Hotel InterContinental, Toronto Centre Toronto Ontario October 23, 2009

1. Day 2 Hotel InterContinental, Toronto Centre Toronto Ontario October 23, 2009

2. Behavioural Finance / Investment Beliefs

3. Overview • What is behavioural finance? • Common behavioural biases and their implications for investment beliefs and decision making

4. What is Behavioural Finance? • Relatively new school of thought • Gradually recognized as a legitimate field in finance in the 1990s • A marriage of psychology and finance • It says psychology plays a role in financial decision making • Is it a surprise that we are human? • Cognitive errors and biases affect investment beliefs, and hence financial choices • Poses a challenge to the traditional idea that markets are always efficient

5. What is Behavioural Finance? • Why should we care? • To better understand our own investment behavior, and that of others  set the right incentives for clients, pension plan design, financial product design • To better understand asset management companies and active strategies that base their investment philosophy on behavioral finance • Even retail banking is talking to customers about it • E.g. CIBC Imperial Service: Investor Psychology 101 • Taking investor psychology into account

6. Behavioural Biases • Summary of well-known cognitive errors and biases, and their impact on investment beliefs and financial decision making • Overconfidence • Loss aversion • Narrow framing • Representativeness • Regret avoidance • Ambiguity aversion • Mental accounting

7. Overconfidence • Better than average • “I am a better than average driver.” • 95% of British drivers believe they are better than average (Sutherland 1992) • Illusion of control • “I am unlikely to be involved in a car accident.” • As applied to investments, overconfidence may lead to excessive trading • “Trading is hazardous to your wealth” by Barber and Odean (2000a) • Find that portfolio turnover is a good predictor of poor performance: Investors who traded the most had the lowest returns net of transaction costs • Barber and Odean (2000b): Result mostly confined to one particular gender…

8. Barber and Odean (2000a)

9. Why Don’t They Learn? • Similar results in other studies: Overconfident traders contribute less to desk profits (Fenton-O’Creevy et al. 2007) • Why don’t overconfident investors learn from their mistakes? • Self-attribution bias • Attribute successes to their own ability • Blame failures on bad luck • Selection of portfolio managers/traders: Type-A personalities or Type-B?

10. Loss Aversion Prospect Theory Pleasure Small Pleasure -10% Loss Gain +10% Big Pain Pain

11. Narrow Framing • Loss aversion may be a consequence of narrow framing • Narrow frame of evaluation • Limited set of metrics in evaluating investments • Myopic behavior even though investment is long-term • Obsessive about price changes in a particular stock • Can lead to over-estimation of risk

12. Narrow Framing / Loss Aversion • Consequence • “Disposition effect”: Tendency to sell winners too soon, and hang on to losers for too long (Shefrin and Statman, 1985, Odean 1998)) • E.g. Nortel • “If I haven’t realized the loss, then it isn’t yet a loss.” • Affects design of financial products • If investor cares more about loss, rather than risk, then products that limit downside risk (or manages shortfall risk) is more attractive than products that have low volatility • Another rationale for asset-liability management (ALM), rather than asset-only management

13. Myopic Loss Aversion • Example: Currency hedging • Influenced by recent events or stick with long-term view? • Combination of loss aversion and representativeness

14. Representativeness • Making decisions based on recent history, or a small sample size • Believe that it is representative of the future, or the full sample • May lead to “excessive extrapolation” • Erroneously think that recent performance is representative of longer term prospects • Results: Investors chase past winners • Overreacts to glamour stocks (e.g., technology bubble) • Overreacts to bad news which may be temporary (thus creating “value opportunities”) • Creates short-term momentum, but long-term reversal in returns

15. Representativeness • Let’s look at performance of portfolio managers Based on a sample of 220 U.S. equity managers (Wood 2006)

16. Representativeness • Another example of excessive extrapolation: sample size • Erroneously think that a small sample size is representative of the population • E.g. opinion of a car vs. investing in the car company

17. Regret Avoidance • Leads to procrastination and inertia • Status quo bias • Good intentions but poor follow-through • Consequences: • Delayed saving and investment choices • Defined Contribution Plans: A significant number of accounts are kept in their default allocation for a long time • Limit divergence from peers’ average asset allocation, if sensitive to peer comparison

18. Ambiguity Aversion • Sticking with the familiar • Results in under-diversification • Investors may exhibit home bias, local bias • Bias is more substantial if take into account human capital • From a diversification point of view, DC plans should restrict company share ownership

19. Mental Accounting • Tendency to divide total wealth into separate accounts and buckets • Ignores correlation between assets across portfolio • May result in tax-inefficient allocations • Naïve diversification in DC pension plans (Benartzi and Thaler 2001) • 1/n is found to be the predominant rule • Authors find that “the proportion invested in stocks depends strongly on the proportion of stock funds in the plan” • Plan sponsor’s menu of options and choices very important

20. Impact on Committee Decision Making • Lack of diversity in membership could pose a problem • Common knowledge syndrome • Less willing to share unique or different information for the sake of social cohesion • It takes 16 similarly-minded committee members to generate the diversity of 4 different-minded members

21. Final Note • Some empirical findings are more respected in the profession than others • Stock market returns affected by number of hours of sunshine, seasonal changes (SAD)…etc. • Point of disagreement • More and more asset management companies are using the “behavioural finance” buzz word (mostly value strategies), as well as investment advisors

22. Questions?