As you may have noticed from my previous posts, I've been taking a course in Behavioural Finance.* Yesterday, the professor announced that he wasn't going to mark and give back our earlier assignments, but instead he would mark them based on effort, and that as he was happy with everyone's effort he was going to award everyone full marks.
First, I found this quite upsetting and indeed insulting. My group and I had worked very hard on our assignments and had produced work that was, in my subjective opinion, of an exceptionally higher standard than what was presented by others in the class. To have that effort rendered worthless was very frustrating.
Second, the irony is that I suspect the reason for switching to effort-based marking is because the professor does not want to expend the effort to read, review or mark our work - in which case, he deserves an exceptionally low grade for his effort.
Argghhh... okay, frustration vented.
*I've also been doing a class on fixed income securities. If you've been wondering why I haven't blogged about this class, it's because it's hard to find exciting things to blog about in fixed income. That's not to say fixed income isn't exciting (after all, there's nothing quite like building and flexing yield curves for excitement...), but I'm not sure what I could say exciting things about fixed income - unless anyone's interested in discussing the application of the Vasicek model of short-term interest rates? Anyone? Anyone? Bueller? Bueller?
Friday, 18 February 2011
Saturday, 5 February 2011
The unsinkable Titanic...
Since my last post on behavioural finance was such a hit, I thought I would share a gem from a recent case study.
A common trait among individuals is to be over-confident of their abilities. For example, the majority of individuals would say that they are safer than average drivers, which is of course statistically impossible.* This is also observed amongst investors; they are overconfident of their ability to pick successful investments. This can often be seen in over-trading amongst retail investors - rather than investing in long-term value they are trying to pick short-term investments. This can lead to much higher frequency of trading, which reduces net returns because of the additional transaction costs incurred. (Interestingly, this seen more prevalently among men than women - although both do it. Also, the data shows that for men, the tendency to overtrade is reduced after men get married.)
Although the above uses an example from retail investors, overconfidence can also be seen among institutional investors. It's so prevalent, in fact, that some fund managers deliberately set out to trade upon it. For example, a recent case study I've looked at focused on the asset management arm of a big Wall Street bank which set up a number of funds specialising in using behavioural finance. This an excerpt from the comments of the head of the behavioural finance team:
"Our approach, which forces our funds to systematically overweight value stocks, means that our investment behaviour is changed. We are forced to focus on out of fashion stocks that we wouldn't naturally have bothered with and that means that we cannot fall into the same overconfidence trap."
This amused me.
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* I'm not sure that this is "irrational". Rather, people base their assessment of the likelihood of their having or causing an accident on their past experience. They may never have had an accident, or any accidents sufficiently long ago for them to be discounted - e.g. "I've grown up and matured since then". I expect few individuals know what the average likelihood of having or causing a traffic accident is (I don't). Also, this is an example that can be misused; I've often seen it phrased as "better driver", but the measure itself is then subjective - different drivers might rank on different measures - e.g. ability to drive at speed, likelihood to have an accident, ability to offer a smooth ride, or the extent to which they are law-abiding.
A common trait among individuals is to be over-confident of their abilities. For example, the majority of individuals would say that they are safer than average drivers, which is of course statistically impossible.* This is also observed amongst investors; they are overconfident of their ability to pick successful investments. This can often be seen in over-trading amongst retail investors - rather than investing in long-term value they are trying to pick short-term investments. This can lead to much higher frequency of trading, which reduces net returns because of the additional transaction costs incurred. (Interestingly, this seen more prevalently among men than women - although both do it. Also, the data shows that for men, the tendency to overtrade is reduced after men get married.)
Although the above uses an example from retail investors, overconfidence can also be seen among institutional investors. It's so prevalent, in fact, that some fund managers deliberately set out to trade upon it. For example, a recent case study I've looked at focused on the asset management arm of a big Wall Street bank which set up a number of funds specialising in using behavioural finance. This an excerpt from the comments of the head of the behavioural finance team:
"Our approach, which forces our funds to systematically overweight value stocks, means that our investment behaviour is changed. We are forced to focus on out of fashion stocks that we wouldn't naturally have bothered with and that means that we cannot fall into the same overconfidence trap."
This amused me.
---
* I'm not sure that this is "irrational". Rather, people base their assessment of the likelihood of their having or causing an accident on their past experience. They may never have had an accident, or any accidents sufficiently long ago for them to be discounted - e.g. "I've grown up and matured since then". I expect few individuals know what the average likelihood of having or causing a traffic accident is (I don't). Also, this is an example that can be misused; I've often seen it phrased as "better driver", but the measure itself is then subjective - different drivers might rank on different measures - e.g. ability to drive at speed, likelihood to have an accident, ability to offer a smooth ride, or the extent to which they are law-abiding.
The King's Prisoners
Trapped in a fairytale nightmare, you have been caught by the King of a far away land. Fortunately, it is his birthday and as is his custom, he's going to let one of his prisoners free. However, this year he has decided he will set free the wisest and most worthy of his prisoners.
So he takes you and his other two prisoners to the highest room of the highest tower of his great dark castle. It's a round room, and he's had three sets of chains built into the walls. You and the other prisoners are put in the chains so that each prisoner can see the other two prisoners. The King then brings out five little dots for all to see; three of them are white, two of them are black. "I shall put one of these dots on each of your foreheads. The first of you to tell me what colour the dot on his forehead is shall be set free! Even more, I shall give a banquet in honour of his wisdom!" says the King. Then he has you and the other prisoners blindfolded, and puts a dot on your forehead and those of the other prisoners. The blindfolds are removed...
How will you escape?
So he takes you and his other two prisoners to the highest room of the highest tower of his great dark castle. It's a round room, and he's had three sets of chains built into the walls. You and the other prisoners are put in the chains so that each prisoner can see the other two prisoners. The King then brings out five little dots for all to see; three of them are white, two of them are black. "I shall put one of these dots on each of your foreheads. The first of you to tell me what colour the dot on his forehead is shall be set free! Even more, I shall give a banquet in honour of his wisdom!" says the King. Then he has you and the other prisoners blindfolded, and puts a dot on your forehead and those of the other prisoners. The blindfolds are removed...
How will you escape?
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