Posts Tagged ‘behavioral finance’

The economics of a fair game are intuitive. Even very young children understand the rules. In aggregate the participants get out of the game the resources they put in. There is seen to be an equitable arrangement between participants.

Adult bargaining games designed to test understanding of fairness, reciprocity and altruism can be helpful to clarify our understandings of these concepts. Two of these games are the ultimatum game and the dictator game.

Ultimatum game: In this game there are two players, a proposer and a responder. The proposer offers any amount of a given total stake to the responder and the proposer keeps the remainder of the stake. If the amount is accepted, both receive the agreed upon amount. If rejected, neither player receives anything.

In this game participants have to consider the concepts of reciprocity and fairness.

Dictator Game: In the Dictator Game, the responder must accept any offer by the proposer. The proposer’s stake remains constant so they don’t have to give anything to the responder.

In this game altruism motivates the proposer to give.

Game results are consistent across western cultures. In the ultimatum game, proposers offer, on average, 40% of the stake. They usually keep 60%. Offers of less than 20% are rejected half the time.

In the dictator game, an average offer is 20% of the stake, though the proposer has nothing at risk and is offering more than is necessary.

These results support the idea that people are perhaps genetically wired to be co-operative. They will also exhibit altruistic tendencies when there is no cost to them. The results also show that children have an innate propensity for fairness, reciprocity and altruism. There is a tendency for these traits to moderate as we age, perhaps from learned behaviours. In general these studies paint a positive view of basic human wiring. We expect and tend to benefit from a fair game.

Several studies are available on these games, both for adults and children. For a good review see A fair Game: Intuitive economics of Resource Exchange in four-year olds, Lucas, Wagner, Chow. Journal of Social, Evolutionary, and Cultural Psychology www.jsec.com – 2(3):74-88.

Well as the above math indicates, the markets have improved so now they are  fully half of what they once were.

There are so many opinions/recipes/predictions for fixing the financial system:

Do Mark to Market assets on company balance sheets to improve visibility and certainty about earnings; or

Don’t mark to market assets as these add to volatility in earnings and in the end are estimates only

Buy equities, the recession is ending in 2009; or

Do nothing, the recession is deeper than expected and mid 2010 is the earliest relief point

Since the public purse is bailing out AIG (Citigroup, Bank America…) the new owners should protect us by reneging on employee bonuses. The principle is one of fairness to those who are preventing these companies from disappearing entirely; or

Pay the bonuses, keeping the companies whole will pay off in the future as a more valuable asset is sold. These bonuses represent insignificant dollar values

New expanded monetary policy is helpful in the short term and disastrous later; or

The US economy is expected to drive world recovery, the reasonable  cost of this effort is more US dollars in circulation

I expect many of you find all of these conflicting views compelling even as they are source of argument. I  usually find both sides of the noise plausible and somewhat meaningless as a result. The loudest opinion is unlikely to be the most helpful, or best considered. In times as these, we need to have some reasonable basis for  making investment decisions.

There seems to be a quest to define the moment of inertia, when the economy begins to grow instead of shrink.  If we could guess the day what would we do exactly? Search for a new job… buy an investment property? Maybe we could pick that exact moment to buy stocks in our retirement accounts.

Unfortunately,  we would probably be late to the party for stock markets.   If we look at the most severe recessions in the past 40 years for Japan, UK, US and Germany at the official end of each recession the local stock market had rebounded from a low of 31% in US markets in March of 1975 to a high of 137% in the UK in December of 1975. Of course the end of recessions are defined by looking back 6 months. Not helpful if you are trying to time a stock entry point or major purchase.

Good judgement starts with clearly understanding your unique situation. Investment activities should be added to after accounting for and funding cash requirements and perhaps reducing debt. In this way you will not be forced to turn what should be a positive into a negative investment experience.

It’s 3 o’clock, an hour before the close of the markets. I really don’t prescribe to technical analysis for stock trading, but like reading your horoscope, it makes you feel better to see a five star day.  We are currently equal to the old low from last November. Optimists (bulls) cling to the notion that this value represented a low level from which the markets would slowly and carefully resume an new upward trajectory. So to avoid a problem I am posting this before the close of market trading. Maybe the market (world) cares about the S&P 500 staying above 752 or maybe not. Intellectually I know it doesn’t make any difference. Emotionally I could use the boost.

As a follow-up to statements in recent blogs, here is my take on the discount brokerage (DB) model.

If lower trade costs result in better, more efficient portfolio’s then I am all for discount brokerage. There isn’t a large body of evidence aggregating results for investors in DB accounts since none of that data is released by the sponsoring companies. The data that does exist supports the position that investors should steer clear. In my opinion there is little incentive for DB firms to release data as it would be unflattering to their client base.

One notable exception was written by BRAD M. BARBER and TERRANCE ODEAN “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, in the Journal of Finance, April 2000. The article considered position statements and trading activity for 78,000 households at a large discount brokerage firm over a six-year period ending in January 1997. As the title implies the results were not encouraging. There was strong evidence of under performance when compared to the broad market return. In addition, this under performance was enhanced (synonymous with lower returns) in the group of accounts that traded  most.

There are several implications.

Firstly, even though stock trading costs are lower in discount brokerage accounts somehow this advantage is not exploited for better client returns. The authors suggest over-confidence in trading strategies explains the drop in return. The correcting behavior recommended is lower cost transacting. When that doesn’t work, the individual  usually feels the need to try harder. More effort is made on understanding the research. More time is spent staring at the screen to find meaning in the trading patterns. This can and often leads to more trading. A virtuous circle is created, from the point of view of the DB.  A highly stressful and time consuming role is created for the investor-client (you).

Secondly, costs to DB clients are not lower for most asset classes, while the over-confidence factor presumably still operates. For example:  the biggest DB wire house doesn’t currently rebate clients the fees for advice that are embedded into mutual funds. Instead the fees are collected as revenue though no advice is given. In addition, in my opinion, spreads or commission on fixed income securities such as CDs and GICs are collected by the firm though they are intended as compensation for professional advisers. The same can be said of bonds and syndication revenue,  in which compensation for advice and distribution is simply absorbed into profits of DBs. As I said I’m for lower costs for investors. DB’s are simply not sharing the lower costs implied by their model with investors like you.

Thirdly, watch any ad for a discount brokerage firm and you will find that it exploits the view that lower transactions on stock trades equates to higher returns for investors. The clear parallel is drawn between superior trading strategies and their proprietary research resulting in confidence and better results. To me this is clearly a red herring. Most revenue streams, all of which are borne by their investors, are not disclosed. In addition, behaviors that reduce the likelihood of investor success are glamorized. Whereas behaviors that lead to better returns, like lower transaction counts and passive investment approaches are often discouraged through the introduction of additional fees. The overall result is that the incentives for DB and their clients are usually at odds.

Finally, DBs have institutional clients as well as retail clients (like you) who are often on the other side of aggregated small transactions. The research they provide is conflicted to the extent that DBs  are efficient in terms of their institutional clients if they can provide liquidity. While no advice is provided to individual clients, advice is aggregated and released to many in the form of independent research.  While no direct relationship exists, the overall effect is the same if it results in large numbers of small clients transferring one large position to a big institution.

My bias is clear. Advisors provide the best source of independent, professional advice specifically tailored to the best interest of the client. DBs may appear to present a cheaper option, but they are driven by profit motives and are generally profit centers for larger concerns. If your assets are important to you I advise you to choose a professional not a profit center, for your source of investment advice.

Liquidity…give them what they want

Behavioral finance is the study of how we make financial decisions. Finance professor Dr. Meir Statman spoke at a conference I attended last year and his basic argument is that we are all wired to act poorly as investors. Our fight or flight heritage gets in the way so we need rules and guidelines to overcome financially costly basic human tendencies. Meir generously shares his research and thoughts on his website and through his blog. – Santa Clara University – Leavey School of Business -Statman Profile

One of these rules or policy that I try to keep in mind is to be a liquidity provider. When the market is falling as it is this year, we should think about granting the emotional investor their wish. While the math may seem obvious it is a great mental check to categorize the liquidity preference of your strategy. Are you offering your position with the herd in flight or are you getting a preferred price by buying your position from those who want out…at whatever it takes. When stocks are rising the principle still holds. If a position is unbalanced and investors are fighting to get into what appears to be a can’t lose investment , give them what they wish for. Trading costs will be reduced since you will likely be selling at the offer or better and buying at the bid or better. In addition, your asset allocation decisions will be greatly advantaged by using this mental check.