Stacey Gilbert from Susquehanna and Ilya Feygin from WallachBeth Capital teamed up to talk about Behavioral Finance at Cboe RMC today in Bonita Springs, FL. 

Stacey started out with an experiment discussing certain and probable wins and losses.  The point was to show that the expected rationality of decisions breaks down in certain situations.  She then mentions Prospect Theory which is basically the study of how people made decisions.  Specifically, she talked about loss aversion.  Her ultimate point was that through not making purely rational decisions we introduce volatility into our portfolio. 

A very interesting piece of data that Stacey shared was that out of the money puts actually are less likely to finish in the money than out of the money call options.  We operate with the assumption that downside options are riskier to sell, but this may be more accurate on the call side.     

Ilya took over and asked, “Why does behavioral finance matter?”  Mainly because it challenges assumptions of traditional finance that center around us always being rational, efficient, and unbiased decision makers.  Also, there is asymmetrical reactions to losses versus gains.  Markets over and under react to information creating momentum.  People’s reactions are skewed by recent volatility which shows up in risk premium pricing. 

Speaking about the most relevant biases these days he highlighted investor sentiment, availability bias, frame dependence and mental accounting, herding, representativeness bias, errors made by investment committees, and limits to arbitrage, segmentation, and constrained investors.

An example of investment sentiment is that literature shows growth stocks underperform when sentiment is high.  Availability bias shows up in repricing of relative volatility levels.  An example of frame dependence and mental accounting is people believing a diversified portfolio has less risk than a small weighting in short volatility plus fixed income.  Factor based investing (low volatility or high beta) is a current day example of herding.  Representativeness bias can work its way into investing through thinking companies, strategies, or rebalancing methods are ‘good’.  Investment committee decisions usually err on the side of being safe.