“Inevitably, [investors] lose out on a better opportunity while waiting for ‘their’ stock to fight back.” Leading Wealth Advisor Nancy E. Cooley, Senior Vice President and Financial Advisor Falisha I. Mamdani, Senior Vice President and Financial Advisor Jason M. Friedman, Vice President and Financial Advisor You may remember Eugene Fama from Econ 101. He argued that in an efficient market that includes equally well-informed and rational investors, securities will be appropriately priced to reflect all available data1. The rejection of the theory is represented by another breed of market analyst who believes markets are inherently inefficient, and prices are not always an accurate reflection of the intrinsic value of securities. Enter behavioral finance, which seeks to understand how investor psychology influences decisions and which might better explain anomalies like bubbles and crashes. A common bias that affects even the most seasoned investor is anchoring2, or placing too much emphasis on one factor or trait when making a decision. Loss aversion 3 is a typical example of anchoring; investors get anchored to their cost basis and are so intent on breaking even, they lose focus on whether the security is still a good long-term investment. Inevitably, they lose out on a better opportunity while waiting for “their” stock to fight back. ” Confirmation bias, or seeking out information that supports one’s own view, undermines the rational decision-making process. In this scenario, bullish investors seek out positive data points, whereas bearish investors find negative data points. 4 Similar to confirmation bias is herding behavior, which is most often characterized as both irrational and driven by emotion. Periods of panic buying or selling are examples of extreme market sentiment in which there is a clear disconnect between prices and fundamentals. These are, in our opinion, the critical times for investors to recognize the psychology of the markets and to avoid the pitfalls of emotional decision making. The “recency effect”5 refers to investors placing greater relative importance on events that have occurred in the recent past. In our view, the crash of 2008 has spawned a cottage industry of bubble hunting even though a repeat of a wholesale market drawdown of a similar magnitude is unlikely, statistically speaking. Linked to this bias is herding behavior,6 for example, investors who overreact and shift completely out of an asset class, i.e., equities, to protect against a disastrous loss instead of looking at the potentially greater risk of inflation. This leads investors to irrationally prepare for a devastating event with a 5 percent probability of occurring and to ignore the more mundane 50 percent event. Lastly, we draw attention to the concept of money illusion. 7. For example, let us say an avid movie fan invested in a bond 10 years ago that pays $5 interest per year to purchase one ticket. Fast forward 10 years. Our fan is stuck watching matinees because his $5 interest payment no longer covers a primetime movie. He did not lose any money, but in real terms he lost purchasing power. The CMF Group continues to stress the importance of taking in all available information when making decisions and structuring tactical portfolios with as little emotional overlay as possible. We believe this is the best way to avoid the biases that can stand in the way of prudent and thoughtful active management. http://www.dimensional.com/famafrench/2009/08/fama-market-efficiency-in-a-volatile-market.html, Journal of Finance, May 1970: Efficient Capital Markets: A Review of Theory and Empirical Work; 2 Tversky, A. & Kahneman, D. (1974), Judgment under uncertainty: Heuristics and biases. Science, 185, 1124-1130; 3 Kahneman, D., Knetsch, J., & Thaler, R. (1990), Experimental Test of the Endowment Effect and the Coase Theorem, Journal of Political Economy 98(6), 1325-1348; 4 Zweig, Jason (November 19, 2009), How to Ignore the Yes Man in Your Head, Wall Street Journal (Dow Jones & Company), http://online. wsj.com/article/SB10001424052748703811604574533680037778184.html, retrieved 2010-06-13; 5 Murdock, B.B., Jr. (1962) The Serial Position Effect of Free Recall, Journal of Experimental Psychology, 64, 482-488; 6 Markus K. Brunnermeier, Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding, Oxford University Press (2001); 7 John Maynard Keynes, Fisher, Irving (1928), The Money Illusion, New York: Adelphi Company. Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Smith Barney financial advisors do not provide tax or legal advice. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their personal tax or legal advisors to understand the tax and related consequences of any actions or investments described herein. The views expressed herein are those of the author and do not necessarily reflect the views of Morgan Stanley Smith Barney or its affiliates. All opinions are subject to change without notice. Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. Past performance is no guarantee of future results. © 2011 Morgan Stanley Smith Barney LLC, member SIPC. 1 – The CMF Group The CMF Group at Morgan Stanley Smith Barney By The CMF Group at Morgan Stanley Smith Barney Reach Nancy at 212.315.6228, Falisha at 212.315.6253, or Jason at 212.307.2853. We look forward to serving as a resource for you. live “ What is behavioral finance, and should it matter to me? How to reach The CMF Group grow The CMF Group at Morgan Stanley Smith Barney make New York, NY Left to right: Jason M. Friedman, Nancy E. Cooley and Falisha I. Mamdani About The CMF Group Nancy E. Cooley, Falisha I. Mamdani and Jason M. Friedman, of The CMF Group, are advisors within Morgan Stanley’s Private Wealth Management Division. With 57 years of combined industry experience, they provide customized wealth management solutions for individuals, families and institutions. Ms. Cooley, a senior vice president and a senior investment management consultant, has been named among Barron’s top 100 women financial advisors since 2006. A native of the San Francisco area, she graduated from UC Berkeley. Ms. Mamdani, a senior vice president and a senior investment management consultant, was one of Barron’s top 100 women financial advisors in 2006 and 2009. Born in Tanzania and raised in Bahrain, she graduated from Sevenoaks School in the United Kingdom and Brown University. Mr. Friedman is a vice president and an investment management consultant. A native of Long Island, N.Y., he is a graduate of the University of Maryland and has an MBA degree from the Stern School of Business at NYU. Assets Under Management $800 million (as of 1/2011) Compensation Method Asset-based fees and commissions (insurance products) Minimum Net Worth Requirement $5 million Primary Custodian for Investor Assets Morgan Stanley Smith Barney Largest Client Net Worth Confidential (available on request) Professional Services Provided Planning, investment advisory and money management services Financial Services Experience Cooley, 29 years; Mamdani, 20 years; Friedman, 8 years Email nancy.cooley@morganstanleypwm.com falisha.mamdani@morganstanleypwm.com jason.friedman@morganstanleypwm.com The CMF Group at Morgan Stanley Smith Barney 590 Madison Avenue, 11th Floor, New York, NY 10022 worth.com 212.315.6228 october-november 2011 101