womenandwealth&,& lessonsfrom&& behavioral&...

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Women and Wealth -‐ Lessons from Behavioral Finance

cheryl.young @morganstanley.com

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Cheryl L. Young BIOGRAPHY

Young & Associates at Morgan StanleyCheryl L.Young, CPM®, CFP®, ChFC®

Cheryl L. Young, CPM®, CFP®, ChFC® Managing Director Young & Associates – A Morgan Stanley Advisory Team [email protected] 408-358-0976

Disclosures and Credit

Thank you to Legg Mason who provided the basis for this presenta?on, and is a valuable business partner. This material is provided on an informa?onal basis only and should not be construed as a solicita?on for any specific Legg Mason product or service. All discussion of behavioral finance, and market psychology reflects general principles and does not represent a recommenda?on for specific ac?on. All investments involve risk including loss of principal amount invested. There is no guarantee that investment objec?ves will be achieved. Investors should carefully consider their objec?ve, risk tolerance and ?me horizon before inves?ng.

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Learning objec?ves

• Provide informa?on on how to help investors recognize why they can easily make irra?onal investment decisions because of emo6ons, mispercep6ons and errors in logic and discuss various op?ons to help avoid them.

• Outline key differences between various emo?ons, mispercep?ons and errors of logic

• Provide details of various kinds of client emo?ons, mispercep?ons and errors in logic (using examples).

• Gain a deeper understanding of the role of the financial advisor.

Agenda

•  Are you a ra?onal investor? •  What is behavioral finance? •  Noise vs. signal: the quest for meaning •  Common mistakes by investors: examples from behavioral

finance • When emo?ons take over • When percep?on is decep?on • When logic isn’t enough

•  Staying on track: lessons for investors

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Are you a ra?onal investor?

1 This chart is for illustrative purposes only and does not represent actual performance, past or future, of any investment. Past performance is no guarantee of future results. Please note S&P 500 (please see slide number 24 for a definition), and Barclays U.S. Aggregate Bond (please see below for a definition), performance does not reflect the deduction of any fees and expenses. Indexes are unmanaged and one cannot invest directly in an index. Source: DALBAR Quantitative Analysis of Investor Behavior 2013. www.dalbarinc.com. DALBAR uses industry cash flow reports from the Investment Company Institute (ICI), www.ici.org to calculate the figure for the “Average equity fund investor” and “Average fixed income investor” categories. The figures are based on the ICI’s reports for the “stock fund” and “fixed income” categories, which represents flows and performance for U.S. mutual fund assets. “Average equity fund investor, and ”Average fixed income fund investor” and as defined by DALBAR, refers to the universe of all mutual fund investors whose actions and financial results are restated to represent a single investor. This approach allows the entire universe of mutual fund investors to be used as the statistical sample, ensuring ultimate reliability. “Average equity fund investor” and “Average fixed income fund investor” returns are calculated by the DALBAR Quantitative Analysis of Investor Behavior (QAIB) Report. QAIB calculates investor returns as the change in assets after excluding sales, redemptions and changes. This method of calculation captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After calculating investor returns in dollar terms, two percentages are calculated: total investor return rate for the period and annualized investor return rate. Total return rate is determined by calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for the period. The Barclays U.S. Aggregate Index is a broad-based bond index comprised of government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity. 6

Behavioral finance defined

•  Emo?onal: when decisions made based on feelings rather than logic

•  Perceptual: when informa?on is misunderstood or taken out of context.

•  Intellectual: when the wrong mental process leads to faulty judgments.

Behavioral finance draws on finance, psychology and sociology to explain these common investor mistakes:

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Source: Legg Mason, 2013.

Noise vs. signal

“The market is strong!”

“The market is weak!”

“Profits are down!” “Profits are up!”

“Consumer sen?ment is down!”

“Consumer sen?ment is up!”

Everybody’s got an opinion… • Cable TV • The daily paper • The Internet • Talk radio • Financial magazines • Financial newspapers • Friends • Family • Your dry cleaner

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Choice overload…

2 “When Choice is Demo?va?ng: Can One Desire Too Much of a Good Thing?,” by S.S. Iyengar and M. Lepper, M., Journal of Personality and Social Psychology, 79, 995-‐1006, 2000. “How Much Choice is Too Much?: Contribu?ons to 401(k) Re?rement Plans,” by S.S. Iyengar, W. Jiang, and G. Huberman, Pension Research Council of the Wharton School of the University of Pennsylvania (2003). Please note that the figures cited in the above chart are es?mates based on the illustra?ons provided in the research.

A research study on 401(k) accounts showed the more investment op?ons, the less par?cipa?on in the 401(k) plan2

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When emo?ons take over:

–  Overconfidence: “I’m on a roll”

–  Loss aversion: “No regrets” –  Thrill seeking: “I want to shake things up” –  Fear: the most dangerous emo?on of all

Decisions made on feelings

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Source: Legg Mason, 2013. This image is for illustra?ve purposes only.

Riding an emo?onal rollercoaster

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Overconfidence: “I’m on a roll”

•  Too many people confuse access to financial informa?on with having the exper?se of an investment professional

•  Overconfidence can lead to: –  understa?ng the price swings of a security –  taking excessive risks

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How would you rate your automobile driving skills:

q  Above average? q  Below average?

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The behavioral view:


3 “Are we all less risky and more skillful than our fellow drivers?”, by Ola Swenson, Acta Psychologica, Volume 47, Issue 2, February 1981, pp. 143-‐148.

In one study, 93% rated themselves above average…

…far more than is actually possible! 3

Loss aversion: “no regrets”

The tendency to avoid accepting the reality of losing money

* “A Conversa?on With Daniel Kahneman; On Profit, Loss and the Mysteries of the Mind, “ by Erica Goode, November 5, 2002, The New York Times.

Consider this wager:

We flip a coin. If heads, you lose $100; if tails, you win $100.

Do you take the bet?

Loss aversion research shows people look for a poten?al gain at least TWICE as large as the poten?al loss in order to accept this gamble*

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•  Consequences: –  Do nothing and miss good opportunities –  Take imprudent risks to make up a loss –  Holding onto a “loser” too long


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Security A’s price rose to $30 before falling to $15

Source: Legg Mason, 2013. This graphical depic?on is hypothe?cal and for illustra?ve purposes only.

Which investor is less likely to sell?

q  Investor #1 q  Investor #2

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Investor #2 Would regret the loss if he sells…

…doing nothing lets him avoid the reality of losing money

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Source: Legg Mason, 2013. This graphical depic?on is hypothe?cal and for illustra?ve purposes only.

Thrill seeking: “I want to shake things up”

•  T-‐Type individuals: easily bored, tremendous appe?te for excitement who seek out daring experiences

•  T-‐Types are prone to take risky posi?ons with the goal of quickly turning a profit

•  Consequences: –  Taking on too much risk

– Making too many trades

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Fear: the most dangerous emo?on

•  Why? It has immediate effects on our physical bodies that affect our thinking –  Increased heart rate –  Shallow breathing –  Goosebumps

•  The dangers for investors –  Panic selling –  Investment “paralysis”

•  The best defense –  Make a plan for adversity and follow it, not your emo?ons

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When percep?on is decep?on:

Decisions based on misinforma?on –  Anchoring –  Hindsight bias –  Prejudice –  Framing –  Patern recogni?on

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Source: Legg Mason, 2013. This graphical depic?on is hypothe?cal and for illustra?ve purposes only. 22

When percep?on is decep?on:

Anchoring: “stuck on you”

•  Investment A –  15.3% average annualized return

– Manager tenure 10 years

–  Standard devia?on* 19%

–  Lower-‐ranked investment

•  Investment B –  11.9% average annualized return

– Manager tenure 10 years

–  Standard devia?on* of 6%

–  Highly-‐ranked investment

This depic?on is hypothe?cal and for illustra?ve purposes only. * Standard devia?on measures the risk or vola?lity of an investment’s return over a par?cular ?me period; the greater the number, the greater the risk.

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Hindsight bias: “I could have predicted that!”

•  Inclina?on to see past events as more predictable than they actually were — the “Monday Morning Quarterback” phenomenon

•  Seeing the past through “rose-‐colored” pair of glasses

•  Consequences: –  Believing that you’re smart when you were only lucky

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–  Percep?on based on limited experiences –  Can hinder our acceptance or denial of the truth

“I once owned a small-‐cap value investment and it was a s?nker…I’ll never buy one of those again.”

“My father got burned in the bond market…there’s no way I’ll ever buy fixed income.”

“I only purchase investments that are within the top quartile.”

Prejudice: “I know what I know”

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–  The manner in which a choice has been presented

–  Framing is evident in what is known as the “money illusion”

•  Excitement about a 10% raise when the rate of infla?on is 12% rather than with a 5% raise when the rate of infla?on is at 3%.

Examples of Framing

•  Half-‐empty vs. Half-‐full

•  50% chance of success vs. 50% chance of failure

•  $3 a day vs. $1,095 a year

Framing

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It’s not what you say, but how you say it.

Source: FactSet. Past performance is no guarantee of future results. The charts provided is for illustra6ve purposes only and represents unmanaged indices in which investors cannot directly invest. The S&P 500 Index is an unmanaged index of 500 stocks that is generally representa?ve of the performance of larger companies in the U.S. Please note an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charge.

S&P 500 performance 12/31/05 to 12/31/12

Patern recogni?on: ‘I see, therefore I think’

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When logic isn’t enough:

Decisions based on faulty judgment – Mental accoun?ng –  Heuris?cs

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Source: Legg Mason, 2013. A CD is a debt instrument issued by a bank that usually pays an interest rate set by compe??ve forces in the marketplace. CDs are FDIC-‐insured up to $100,000, offer a fixed rate of return, but may be subject to fluctua?ng rates and early withdrawal penal?es.

* Illustra?on based on research from “Toward A Posi?ve Theory of Consumer Choice,“ by Richard H. Thaler, Journal of Economic Behavior and OrganizaCon, Vol. 1: pp. 39-‐60. 1980.

Mental accoun?ng: ‘everything is in its place’

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Heuris?cs: You can’t compare apples to oranges

* There are special considera?ons associated with inves?ng in emerging markets, including risks related to currency fluctua?ons and adverse social and poli?cal developments. Furthermore, the securi?es markets of emerging markets countries are substan?ally smaller, less developed, less liquid and more vola?le than securi?es markets of the U.S. and more developed countries.

•  Heuris?cs are simple rules that people use to make decisions when facing complex problems or incomplete informa?on.

•  For instance, many people tend to believe in “the more expensive the beverage the beter it tastes.”

Would you use the same criteria to select an emerging market investment* as a U.S. “blue-‐chip” stock? Or do you consider other criteria?

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Lessons for investors

•  Lesson 1: –  Work with a trusted financial advisor

•  Lesson 2: –  Iden?fy your goals, your ?me horizon and your tolerance for risk

•  Lesson 3: –  Don’t let emo?ons drive your decisions

•  Lesson 4: –  Focus on building wealth instead of reducing losses

•  Lesson 5: –  Understand your percep?ons

•  Lesson 6: –  Avoid “mental accoun?ng”

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“When I let go of what I am, I become what I might be”

― Lao Tzu

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