FinQuiz - Smart Summary, Study Session 3, Reading 9

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2013, Study Session # 3, Reading # 9

BEHAVIORAL FINANCE AND INVESTMENT PROCESSES

2. THE USES AND LIMITATIONS OF CLASSIFYING INVESTORS INTO TYPES

Risk own capital to gain

wealth.

Prefer to maintain control of

own investments.

Risk tolerance.

2.1 General Discussion of Investor Types

Models of Investor Psychographics

2.1.1 Barnewall Two-Way Model 2.1.2 Bailard, Biehl, and Kaiser Five-Way Model

Passive Investors Active Investors

Investors who have become

wealthy passively.

Risk averse and have a

greater need for security.

Whether then investor is

methodical, careful &

analytical in his approach to

life.

Method of action can range

from carful to impetuous.

Confident axis Careful-impetuous axis

How confidently investor

approaches life.

Emotional choices.

Investor Personality Types

The Adventurer The Celebrity

Might hold highly concentrated portfolios.

Willing to take chances & likes to make own

decisions.

Advisors find them difficult to work with.

Like to be the center of attention.

Might have opinions but recognizes limitations.

Willing to seek & take advice about investing.

The Individualist The Guardian

Confident & careful.

Listen & Process information rationally.

Likes to make own decisions after careful

analysis.

Cautious & concerned about the future.

Concerned about protecting their assets.

Seek advice of someone they perceive as more

knowledgeable.

The Straight Arrow

Sensible & secure.

Willing to take risk for expected return.

Two Methods

Bottom-Up Approach Top-Down Approach

Test for all behavioral biases in the client.

Create an appropriate IPS & behaviorally

modified asset allocation.

May be time consuming or complex.

Called behavioral alpha approach.

Simple & more efficient than a bottom-up

approach.

Determine type of bias in the client & how to

correct for or adapt to the biases.

2.1.3 Behavioral Finance and Investment Processes Behavioral Investor Types

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Step in Top-Down Approach

Step 1 interview the client & identify active or passive traits & risk tolerance.

Step 2 the investor on the active/passive & risk tolerance scale.

Step 3 tests for behavioral biases.

Step 4 Classify investor into a behavioral investor type.

Passive Preserver (PP)

Low risk tolerance & are subject to emotional biases.

Emphasis on financial security & preserving wealth.

Most common emotional biases to PPs:

Endowment, loss aversion, status Quo & regret aversion.

Cognitive errors:

Anchoring & adjustment & mental accounting.

Advising Passive Preserver

Difficult to advice (driven mainly by emotion).

Receptive to big picture advice.

Friendly Follower (FF)

Passive investors with low to medium risk tolerance.

Cognitive biases.

Prefer popular investments.

Overestimate risk tolerance.

Influenced by availability, hindsight, framing & regret aversion biases.

Advising Friendly Followers

Difficult to advise (overestimate their risk tolerance).

Education is usually the best course of action (cognitive errors).

Independent Individualist

Active investor with medium to high risk tolerance.

Strong willed & independent thinker (maintain their opinions).

Most likely to be contrarian & typically subject to cognitive errors.

Advising Independent Individualists

Difficult to advice but usually willing to listen to sound advice.

Regular educational discussion is effective

Active Accumulator

Active investor with high risk tolerance.

Most aggressive investors & primarily subject to emotional

biases.

Quick decision makers with risky investments.

BF = Behavioral Finance BB = Behavioral Biases

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Advising Active Accumulator

Most difficult client to advise (like control).

May lack self control.

Best approach to deal take control of the situation.

2.2 Limitations of Classifying Investors into Various Types

Individuals may simultaneously display both emotional & cognitive biases.

Might display traits of more than one behavioral investor type.

As investors age, they will most likely go through behavioral changes.

Two individuals with same behavioral investor type are likely to require unique

treatment.

Individuals, tend to act irrationally at unpredictable time.

3. HOW BEHAVIORAL FACTORS AFFECT ADVISER- CLIENT RELATIONS

Goal of the client/adviser relationship construct a portfolio with

which a client is comfortable.

Portfolio should serve the clients longer term goals.

BF can enhance the following important areas of every successful

advisory relationship.

3.1 Formulating Financial Goals

BF helps the adviser understand the reasons for the clients goals.

3.2 Maintaining a Consistent Approach

BF adds structure & professionalism to the relationship.

3.3 Investing as the Client Expects

Area that can be most enhanced by incorporating BF

Adviser is fully awared of what actions to perform &

what information to provide.

3.4 Ensuring Mutual Benefits

Incorporating BF into client/adviser relationship act as a

closer bond b/w them.

3.5 Limitations of Traditional Risk Tolerance Questionnaires

Risk tolerance questionnaires:

Ignore behavioral issues.

Can generate different results when applied repeatedly.

May not be revised.

Adviser may interpret the results of such questionnaire too literally.

May work better for institutional investors.

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4. HOW BEHAVIORAL FACTORS AFFECT PORTFOLIO CONSTRUCTION

BB affects how investors construct

portfolio from the securities available

to them.

4.1 Inertia and Default

In most DC plans members show inertia & dont their asset allocation.

Target date funds fund that automatically switch from risky

assets to fixed income assets as the plan member nears the

intended retirement date.

Standardized strategy (one size fits all solution).

4.2 Naive Diversification

Allocating an equal proportion of assets to each fund

alternative.

Also called 1/n nave diversification strategy & often used by

DC plans.

Conditional 1/n strategy allocation equally among chosen

subset of funds.

Such strategies minimize future regret from one asset class

beating the other.

4.3 Company Stock: Investing in the Familiar

Reasons why employees have a tendency to invest in their

companys stocks:

Familiarity bias.

Overconfidence.

Naively extrapolate past returns.

Framing.

Loyalty effect & financial incentives.

4.4 Excessive Trading

Investors with retail accounts appear to be more active trades

(overconfidence which leads to excessive trading).

Disposition effect selling winners too soon & holding losers

too long.

4.5 Home Bias

Proportion of assets in the stocks of firms listed in home

country.

Closely related to familiarity.

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5. BEHAVIORAL FINANCE AND ANALYST FORECASTS

Undue faith in forecasting ability.

Several behavioral biases that contribute to overconfidence:

Illusion of knowledge bias.

Self attribution bias.

Representativeness bias

Availability bias.

Hindsight bias.

5.1 Overconfidence in Forecasting Skills

Self calibration process of remembering previous forecasts

more accurately.

Well structured feedback, unambiguous forecasts &

systematic review process can reduce hindsight bias.

Counter arguments, appraisal by colleagues, superiors as well

as self appraisal can help to control overconfidence.

Incorporate additional information with a Bayesian approach.

5.1.1 Remedial Actions for Overconfidence and Related Biases

The way a companys management frames information can

influence how analysts interpret it & include it in their forecasts.

Three cognitive biases frequently seen when management

reports company results:

Framing

Anchoring & adjustment

Availability

Analysts should also look for self attribution bias that arises from

the impact of incentive compensation on company reporting.

5.2 Influence of Company's Management on Analysis

Biases are usually related to analysts collecting too much information

some biases are:

Illusion of knowledge & control.

Representativeness bias.

Confirmation bias.

Gamblers fallacy thinking that there will be a reversal to long-

term mean more frequently than actually happens.

Hot hand fallacy wrongly project continuation of a recent trend.

Endowment bias.

5.3 Analyst Biases in Conducting Research

Focus on more objective data.

Collect information in a symmetric way.

Assign probabilities to base rates.

Consider the search process, limits & context of information.

Prompt feedback & document decision making.

5.3.1 Remedial Actions for Analyst Biases in Conducting Research

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In a group setting, the individual biases mentioned before can be

either diminished or amplified with additional biases being created.

Social proof bias bias in which individuals are biased to follow the

beliefs of a group.

Typically a group will have more confidence in its decisions (leads to

overconfidence bias).

6. HOW BEHAVIORAL FACTORS AFFECT COMMITTEE DECISION MAKING

Committee decision can be improved by carefully analyzing

& learning from past decisions & good quality feedback.

Changing committee membership can be unhelpful.

6.1 Investment Committee Dynamics

Committee should be made up of members from diverse

backgrounds.

Ensure professional respect & analysts self esteem.

Collect individual views in advance of discussion (can

suppressed privately held information).

6.2 Techniques for Structuring and Operating

Committees to Address Behavioral Factors

Anomalies are identified by persistent abnormal returns that

differ from zero & are predictable in direction.

Some apparent anomalies may be explained by:

Small sample involved.

Selection or survivorship bias.

Data mining.

7. HOW BEHAVIORAL FINANCE INFLUENCES MARKET BEHAVIOR

Momentum effect pattern of returns that is correlated

with the recent past.

Return are +vely correlated in short term (up to 2 years) &

-vely correlated in long term (revert to the mean).

Several forms of Biases.

Herding

Availability bias (extrapolate trends).

Hindsight bias (trend chasing effect).

Disposition effect (mean reversion at longer periods

of three to five years).

7.2 Momentum

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Bubble & crashes respectively periods of unusual +ve or ve return.

Bubbles typically develop more slowly relatively to crashes (due to

difference in behavioral factor involved).

A no. of cognitive & emotional biases during such periods are:

Overconfidence.

Confirmation & self attribution bias.

Hindsight.

Illusion of knowledge.

Disposition effect.

Anchoring.

7.3 Bubbles and Crashes

Studies have identified that the value stocks have outperformed relative

to growth stocks.

Halo affect investor transfers favorable company attribute into thinking

that the stock is a good buy.

Behavioral explanations present the anomalies as mispricing rather than

risk.

Overconfidence in predicting growth rates (growth stocks over valuation).

Home bias anomaly investors favor investing in domestic country as

compared to foreign countries.

7.4 Value and Growth

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FinQuiz - Smart Summary, Study Session 3, Reading 9