INVESTOR BEHAVIOUR

AND BENCHMARKS

Presentation to Finansmarkedsfondet
Executive Board

Sari Carp
Norwegian School of Management (BI)

8 December 2005
 PART I:

Background on Behavioural Finance

Isaac Newton (losing investor in the
South Sea Bubble):

“I can calculate the motions of the

heavenly bodies, but not the madness
of people.”
 Three Viewpoints on Market Efficiency
(borrowed from Richard Thaler)

1) Efficient Market Zealot (vanishing breed)

 Security prices are always equal to intrinsic value.
 Price movements are random, and hence unpredictable.

2) Behavioural Finance Zealot (figment of EMZs’

imaginations)
 Prices depend only on market psychology.
 It is easy to predict price movements.

3) Sensible Middle Ground (nearly everyone)

 Prices are highly correlated with intrinsic value, but
sometimes diverge significantly.
 It is sometimes possible to predict prices, but
generally not with great precision.
 The Development of Behavioural
Finance Research

 Documentation of anomalies
 Theory building: Economics + Psychology

 Testing of theories
 Experimental
 Empirical
 “Bounded” Rationality

Decision Making Rules =
Heuristics


Biases


Market Imperfections =
Anomalies
 PART II:

Investor Behaviour and Benchmarks

 Psychology of Benchmarking

 Fundamental human desire to evaluate one’s own

abilities
 Cannot assess abilities directly, so evaluate the result
of abilities; i.e., performance
 Even if performance can be measured unambiguously
(e.g. time to run a race), how do we know if it’s good?
 compare with others’ times
 If an objective, non-social criterion exists, then
evaluation relative to others is not used
 Focus on a reference point, or goal, decreases as the
difference between it and one’s own ability increases
 Antecedents

 Prospect Theory (Kahneman and Tversky, 1979)

 ascribes value to gains and losses, not total wealth
 decision makers are risk averse in gains, risk seeking in
losses
 pain of loss is sharper than pleasure of gain

 March and Shapira, 1992

 two reference points: aspiration and survival
 decision makers tolerate high risk when resources are
below reference point, lower risk when resources are above
reference point
 decision makers focus only on one of two reference points
at a time
 Model of Investor Risk Behaviour

 Performance (return) evaluated relative to two

benchmarks:
 Success (S)
 Exit (X)

 In each period, investors choose portfolio risk

according to:
 benchmark(s) focused on
 distance from focal benchmark(s)
 Timeline

time 2
portfolio values change
again; Success and Exit
benchmark returns also
change; investors
time 0 restrategize based on
portfolios homog. new values
in value, variance;
heterog. in
assets

time 1 time t
portfolio values evaluation period ends;
change according to investors performing
random walk; below Exit are eliminated
investors choose risk from the market; all
strategies based on others may invest again
own returns relative
to Success and Exit
levels
Risk Taken Relative to Performance Benchmarks

Success Focus
Exit Focus
Mixed Focus
Risk

X S
Performance (Cumulative Return)
Risk Taken Relative to Performance Benchmarks

Risk

X S
Performance (Cumulative Return)
 Mutual Fund Manager Data

Offshore
U.S.
 787 funds (Datastream)
 7,606 funds (CRSP)
 25 countries
 equity and bond
 all equity
 2001-2002
 1993-2002

 actively managed (no index funds)

 single country focus

 Results from Fund Manager Data

 Results support model; highly statistically

significant

 Model holds across economic, political and legal

contexts

 But…how can we know if benchmarking is driven

by behavioural or compensation based factors??

 By comparing individual and institutional

investors, we can “factor out” the compensation
based element
 VPS Data

 Unique in the world

 “Gold mine” for behavioural research!!!
 Some behavioural research has been done on
similar databases from other Scandinavian
countries…but, these databases are incomplete
 Very famous behavioural research has been done
on an individual investor database from a U.S.
brokerage firm…but, this database is both
incomplete and biased
 VPS Data

 Complete database of ownership in Norwegian stock

market
 10 years of monthly portfolios for each investor
 Investors categorized as individual, financial
institution, non-financial corporation, government or
foreign investor
 Tracks each investor by ID over time, allowing
comparisons of investment decisions under same
conditions
 Eliminates sample bias
 Predicted Results on VPS Data

 Both professionals and individuals will take

increased risk as their performance improves
above the Success or Exit points; this result will
be more pronounced for professionals
 Both groups will take increased risk as
performance deteriorated below Success or Exit
points; this result will also be more pronounced for
professionals
 So, the pattern will be the same, but more
extreme for professionals