4 psifinance behavioral finance course mitroi 2015

8/9/2019 4 PsiFinance Behavioral Finance Course Mitroi 2015

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Master Programs, ASE, 2014-2015

Behavioral Finance

A Psi Finance Perspective on Investment Management

Dr. Adrian T. Mitroi, CFA


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Course 4Investment

ManagementEconomics

2ASE, Facult of Finance, Master Pro rams, Course and Seminars onA lied Behavioral Finance, ASE, 2014 PsiFinance and Investment Finance Adrian Mitroi CFA PhD


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Dire Straits of 2008/9/10/11/12/13/14.. Dire Straits of last period: deeper, longer than expected recession

The rational expectations are form by two methods:-Intellectual reasoning and evaluation, logical processing of information(sector, specific, market) construction of opinion on intrinsic value of asset

-Estimation of psychological reasoning of other participants behavior; their

actions can have a decisive effect on own success or failure; formation ofexpectations is subjected to time pressure and omniscient uncertainty

Even-driven investor perception is shaped by the autobiographicmemory; the memory register records events in a highly organized andselective manner, based on their emotional significance and relevance

The outcome of the events is perceived in the light of experience andpossible repercussions of an eventual decision

Information processing is performed at the semantic level (personalknowledge accumulated during lifetime) and then at emotional level

(autobiographic memory and personal experiences during lifetime)3

ASE, Facult of Finance, Master Pro rams, Course and Seminars onA lied Behavioral Finance, ASE, 2014 PsiFinance and Investment Finance Adrian Mitroi CFA PhD


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Investment is a risky business

Financial behavior analysis relaxes the fundamental analysisrequirement for convergence of price and value.The difference between the two is seldom systematic, so itcan be exploited by a rational and disciplined investor

Can an informed investor make money systematically byexploitation of behavioral, cognitive and psychologicalinefficiencies of the market?

There can be no reward, without risk. Gaining an advantageover so many skilled and knowledgeable competitors, in a

free market, is extraordinary difficult

Managing in bear market is the skill. Bear correlations caneasily destroy the hard earned return



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Highest velocity ever of a market reactionMay 6, 2010

(the panic, the fat finger and the revenge of the machines)

A big block of P&G (2:30), followed by another hugeblock, right before the market crashed, then, nothing,probably sell orders, big enough to blow all the bids,for a few minutes, buyers just disappeared

Existing stop-loss orders on P&G forced selling into ano-bid market

Every $1 change in price in a stock, results in a 7.56(1/0.132319125) change in DJIA

Worst timing: stocks had started selling off earlier,

panicked. The velocity/severity triggered stop-lossselling, feeding on itself

Even as P&Gs share price was recovering, bidswere falling rapidly in the other 29 Dow components;at one point was down 997



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Valuation does matter(both assets and liabilities)

How to measure the value of pension obligations in todaysassets? what investment returns that will be earned from fundsset aside today?

Generous assumptions on returns - higher discount rates, lead

to smaller liabilities; returns may never be earned Aggressive discounting dramatically shrinks liabilities; when it

is too good to be true, it is

P/Es may decline under significantly lower as well as higher

real interest rates, and under falling rates

Pensions in real terms could experience a drop in funded ratiosdeclining asset values and rising liabilities



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Discount rate and the investment

risk of a LT investment portfolio

A pension that has to pay 10,000 in 50 years whichdiscounts that obligation at 4 % will show that obligation intodaysmoney at 1,400; the use of 7 % rate reduces that toonly 340 today, but 10,000 remains

IFRS: discount rate should be determined by reference tomarket yields on high quality corporate bonds with similar

durations to those of benefit obligations

Where a deep market of highly quality corporate bonds do notexist (CEE) pension companies are required to account forthe yield on government bonds when selecting discount rate



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Mismatching Assets and Liabilities

If A and L do not have same growth, deficit has to be made

up by higher contributions, but how you value liabilities?market indexes do not reflect pensioner unique liabilityschedule, true investment objective

The funded ratio: market value of A/market value of L(custom not market); mismatch can lead to large deficit,distorted, inadequate asset allocation; in loss domain,people assume undue risk

By using the wrong benchmark the portfolio returnsinadequate information ratio; can still beat a market indexwith assets but still underfund with liabilities; the pensionobjective should be liability driven not asset driven



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Quantifying Capital Market Expectations

Correlation

with OtherAssetClasses

StandardDeviation

ExpectedReturn

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Strategic Asset Allocation (SAA)

Cash

Equities

Bonds

Real Estate

AlternativeInvestments

Strategic asset allocation (SAA) is a means to providingthe investor with exposure to the systematic risks of assetclasses in proportions consistent with the IPS.

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Defining an Asset Class

Bonds

Government

Domestic

Foreign

Corporate

InvestmentGrade

High Yield

Are all of these specifications

necessary?

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Asset Classes

Allocation maters more than selection

Asset class correlation matrix:

High-paired correlations between equity asset classessuggest that defining equity asset classes narrowly haslimited value.

The case for treatment as a separate asset class canbest be made for emerging/frontier market stocks.

A B C D E F G H I J K L

A. MSCI Europe 1.00 0.77 0.95 0.97 0.88 0.20 0.59 0.08 0.35 0.10 0.29 0.01

B. MSCI Emerging Markets 0.77 1.00 0.82 0.83 0.76 0.35 0.63 0.18 0.25 0.22 0.20 0.11

C. MSCI World 0.95 0.82 1.00 0.96 0.97 0.25 0.69 0.00 0.31 0.18 0.27 0.06

D. MSCI EAFE 0.97 0.83 0.96 1.00 0.88 0.27 0.65 0.01 0.34 0.15 0.29 0.05

E. MSCI U.S. 0.88 0.76 0.97 0.88 1.00 0.20 0.70 0.01 0.27 0.18 0.24 0.06

F. Commodities 0.20 0.35 0.25 0.27 0.20 1.00 0.27 0.25 0.04 0.14 0.07 0.14

G. Real Estate 0.59 0.63 0.69 0.65 0.70 0.27 1.00 0.18 0.01 0.40 0.02 0.32

H. Gold

0.08 0.18 0.00

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0.01 0.25 0.18 1.00 0.21 0.30 0.12 0.14I. U.S. Treasuries 0.35 0.25 0.31 0.34 0.27 0.04 0.01 0.21 1.00 0.67 0.78 0.55

J. U.S. Investment Grade 0.10 0.22 0.18 0.15 0.18 0.14 0.40 0.30 0.67 1.00 0.61 0.79

K. European Government Bonds 0.29 0.20 0.27 0.29 0.24 0.07 0.02 0.12 0.78 0.61 1.00 0.83

L. European Investment-Grade Corporates 0.01 0.11 0.06 0.05 0.06 0.14 0.32 0.14 0.55 0.79 0.83 1.00

Annualized Volatility 16.6% 20.7% 15.0% 15.4% 15.7% 25.4% 18.9% 16.6% 5.0% 6.0% 3.1% 3.2%

Sources: MSCI, NAREIT, Barclays Capital, Standard and Poors

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Tactical Asset Allocation and Security

Selection

StrategicAsset

Allocation

- - - -

Tactical

AssetAllocation

SecuritySelection

Nonsystematicrisk factors

Systematicrisk factors

Marketreturn:passiveinvesting or

indexing

Excessreturn or

alpha:activeinvesting

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Can Security Selection Add Value?

ValueAdded by

SecuritySelection

ValueLost bySecuritySelection

Zero

At the macro level,security selection is azero-sum game.

What factors affect the ability to addvalue via security selection?

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4 psifinance behavioral finance course mitroi 2015

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