Easing is expected to affect emerging markets the most, which have been propped up in recent years by the large influx of cash from the Fed and China’s strong growth. With the Fed’s stimulus cutbacks looming, as well as China’s lower-than-expected growth numbers, many investors are growing more and more uncertain and fearful about short-run stock prices. To illustrate, we can take a look at the VIX index, which is an index of the volatility (standard deviation) of the prices in the S&P 500 index. Essentially, the VIX is used informally as a “fear gauge” and since it typically spikes during periods when the S&P 500 drops. Last Friday, January 24th, the VIX jumped nearly 32%.

VIX 2014

The contrasting stock boom of 2013 and the anticipated fall-off of 2014 often leaves investors uncertain of where the price of a stock will be headed, which is believed to account for the current higher volatility or variation in stock prices. You might think that rational investors are simply in a state of temporary disagreement about the stock price and that in the end the market will assign an efficient price even though many investors will be incorrect. But what if the assumption made by the efficient market hypothesis (EMH) that investors are rational is not exactly correct? More specifically, what if many of the investors we’d expect to behave rationally fall for the same cognitive biases as those that are deemed irrational?

I realize this sounds a bit confusing, so let me illustrate with a recent example. The Wall Street Journal recently ran an article called “When a Giant Gain Causes Pain” about the investing habits of two Harvard educated economics professors. Ross Miller was a finance professor at State University of New York at Albany who taught a class on analyzing and trading stocks. Miller never bought any of the stocks his students analyzed, sticking with index funds ever since losing a sizable amount of money when he traded options on his own earlier in his academic career. He changed his strategy when he came upon the emerging electric car company Tesla and decided to buy a few shares and options. When the stock soon doubled, he had at one point made over $30,000 in one week. Despite his small success, Miller’s small hobby of stock and options trading became increasingly stressful, especially as he watched the stock price “gyrate wildly up and down.” In the end, poor health and high stress got the best of Professor Miller, who died of a sudden heart failure just a few days after his small windfall.

What makes this an interesting story is that Ross Miller had been a pioneer of modern risk and portfolio theory, and ran a financial risk consulting firm on the side with his wife, a fellow Harvard economics PhD graduate. Miller had been just about the most rational investor that you could find, but even this finance professor found his emotions creeping into his options trading. Just before his heart attack, he had told his wife that in order to combat his stress that trading was causing him, he would soon sell all of his stock in Tesla, that is, if the stock hit $200 a share. What the author of the article seemed to hint at was that professor Miller’s reactions to his trades and Tesla’s price swings suggest unhealthy, highly emotional behavior (which in my opinion seems like a sign of a possible addiction to trading, but I’d need a longer bio of his habits to be sure), in which his beliefs about the stock may have not been perfectly rational. Either way, to me it is a bit disheartening to find that even esteemed professors of finance and portfolio theory still find it difficult to be perfectly objective when large sums of money are being moved around.

In order to close out this post, I wanted to toss out a few questions that I thought might be interesting to discuss:

-First, I’m curious about the assumptions of the Efficient Market Hypothesis. It explains that the market is “informationally efficient” and that the market, on average, is rational even when a minority of the participants are not. Since people tend to be affected in similar ways (maybe to different degrees) by cognitive biases, is it appropriate to say that the market is rational? Or, to put it a different way, if all participants are at least a little irrational at times, can the market as a whole ever be perfectly rational?

– Behavioral finance, or applying behavioral and cognitive research (i.e. psychology, neuroscience, and human biology) to the study of finance, has shown a lot of promise for helping to explain economic phenomena, including market forces. What are some of your thoughts about using psychological concepts to understand the world of economics?

Who can solve the inequality?

President Obama is going to give a speech in next week’s State of Union address focusing on inequality, which is the current Democrat political proposition. This time, will the Democrats solve the problem at root and successfully win more voters?

Speaking of inequality, it’s takes a long time for people and economists to dig into the matter and reveal the reasons behind the surface. At the very beginning, we noticed the differences of salaries and the gap between rich and poor, and we owned this to the exploitation of men by others. So we made laws to set the minimum wage and gradually increase that. We changed the tax rate so that we can take more from the rich and redistributed the wealth to those who needed most. After that, we came to realize that the income inequality is largely caused by opportunity inequality. Then we established all kinds of social security programs, increased welfare for the poor and distributed more unemployment benefits. The past has shown us that most of those steps failed nonetheless. The evidence is that we are facing the elimination of the middle class­—the backbone of the country.

For me, all the federal programs are not to be blamed. People may say that they are ideas of wasting tons of money and in return, we get bunch of people who must rely on the benefit plans and provide nothing to the society. But for me, all those plans are just good enough in solving the inequality provided that people who are helped must think like a real mid-class. However, they can’t do that. I call this “thinking inequality”, which is some kinds of related to the theory of Sendhil Mullainathan and Eldar Shafir, they explained their theory in their book.

To put it simple, if you want to get rid of poor situation, you must think and act like someone who are rich. Sounds weird but imagine this: if you are born in a poor family with parents only finished their primary education, then you will think like a poor because that’s how you have been educated. Before you grow up and want to change your life, you are already left behind—in thinking. When people are trying their best to make use of all kinds of resources, you don’t even realized the importance of doing that because you are brought up in a totally different circumstance. And it will be less chance for you to think as a mid-class and try your best to be a rich person.

Just like David Brooks pointed in his article, It takes a generation before we can finally solve the problem, because in order to solve the thinking inequality we must focus our target on the parents who are going to give birth to their child. They are the people who impact their children most, and the people who can save their children from poor—as long as we get them prepared by some kinds of education programs. Once the children from poor families are thinking in the same way as children from rich families, then the mechanisms set up by our government can function well. The federal programs will ensure all those children to have equal opportunities and close income. Only in this way can they compete equally.

The education is important for solving the ineuqlity, but not only from schools’ side, but also from the side of parents. Actually, parents determined whether the problems can be solved.

I can foresee the successful outcome of the war on inequality: the middle class takes more proportion in the whole social class structure. It may takes a long time but it also worth waiting for.

Parents and their children don’t share economic values? I’m not so sure.

As far as economic values go, I have always assumed (as well as taken from personal experience) that children receive a fair amount of their parents’ knowledge and wisdom. Ever since I started working when I was about 15 or 16 years old, and even before that, I can remember my mom explaining to me that I needed to start saving my money. At least some percentage of each paycheck I received needed to be put into my savings account so that — even at such a young age — I could start to accumulate my money. Of course she told my brother, two years older than I am, the same thing. I would say that in general I have been a pretty good saver up to this point in my life. There are always things that I want to buy, and do buy, but I have taken my mom’s advice about saving to heart. Thus, it comes as somewhat of a surprise to me that parents and children apparently do not share financial principles. This is according to an article in the Journal of Economic Behavior & Organization by Marco Cipriani, Paola Giuliano, and Olivier Jeanne (http://www.anderson.ucla.edu/faculty/paola.giuliano/Giuliano_JEBO.pdf).

In an economic experiment run by Cipriani, Giuliano, and Jeanne, “The researchers found, in an experiment involving financial contributions to a group fund, that there was no statistical correlation between the actions of a child and a parent,” (http://blogs.wsj.com/economics/2014/01/06/parents-kids-dont-share-economic-values/). In this experiment the children were very young as they conducted it in an elementary school. However, there was another experiment discussed in the journal article where the “kids” in the experiment were age 23. In that particular experiment the researchers found that the “children’s trusting behavior,…, is strongly correlated to that of their parents,” (Cipriani, Giuliano, and Jeanne, 2013). The reason this is so interesting is that I have found that in my case as well as in that of my brother, both of us have started to act more like our parents in terms of economic and financial values as we’ve gotten older. It seems to me that elementary school children would not yet necessarily be at a point in their lives where they have fully received the economic values from their parents; let alone be at a point where they can even truly understand the game they are playing in the experiment. Also, does it even matter if a five year old shares his or her parents’ economic and financial values or not?

I believe that to say children and parents do not share economic or financial values, based on an experiment done with elementary school children, is not quite fair. Given the other experiment done with 23 year olds and the result that they achieved, the children need to be at least a little bit older in order to get a meaningful result. All in all, I’m curious to know what the results of a similar experiment would be if conducted with children of age 15, 16, 17, and so on.