Financial Market Actors: Cognitive Biases, Portfolio Diversification and Forecasting Ability
by Thomas Nahmer
Date of Examination:2019-04-26
Date of issue:2019-05-10
Advisor:Prof. Dr. Kilian Bizer
Referee:Prof. Dr. Kilian Bizer
Referee:Prof. Dr. Markus Spiwoks
Referee:Prof. Dr. Holger A. Rau
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Description:Financial Market Actors: Cognitive Biases, Portfolio Diversification and Forecasting Ability
Abstract
English
For investments in the capital markets, portfolio theory (Markowitz, 1952) plays a significant role and continues to form an important basis for decisions on the structuring of investment portfolios. For risk-averse investors, diversifying the contents of their portfolio is a meaningful strategy. This applies whenever the direction of future price trends is uncertain, because diversification is pointless when market movements are highly predictable. In that case the optimal strategy would be to invest solely in the security with the highest expected increase in value (Markowitz, 1991). In practice, however, investors continue to hold underdiversified portfolios which contradict the basic tenet of portfolio theory. The first three studies of this cumulative dissertation address different aspects of portfolio management. In the first study, a simulated calculation is used to examine the suitability of fine wine as a means of diversification. The results for the periods indicated are sobering. The inclusion of fine wine leads - at an index level - to only a slight improvement of the annualised return, but to a marked increase in risk. When considering the real investment, the considerable costs of an investment in fine wine come to bear. The second contribution examines the influence of herding, status-quo bias and gambler’s fallacy on diversification behavior. Neither herding nor status-quo biases significantly contribute to non-optimal portfolio choices. Gambler’s fallacy, however, plays an important role in these decisions. Many participants are zealous to notice patterns in a history of random events and to infer from these pattern the sequence of future events. And in the third study, a method to improve the measuring of the risk preference of subjects is presented. Experimental research on diversification behavior requires a clear differentiation between risk-averse, risk-neutral and risk-loving subjects, because decisions which can be absolutely meaningful for a risk-loving subject are completely inconceivable for a risk-averse subject and vice versa. The procedures previously used to determine risk preference exhibit a number of weaknesses. Therefore in the third contribution a new procedure for the determination of risk preference is proposed. The fourth study deals with the influence of mood on the tendency towards herd behavior in the context of share price forecasts. It is shown that mood really does have an influence on the tendency towards herding behavior. A neutral mood in particular favors a tendency towards herd behavior. Finally, the fifth study evaluates real interest rate forecasts for the Asia-Pacific region in order to be able to assess the forecasting skills of the financial analysts. Overall it can be stated that - at least in some countries and for some forecast horizons - forecasts of future interest rate trends in the Asia-Pacific region are more successful than those made in other parts of the world.
Keywords: behavioral finance; cognitive biases; experimental economics; investor rationality; portfolio choice; fine wine; index fund; bid-ask Spread; portfolio diversification; risk preference; herding; status-quo bias; gambler's fallacy; emotions; mood; forecast accuracy