CFA level 3 study notebook1 2015 2

StudySession 3Cross-Reference to CFA InstituteAssigned Reading#7-The Behavioral Biases of Individuals FurtherImplicationsofBiases onInvestmentPolicyand Asset Allocation Investmentpractit

Professor’sNote:Statusquoand thenext twobiasesare veryclosely related.But

statusquoismaintaining achoiceoutofinertia,while endowment biasarises

whensomeintangible value unrelatedto investment merit isassignedto aholding,

and regret-aversionisjust whatitsays,ifyoumakeachange andit goesbadlyyou

willfeelbad aboutitsodo nothing and thenyou arenot toblame All threecan

leadtothesameresult (keep whatyou have)but thereasonfordoingso isslightly

different.

5 Endowment biasoccurswhenanasset isfelttobespecial andmorevaluable

simply becauseit isalready owned.Forexample, whenonespouse holdsontothe

securitiestheir deceased spouse purchased forsome reasonlikesentimentthatis

unrelatedtothecurrentmeritsof thesecurities.Instudies individuals have been

askedto statetheirminimumsale price foran assettheyown(say$25)and their

maximumpurchase price (say$23).Thefact that they will sellitat apricehigher

thanthey wouldpayhas beenexplainedasendowment Once theyownit,theyact

asifit isworthmorethanthey would pay

Consequences andimplications of endowmentmayinclude:

• Failingtosellaninappropriateassetresultingininappropriateassetallocation

• Holding thingsyouarefamiliar with becausethey providesomeintangiblesense

of comfort

Endowmentiscommonwith inheritedassetsand might be detectedormitigated by

askingaquestion suchas“Wouldyoumake thissameinvestmentwithnewmoney

today?” If inheritedassetsaresignificant holdingsinthe portfolioit maybe essential

toaddress the bias Startingadisciplined diversification program could beawayto

easethe discomfortof sales

6 Regret-aversion biasoccurswhen market participants do nothingoutofexcessfear

thatactionscould bewrong.They attach undue weighttoactionsofcommission

(doing something) and don’t consideractionsofomission(doing nothing) Their

senseofregretand painisstrongerforactsofcommission

Consequences andimplications of regret-aversionmayinclude:

• Excess conservatism inthe portfolio becauseit is easyto seethat riskierassets

doattimesunderperform.Therefore,donotbuy riskierassetsandyouwon’t

experienceregretwhen they decline

• This leadstolong-term underperformance andafailureto meetgoals

• Herding behaviorisaform of regret-aversion where participantsgowith the

consensusorpopular opinion Essentially the participants tell themselves they

are not toblame if othersarewrongtoo.

Regret-aversionmight be mitigated through effectivecommunicationonthe benefits

ofdiversification,theoutcomesconsistentwith the efficient frontier tradeoffof risk/

return,and theconsequencesofnotmeeting criticallong-terminvestmentgoals

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#7-The Behavioral Biases of Individuals

FurtherImplicationsofBiases onInvestmentPolicyand Asset Allocation

Investmentpractitioners who understand behavioral biases haveabetter chanceofconstructing and managingportfolios that benefit normal clients By first acknowledgingand thenaccommodatingormodifyingbiases,moreoptimal resultsarelikely Thisstartswith asking the rightquestions:

• Whatarethe biasesof the client?

• Arethey primarily emotionalorcognitive?

• Howdothey effect portfolioassetallocation?

• Should the biases be moderatedoradaptedto?

• Isabehaviorally modifiedassetallocation warranted?

• Whatarethe appropriate quantifiable modifications?

Goals-Based Investing(GBI)

Professor’sNote: GBIwill be similartothelayersinbehavioralportfoliotheory(BPT).BPTexplained the layersasreflecting whether higherreturn orlower riskwas importanttothegoal GBIstartswith theimportanceofachieving thegoal

GBIstartswithestablishingthe relative importancetothe client of each of the client’sgoals

• Essential needs and obligations should be identified and quantified first Thesewould include essentiallivingexpensesand should bemetwith low riskinvestments

asthe base layer of the portfolioassets.

• Nextmightcomedesiredoutcomessuchasannual givingtocharity whichcanbe

metwithalayer of moderate riskinvestments

• Finally low priority aspirations suchasincreasing the value of theportfoliotoleave

itto afoundationatdeath couldbemetwithhigherriskinvestments

GBI is consistentwith theconceptof loss-aversioninprospecttheory The clientcan seethatmoreimportantgoalsareexposedtoless riskyassetsand less potential loss Itis

better suitedtowealth preservation thantowealth accumulation By utilizing the mentalaccounting of layersto meetgoals, the clientcanbetter understand theconstructionofthe portfolio

BehaviorallyModified Asset Allocation (BMAA)BMAA isanother approachto assetallocation that incorporates the client’s behavioralbiases.Aworst casescenarioformanyclientsistoabandonan investmentstrategy

duringadverse periods Theoutcomecanbeverydetrimental because the change

islikelytooccurat alow point, right beforearecoveryfor thestrategybegins

Determininginadvancea strategythe clientcanadheretoduring adverse periods would

beabetteroutcome.BMAAconsiders whetherit isbettertomoderateoradapttotheclient’s biasesinorderto construct aportfolio the clientcanstick with

BMAAstartswith identifyinganoptimal strategicassetallocationconsistentwith

traditionalfinance It thenconsiderstherelative wealthoftheclient andtheemotional

versus cognitivenatureof the client’s biasestoadjustthat allocation

• Ahigh level of wealthversuslifestyle and what the client considers essential needs

wouldbealowstandardoflivingrisk(SLR).Withalow SLR the clientcanafford

todeviatefromanoptimal portfolio.The richcanaffordtobe eccentric

• Biasesthatareprimarily cognitivein nature areeasiertomodify Working with the

clientcanaccomplish this and allow for less deviation fromatraditionally efficient

portfoliomix.

• Incontrastemotionally basedbiasesaregenerally hardertomodify and may haveto

beaccommodated,resultinginaless efficient portfolio

• Finally theamountof deviationto acceptfromatraditional optimal allocation

shouldbeestablished.Typicallythiswouldbe donebysettingarange in whichan

assetclasscandeviatefromoptimalbefore itmustbeadjusted back.Forexample

supposeanoptimalallocationwould callfor60%equity for theclient

The table belowdemonstrateshow the processcouldbeimplementedinorderto create

an assetallocationthattheclientwillbe abletoadheretoover thelongrun

Figure 1:WhentoAccommodateVersusWhentoModify

Accommodate to orModifythe Biasesof

HighRW and low SLR

HighRWandlow SLR

Low RW andhighSLR

Low RWand highSLR

Emotional Cognitive Emotional Cognitive

Accommodate Some of both Some of both

10 to 15%

5to 10%

5to 10%

• The specific deviation numbers chosenarearbitrary andareintendedtoshow that

low SLR andemotionalbiasescanbe accommodatedwithlarge deviationsfrom the

optimal weights.Theclientcanaffordtoallowtheiremotions tobeaccommodated

• IncontrasthighSLRand cognitiveerrorsrequirethe biases be addressed with the

client and moderatedtoachievea nearoptimalassetallocation Those with low

wealthcannotaffordtodeviate and cognitiveerrors are easier to overcome.

• Theothertwo casesfallinbetween

BF alsouses a setofstandardizedquestionstoidentifythe biasesof each client Ms.

Z showsstrongtendenciesto conservatism,sample-size neglect, framing,endowment,andavailability biases After completing the questions shemeetswithherBFportfoliomanager and asks for further informationregardingthe biases She hasalways enjoyedstudyingnew areasandlearningnewapproachestolife

Recommendwhether her biases should beaccommodatedor modified,andwhetherher portfoliowilldeviatefromatraditional optimalallocation

KEY CONCEPTS

LOS 7.a

Cognitiveerrorsresultfrom theinabilitytoanalyze informationorfrombasing

decisionsonpartial information Individualstry toprocessinformationintorational

decisions,butthey lack the capacityorsufficient informationtodoso.Cognitiveerrors

canbedividedintobelief perseveranceerrorsand processingerrors.Emotional biases

arecaused bythe wayindividualsframe the informationand the decisionrather than the

mechanicalorphysicalprocessusedtoanalyze andinterpretit.Emotional biasismore

CognitiveErrors:Information Processing

• Anchoring and adjustment

• Mental accountingbias

Impact: Slowto react tonew informationoravoidthedifficulties associated with

analyzingnewinformation.Canalso be explainedintermsofBayesianstatistics;place

toomuch weightonthe baserates.

Mitigation:Lookcarefullyatthenewinformation itselftodetermine its value

ConfirmationBias

Impact:Focusonpositiveinformation aboutaninvestmentand ignoreordismiss

anythingnegative Canleadto toomuch confidencein theinvestmentandto

overweightingitinthe portfolio

Mitigation: Actively seekoutinformation thatseems tocontradictyouropinions and

analyzeitcarefully

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#7-The Behavioral Biases of Individuals

RepresentativenessBiasImpact: Place informationintocategoriesutilizinganif-then heuristic Placetoomuchemphasisonperceivedcategoryofnewinformation Likelytochangestrategies basedon

asmall sample of information

Mitigation: Consciously takesteps toavoid baserateneglect andsamplesizeneglect

Consider thetrueprobability that information fitsa category.UsePeriodic Tableof

Investment Returns

Illusion of ControlBiasImpact: The illusion of controloverone’sinvestmentoutcomescanleadtoexcessivetrading with the accompanyingcosts.Canalso leadtoconcentrated portfolios

Mitigation: Seek opinions of others Keep records of tradesto seeif successfulat

controllinginvestmentoutcomes.

HindsightBiasImpact:Overestimate accuracyof their forecasts and taketoomuch risk

Mitigation: Keep detailed record of allforecasts,including the data analyzed and thereasoning behind the forecast

Anchoring and AdjustmentImpact: Tendtoremainfocusedonandstayclosetotheir original forecastsorinterpretations

Mitigation:Givenewinformation thorough considerationtodetermineitsimpacton

the original forecastoropinion

Mental AccountingBiasImpact: Portfolios tendtoresemble layered pyramids ofassets.Subconsciously ignorethe correlationsofassets.May considerincomeand capital gains separately rather than

as partsof thesametotalreturn.

Mitigation: Lookatallinvestmentsasif theyare partof thesameportfoliotoanalyzetheircorrelationsand determinetrueportfolio allocation

FramingBiasImpact: Narrowaframe ofreference;individualsfocuson onepieceor categoryofinformation and lose sight of the overallsituation orhow the information fitsintotheoverall schemeof things

Mitigation:Investorsshouldfocusonexpectedreturnsandrisk,rather thanongainsor

losses That includesassets orportfolios with existing gainsorlosses

AvailabilityBias:Fourcauses areretrievability, categorization,narrowrangeofexperience, andresonance.

Impact: Selectinvestmentsbasedonhow easily theirmemoriesareretrieved andcategorized.Narrowrange of experiencecanleadtoconcentrated portfolios

Mitigation:DevelopanIPSandconstruct asuitable portfolio through diligent research

Loss Aversion BiasMyopic lossaversioncombines theeffects oftimehorizon and framing

Impact: Focuson currentgains and losses.Continuetohold losersinhopes of breakingeven.Sellwinnersto capturethe gains

Mitigation: Performathorough fundamental analysis Overcome mental anguish ofrecognizing losses

Impact:Hold under-diversifiedportfolios;underestimate the downside while

overestimating theupside potential Trade excessively

Mitigation: Keep detailed records oftrades,includingthe motivationfor each trade

Analyzesuccessesand losses relativetothestrategyused

Self-ControlBias

Impact: Lack disciplinetobalance short-term gratification with long-term goals Tendto

try tomakeup theshortfall byassumingtoomuch risk

Mitigation: Maintaincomplete, clearly definedinvestmentgoals and strategies Budgets

help deterthe propensitytoover-consume

StatusQuoBias

Impact: Risk characteristics oftheportfolio change.Investorlosesout onpotentially

profitableassets.

Mitigation: Educationaboutrisk andreturnandproperasset.Difficulttomitigate

EndowmentBias

Impact:Valueof ownedassetshigher thansame assetsifnotowned Stick withassets

becauseoffamiliarityandcomfortor wereinherited

Mitigation:Determinewhether theassetallocationisappropriate

RegretAversionBias

Impact: Stayinlow-riskinvestments.Portfolio with limitedupside potential Stayin

familiarinvestmentsor“follow the herd.”

Mitigation: Educationisprimary mitigation tool

Goals-based investing recognizes that individualsaresubjecttolossaversionand mental

accounting Buildsaportfolioinlayers, each consisting ofassetsusedto meetindividual

goals Pyramiding:bottomlayercomprisedofassetsdesignatedto meettheinvestor’s

mostimportantgoals Eachsuccessivelayerconsistsofincreasingly riskyassetsusedto

meetless and less import goals Providesinvestorwith abilityto seeriskmoreclearly

Althoughportfolio probably won’t beefficient, itwill tendtobe fairly well diversified

Behaviorally ModifiedAssetAllocation

• Emotional biasesare moreoften accommodated through deviations from the

rationalasset portfolioallocation

• Higher wealth relativetolifestyle needs allowsforgreaterdeviationsfromthe

rational portfolio

• The emotionalbiasesof the lower-wealth individualaretreated about thesame as

the cognitive biases of the wealthierindividual

• Theamountofdeviationisalso affected bythenumberofdifferentassetclassesin

the portfolio

• The lower the suggested deviation from the rational portfolioassetallocation,the

greatertheneedtomitigate the investor’sbehavioralbiases

Duetosignificant standardoflivingrisk,forexample, thecognitivebiasesof the

low-wealthinvestormustbe mitigated

A hasdifficultyinterpretingcomplexnewinformation.

B only partially adjusts forecastswhen he receives new information

C hasatendencytovalue thesame assetshigher ifheownsthem than if hedoesnot ownthem

1.

Whichof thefollowing wouldmostlikely indicatethatan investor issubjectto

anemotional bias?

A Regularly basing decisionsononlyasubsetof available information

B Reactingspontaneouslyto anegativeearningsannouncementby quicklysellingastock

C Remaining investedinaprofitable technologystockeventhoughnew

information indicatesits PE ratio istoohigh

A cognitiveerror isbestindicated by whichof thefollowing?

A Takingmoreandmoreriskbecause theinvestormentally attributeshisrecentinvestingsuccess tohis strategies

B Endingupwithasuboptimalassetallocation because theinvestordoesnot use aholisticapproachto constructtheportfolio

C Experiencingasignificant losson aninvestmentbecause theinvestorhoped

to recoverfromanegativeposition that subsequently worsened

DonHenryhas justreceivednewinformationregardinghis investment inOrange,Inc The newinformationappearstoconflictwithhis earlierforecast

of what the stock price should beatthis point.Nonetheless,heisunwillingto

incorporatethenewinformationintohisforecast andtorevise itaccordingly

WhatbehavioraltraitisHenry displaying?

A Conservatism bias

B Confirmation bias

C Anchoring and adjustment

AbbyLaneis asavvy investorwho hasinvestmentsscatteredacrossmanydifferentaccounts,from bank savings and before- and after-taxretirementaccounts totaxablenonretirementaccounts.Shealso hasseveraldifferentinvestinggoalsranging fromimportant short-termgoalstolonger-term“wishlist”goals.Eventhoughshehasmany investmentsalong with different goals, she

issmartenoughtotakeintoconsideration the correlation between herassets.

Sheallocates theassetsaccordingtoher risk-returnprofileacrossdifferentasset classes,viewingtheinvestments ascomprisingasingleportfoliowithasinglemeasure of risk.What behavioraltraitwouldrepresenttheoppositeway Laneapproaches investing?

Twentyyears ago,JaneIvysetupher initialassetallocationinher defined

contribution plan by placinganequalamountin eachassetclass andnever

changedit.Overtime,sheincreasedhercontribution by1% per yearuntilshe

reachedthe maximumamountallowed by law.Duetoher steadfastness and

goodfortune,coupled with matching funds from her employer, shenowfinds

herselfinher early 40s withamillion-dollarretirementaccount.Whichof the

followingbiasesdoes Ivy sufferfrom,andhowshouldsheremedythat bias?

A Representativeness; makesurethesamplesize iscorrectandnew

informationisinterpreted correctly

B Status quo bias; educate the investorontradeoffs between risk andreturn

and subsequentproperassetallocation

C Availabilitybias;developan investmentpolicystatementthrough diligent

research rather than information thatisreadily available

6

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#7-The Behavioral Biases of Individuals

This describes the endowment bias, where individualsplaceahighervalue on assets they own than if they did not own those same assets The other two answer choices describe cognitive errors that are due to the inability to analyze alltheinformation.

1 C

Emotional biases tend to elicit more ofa spontaneous reactionthan a cognitive errorwould Makingadecision based onlyonpartialinformation is indicative of a cognitive Ignoring ahighPE ratiocouldbe indicative of the conservatism bias, which is reactingslowlyto new information oravoiding analyzingnew information It could also indicate the confirmation bias, where the investor focuses on positive information and ignores negative information Both conservatism and confirmationbiasesare cognitive errors of belief perseverance.

2 B error.

Thisdescribesthe cognitive error of mental accounting in which the investorendsup with a layeredpyramidas herportfolio.The differentlayersof investments do not

take into consideration the correlation between the assets and are viewed in isolation fromeachother; thus, the assetallocationtends to be suboptimal from arisk-returnperspective.Takingmore risk as aresultofattributinginvesting success to aparticularstrategy represents overconfidence which is an emotional bias.

3 B

4 A This describes the conservatism bias where individualsmentally placemoreemphasis

on the information they used to form theiroriginalforecast than on new information.

Anchoringandadjustmentis closely related to the conservatism bias but is characterized

asindividuals being stuckon aparticular forecasting number andis not associatedwithhow investors relate new information to old information as the conservatism bias does.

The confirmation bias is when individuals notice only information that agrees with their perceptions or beliefs They look forconfirmingevidence whilediscountingor even ignoringevidence that contradictstheir beliefs.

set of assets used toaccomplisha separategoal.The correlation between those assets is

not taken into consideration; thus, the assets are usually notoptimallyallocated among different asset classes Theframingbias is when individuals view informationdifferentlydependingupon how it isreceived.Overconfidenceis whenpeoplethinktheyknow more than they do, have more and better information than others, and are better at

interpreting it,leadingto under-diversifiedportfoliosand excessivetrading

5 B

Ivy issufferingfrom the statusquobias, where investors leave their asset allocation alone and don’tchangeitaccordingtochangingmarket conditions orchangesin their own circumstances The other two answerchoicescorrectlydescribeways of mitigating those behavioral traits.

6 B

©2014 Kaplan,Inc.

Page 186

statements set forth by CFA Institute This topic is also covered in:

PROCESSES1

StudySession 3

EXAM FOCUS

This topicreviewfocusesontheinfluenceof behavioraltraits onallaspectsof the

investmentprocess—creating theinvestmentpolicystatement,the client/adviser

relationship, portfolioconstruction,analystforecasts,and market anomalies.Beableto

discuss the benefittoboth clients and advisers of incorporating behavioral financeinto

theclient’sinvestmentpolicystatementand the limitations ofclassifyinginvestors into

behavioraltypes.Beabletoexplain how behavioral finance influences the client/adviser

relationship andtodiscuss the benefitstobothof incorporating the behavioralaspects

of investingintothe relationship Understand howinvestorstendto constructportfolios

fromabehavioral perspective.Beabletoexplain how behavioral biases affect analystsin

their forecasting and the remedialactionsthat should be takentoreduce the influence

of those biases.Also,know how behavioral biasesaffect the decision-making processes

ofinvestment committees.Lastly, be abletodiscuss the influence of behavioral biaseson

entiremarkets

CLASSIFYING INVESTORS INTO BEHAVIORAL TYPES

LOS8.a:Explaintheusesand limitationsofclassifyinginvestors into

personalitytypes

CFA®Program Curriculum,Volume2,page108Financial market participants, bothinvestorsand financialadvisers,have found that

when the psychology of investingisrecognizedincreating the client’sinvestment

policystatementand subsequent implementation, theoutcomeislikelytobe favorable

Applyingastrictly traditional finance perspectivecanleadtopitfalls and unpleasant

surprisesfor both the client and adviser.For example,investorswhoareoverly risk

averseorrisk seekingreactmoreemotionallytoinvesting than would beexpected of

the typical, averageinvestor.The adviser will have bettersuccessby addressing these

clients’ emotional biases rather than ignoring them and takinga moretraditional finance

perspective

The traditional finance perspective seekstoeducate clients basedonmorequantitative

measuresof investing, suchasstandard deviation and Sharperatios,and theseareof

littleinteresttothe client whoreactsmoreemotionallytoinvesting Thegoal of viewing

the client/adviser relationship fromapsychological perspectiveascomparedto apurely

1 Terminologyusedthroughoutthis topic review isindustryconvention aspresentedin

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

traditional finance perspectiveisfor the advisertobetter understand his client andtomakebetterinvestmentdecisions.By incorporating behavioral biasesintoclients’IPSs,clients’portfolioswilltendtobe closertothe efficient frontier, and clientswillbemore

trusting and satisfied and tendto stay ontrackwiththeirlong-term strategic plans

Ultimately,since everyone ishappy, the resultisabetter overall working relationshipbetweenclientand adviser

Behavioral Models

Wewill discuss three behavioral models:(1)the Barnewalltwo-waymodel,(2)the

Bailard,Biehl, andKaiserfive-waymodel,and(3)the Pompainmodel

The Barnewalltwo-waybehavioralmodel2wasdevelopedin 1987andclassifiesinvestorsintoonlytwo types:passiveandactive Passiveinvestors arethose who have

nothadtorisk theirowncapitaltogain wealth.Forexample they might have gainedwealth through long, steady employmentanddisciplined savingorthrough inheritance

Asaresultofaccumulatingwealthpassively, they tendtobemoreriskaverseand have

a greaterneedfor securitythantheir“active”counterparts.Active investorsrisktheirowncapitaltogain wealth and usually takeanactiveroleininvesting theirownmoney

Active investorsaremuchless riskaversethan passiveinvestorsandarewillingtogiveupsecurity for control over theirownwealthcreation.

Professor’sNote:The causalrelationshipbetweensteadily accumulatingwealthovertimeandahighaversiontorisk couldgo ineither direction Eitheronecanleadtothe other

TheBailard, Biehl,andKaiser (BB&K)five-waymodel3,developedin 1986,classifiesinvestorsalongtwodimensions accordingtohow they approach lifeingeneral Thefirstdimension,confidence,identifiesthelevelofconfidence usually displayedwhenthe individualmakesdecisions Confidence levelcanrangefromconfidenttoanxious

The seconddimension,methodofaction, measuresthe individual’s approachtodecisionmaking Dependingonwhether the individualismethodicalinmaking decisionsortendstobemorespontaneous,methodofaction canrangefrom carefultoimpetuous

BB&Kcategorizeinvestorsintofive behavioraltypes,whichlieatdifferentpoints ina

grid formed by confidence/methodofaction.Forexample,the“straight arrow”investorwould lieinthecenterofthegrid, with the other four behavioraltypesscattered aroundthecenter.

Using thetwodimensions likeaxes on agraph, the five behavioraltypesof theBB&Kmodelaresummarized in thefollowing accordingtoconfidenceand methodofaction,

asindicatedin Figure1

2 Barnewall,Marilyn.1987.“PsychologicalCharacteristics of theIndividual Investor.”

Asset Allocationforthe Individual Investor Charlottesville, VA: The Institute of Chartered Financial Analysts.

3 Bailard, Brad M., David L Biehl, and Ronald W Kaiser.1986.Personal Money Management,5thed.Chicago:Science Research Associates.

©2014 Kaplan,Inc.

Page 188

1 The adventurer has the followingtraits:

• Confidentandimpetuous(northeastquadrant)

• Mightholdhighly concentrated portfolios

• Willingto takechances

• Likestomakeowndecisions

• Unwillingtotake advice

• Advisors findthemdifficulttowork with

2 The celebrity has the followingtraits:

• Anxiousandimpetuous(southeastquadrant)

• Might haveopinionsbut recognizes limitations

• Seeks and takes advice about investing

3 Theindividualisthas thefollowingtraits:

• Confident and careful(northwestquadrant)

• Likestomakeowndecisionsafter careful analysis

• Goodtowork with because they listen andprocess informationrationally

4 The guardian has the followingtraits:

• Anxiousand careful(southwestquadrant)

• Concernedwith thefuture andprotectingassets.

• Mayseek theadviceof someonetheyperceiveas moreknowledgeablethan

themselves

5 Thestraightarrowhas thefollowingtraits:

• Averageinvestor (intersection of thetwo dimensions).

• Neitheroverly confidentnoranxious

• Neither overlycarefulnorimpetuous

• Willingto takeincreasedriskforincreased expectedreturn.

Figure1:ClassificationofInvestorsAccordingtotheBB&KBehavioralModel4

Confident

The Individualist The Adventurer

The Guardian The Celebrity

Anxious

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

The Pompian behavioral model5, developedin2008,identifiesfour behavioralinvestortypes (BITs).Pompiansuggeststhat theadvisergothrougha4-stepprocesstodeterminethe investor’sBIT

Interviewthe clienttodetermine if sheis activeorpassiveas anindicationof herrisk tolerance

1.

2 Plot theinvestoron arisk tolerancescale

Test for behavioral biases

3

4 Classify theinvestor intooneof theBITs

Figure2showstheresultsofthe Pompianmethodofclassifyinginvestors.Youwillnoticethat both thePassivePreserverand theActiveAccumulator tendtomake emotionaldecisions TheFriendlyFollower andIndependentIndividualist tendto use a more

thoughtfulapproachtodecision making.Themost commoncognitiveandemotionalbiasesassociated witheach investortypearelisted following Figure2.

Figure2:Four InvestorTypes,InvestmentStyles, andBehavioralBiases6

Risk Tolerance InvestmentStyle DecisionMakingInvestorType

Emotional Conservative

Independent

Mostcommonemotional biases exhibited:

• PassivePreserver:Endowment,lossaversion, statusquo,regret aversion.

• Friendly Follower: Regretaversion

• Independent Individualist:Overconfidence,self-attribution

• ActiveAccumulator:Overconfidence,self-control

Mostcommoncognitive biases exhibited:

• PassivePreserver:Mental accounting,anchoring andadjustment

• FriendlyFollower:Availability, hindsight, framing

• Independent Individualist:Conservatism,availability,confirmation,representativeness

• ActiveAccumulator: Illusionofcontrol

5 Pompian, Michael 2008.“UsingBehavioral InvestorTypesto Build Better Relationships with Your Clients.”Journal ofFinancialPlanning,October 2008:64-76

6 Based on Exhibit 4,2015Level III curriculum, vol 2, p 113.

©2014 Kaplan,Inc.

Page 190

Behavioral InvestorTypes(BITs)

Aspreviouslymentioned,the laststepinPompian’s process of determining which

behavioral bias theinvestor isexhibitingistocategorize theinvestor intoabehavioral

investortype (BIT).TherearefourBITs,ranging fromconservativetoaggressive

investing The first BITisthePassivePreserver,characterizedashaving low risk

tolerance, anemotionalbias,notwillingtorisk hisowncapital, usuallynotfinancially

sophisticated, and possibly difficulttoadvise because heisdrivenbyemotion

TheFriendly Follower would also be consideredapassiveinvestorwho has lowto

moderate risk tolerance andsuffers mainly from cognitiveerrors,whichareerrors

resulting from faulty reasoning andnotemotional biases.AFriendly Follower tendsto

overestimateher risk tolerance andwants tobeinthemostpopularinvestmentswith

little regardtomarket conditionsorhow theinvestmentfitsintoher overall long-term

investmentplan.SinceaFriendly Follower tendstoapproach investing fromamore

cognitive(thinking) perspective, the bestcourseofaction inadvising heristousemore

quantitative methodsineducatingheronthe benefitsof portfolio diversification

The Independent Individualistisanactive investorwhoiswillingtorisk hisowncapital

and giveupsecuritytogain wealth.Hehas moderatetohigh risk tolerance and suffers

from cognitive biases Heisstrong-willed,likesto invest,does hisown research,and

tendstobeacontrarian.The Independent Individualist tendstobe difficulttoadvise

but will listentosound advice.Therefore,the best approachtoadvising himisregular

educationoninvestingconceptsrelevanttotheinvestor

TheActiveAccumulatorisan active investorwithahigh tolerance for risk who

approaches investing fromanemotional perspective TheActiveAccumulatorisan

aggressiveinvestorwho oftencomesfromanentrepreneurial background and likesto get

deeply involvedinher investing Sheisstrong-willed,confident,andlikestocontrol her

investing,making her themostdifficultof all the BITstoadvise.Thus,the bestcourse

ofactionfor the adviseristotake controlof theinvestment processandnotlet the

investorcontrol thesituation

LimitationsonClassifyingInvestorsintoBehavioralTypes

Manytimes,individualsactirrationallyatunpredictablemoments,makingitdifficult

toapply the different behavioralinvestor traitsconsistently foranyoneinvestorover a

period oftime.This leadstoseveral limitationsofclassifyinginvestors intothevarious

behavioralinvestortypes:

• Many individualsmaysimultaneously display both emotional biases and cognitive

errors.Thiscanmakeitdifficult and inappropriateto tryand classify themas to

whether their biasesareemotionalorcognitive; theyareboth

• Anindividual might displaytraitsofmorethanonebehavioralinvestortype,making

itdifficulttoplace the individualintoasinglecategory.

• Asinvestors age,they willmostlikelygothroughbehavioral changes, usually

resultingindecreased risk tolerance along with becomingmoreemotional about

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

• Eventhoughtwoindividualsmayfallintothesamebehavioralinvestortype,

the individuals shouldnotnecessarily be treated thesameduetotheir uniquecircumstancesandpsychologicaltraits

• Individuals tendto actirrationallyatunpredictabletimesbecausetheyaresubjectto

theirownspecific psychologicaltraitsand personalcircumstances.In otherwords,people don’t allactirrationally(orrationally)atthesametime

THECLIENT/ADVISER RELATIONSHIPLOS8.b:Discusshow behavioralfactors affect adviser-clientinteractions

CFA®ProgramCurriculum,Volume2,page 117Thegoalof the client/adviser relationshipisconstructingaportfolio that the clientiscomfortable with and will be happy stayinginoverthe longterm.Thisismoreeasilyaccomplishedoncethe adviser recognizes the needtoincorporate behavior biasesintotheinvestmentdecision-makingprocess

Thesuccessof the typical client/adviser relationshipcanbe measuredinfourareas,andeachoneisenhanced by incorporating behavioral financetraits:

1 The adviser understands the long-termfinancialgoalsofthe client Behavioral financehelps the adviser understand thereasonsfor the client’s goals The client/adviserrelationshipisenhanced because the client feels the adviser truly understands himand his needs

2 The advisermaintainsaconsistentapproach with the client Behavioral finance addsstructureand professionalismtothe relationship, which helps the adviser understandthe client before givinginvestmentadvice

3 The adviseractsasthe clientexpects.Thisistheareathatcanbemostenhanced

by incorporating behavioral financeintothe client/adviser relationship.Oncetheadviser thoroughly understands the client and hermotivations,the adviser knowswhatactionstoperform, what informationtoprovide, and the frequency ofcontactrequiredtokeep the client happy

4 Both client and adviserbenefitfromthe relationship The primary benefit ofincorporating behavioral financeintothe client/advisor relationshipisacloser bondbetween thetwo.This resultsinhappier clients andanenhanced practice andcareerfor the adviser

Risk Tolerance Questionnaires

Asoneof the firststepsinthe client/adviser relationship, the adviser has the client fillout arisk tolerance questionnaire Unfortunately, thesameindividualscangive differentanswerstothesamesetof questions dependingontheirframe of mindorcurrentcircumstances In addition,mostquestionnairesarenotstructuredtomeasurebehavioralbiases Thismeansthereare anumber of limitationstothe traditional questionnaire

First,sinceanindividuals responsesareaffected by the wording of questions (framing),

thesamequestionscanproduce different results if thestructureof the questionsis

changedonlyslightly.Then, sinceclientanswersreflect all their behavioralbiases,and

thoseinturnareaffectedby the client’scircumstances,administeringaquestionnaire

only during the initial meetingisinsufficient.Sincethe client’s IPS should beanalyzed

annually for appropriateness, the questionnaire should also be administered annually

Advisers alsomayinterpret what the clientsaystooliterally, when clientstatements

should onlyact asindicators The successful adviserisabletodetermine the clients

intent,for example, when hestates aminimumallowablereturninagivenyear

Rather than interpret theminimumallowablereturnliterally, the adviser should

usethestatement as anindicator of the client’s attitude toward risk andreturn.Asa

consequence,risk tolerance questionnairesareprobably better suitedtoinstitutional

investors,where less interpretationisrequired Institutionalinvestorsaregenerallymore

pragmatic and tendtoapproach investing fromathinking/cognitive approach witha

better understanding of risk andreturn.

BEHAVIORAL FACTORSANDPORTFOLIO CONSTRUCTION

LOS8.c:Discusshow behavioralfactors influenceportfolioconstruction

CFA®ProgramCurriculum,Volume2,page120Researchondefined contribution and401kretirementplansinthe U.S indicatesways

behavioral finance influences portfolioconstructionand how the insight gained might

be appliedinportfolioconstructiontoachieve resultsmoreconsistentwith traditional

finance theory The studies show evidence of thefollowing

Statusquo biasasinvestorsdonotmake changestotheir portfolioevenwhen

transactioncostsare zero.Portfolio theory would clearlysuggestthatastimepasses and

theinvestorsareaging, theiroptimal portfoliomixwill shift These changesare not

being made Inaddition,theinvestorsgenerallyacceptwhatever defaultinvestoroption

isoffered by the employer and the contribution defaultrate.Neitherisoptimalasthe

assetmix isusually heavily weightedtomoneymarket funds and the contributionrateis

lower than allowable

Tocounteractthis biassomecompanies haveautopilot options suchas targetdate

funds.Atargetdate fund hasastatedretirementdate and themanagerof the fund

automatically shifts theassetmix in wayssuitableforinvestorsplanningtoretire onthat

date Once theinvestorpicks thetargetdatefund,the manager makes the adjustments

for passage oftimeand the client doesnotneedtotakeany action

Naivediversificationasinvestorsequally divide their funds among whatever group of

fundsisoffered Accordingto astudy, when offeredastock and bondfund, investors

allocated50/50.Then,if offeredastock and balancedfund, investorsstill allocated

50/50.Otherssuggestinvestorsfollow conditionalnaivediversification.They select

asmaller numberof funds (e.g., threetofive),and then allocate equally.Ineithercase

somearguethisismotivated by seekingtoavoidregret.Owningequalamountsofall,

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

Excessive concentration inemployer stockisalso evident This will be discussedina

later studysessionbutit is veryriskyasretirementfundperformanceisnowlinkedto

compensationatanunderlyingsource,thecompany.This could be basedonfamiliarityandoverconfidence.Employeesmay think,“I know the company andseeiteveryday;

surelyit isagood investment.” Ifpastperformance has been good andyou arefamiliarwithitthat would benaiveextrapolationofpastresults Framing andstatusquoeffect of

matching contributionsisexhibitedasif the employer’s contributionismadeinemployerstock.Insuchcasesthe employees thenincreasetheamountthey chosetoplaceinthe employer stock Loyaltyeffectissimplyadesiretohold employer stockas asign ofloyaltytothecompany.Whenfinancialincentives areoffer by the employertoinvest inemployerstock,the decisionmayberational,but the holdingsare inexcessof whatcan

be justified

Excessivetrading of holdingsisevidentinthe brokerageaccountholdings of individualseventhough individuals showstatusquo in retirementfunds This could be duetooverconfidenceasthe individuals think they have superior stock selection skillsorself

selectionastrading-orientedinvestorsputtheirmoney inbrokerageaccountsand others

putmoney in retirementportfoliosattheir company.Investorsalso showadisposition

effectinselling stocks that appreciate (e.g.,winners)but holdingontostocks thatdepreciate (e.g.,losers)

Homebiasisseeninunder diversification and failingtoinvestoutside theinvestor’shomecountry.

LOS8.d:Explainhow behavioral financecan beappliedtothe process of

portfolioconstruction

CFA®ProgramCurriculum,Volume2,page120

Behavioral Portfoliosvs.MeanVariancePortfoliosInvestorsexhibit behavioral biases when theyconstructportfoliosinlayers,comprising

apyramid with each layer havingaspecificpurpose inachievingadifferent goal Thisisalso referredto asmental accounting because theassetsineach layer of the pyramidareviewed separately from each other withnoregardtohow theyarecorrelated

In thepyramidstructure,themostpressinggoalsareplacedonthe bottom layer and

are metusinglow-risk, conservative investments.Eachsuccessivelayer going toward thetopof the pyramidiscomprised of riskierassets toaccomplish less immediateorlessimportant goals Thetopof the pyramidiscomprised of risky,morespeculativeassets

to meet“wish list”typesof goals Behavioral financecanbe applied and benefit theportfoliomanagementprocessby:

• Leadingtotheuseof portfolios suchas targetfunds,which work around the biasofinvestorstobestatic

• Leadingmanagers and clientstodiscuss the relative importance ofgoalsandperceived risk Tieredinvestmentportfolios that the clientcanunderstand andmaintaincould be superiortotraditional portfolios that consider correlation butthat the clientisunwillingto staywith

ANALYSTFORECASTSANDBEHAVIORAL FINANCE

LOS8.e:Discusshow behavioralfactors affect analyst forecasts and

recommend remedialactionsfor analyst biases

CFA®ProgramCurriculum,Volume2,page125Research has shown thatexpertsinvarying fields makeforecastingerrorsas aresultof

behavioralbiases,and financial analystsaresubjecttothosesamebiases Surprisingly,

it isanalysts’ superior skillsinanalyzing companies that makes them vulnerableto

forecastingerrors Anunderstanding of their weaknessescanhelp analysts limit the

degree of their forecastinginaccuracies

Therearethree primary behavioral biases thatcanaffect analysts’ forecasts:

(1) overconfidence, (2)thewaymanagement presentsinformation,and(3)biased

research

Overconfidence

Professor’sNote: Remember thatoverconfidenceleadstounderestimating risk and

settingconfidenceintervals thataretoonarrow

Analystscanbe susceptibletooverconfidenceas aresultof undue faithintheirown

forecastingabilities caused byaninflated opinion of theirownknowledge,ability,

andaccess toinformation.Analysts also tendtoremember their previous forecastsas

beingmoreaccuratethanthey reallywere (aform of hindsightbias).Thereareseveral

behavioral biases that contributetooverconfidence

Analystsaresubjecttothe illusionofknowledge bias when they think theyare smarter

than theyare.This, inturn,makes them think theirforecastsare more accuratethan

the evidence indicates The illusionof knowledgeisfueled whenanalysts collecta

largeamountof data This leads themtothink their forecastsarebetter because they

havemoreand better information than others Gathering additional information

could addtoananalyst’s overconfidence without necessarily making the forecastmore

accurate.The illusionofcontrolbiascanlead analyststofeel they have all available data

and have reducedoreliminated all riskinthe forecastingmodel; hence,the linkto

overconfidence

Exhibitingrepresentativeness,ananalyst judges the probability ofaforecast beingcorrect

onhow well the available datarepresent (i.e.,fit)theoutcome.The analyst incorrectly

combinestwoprobabilities:(1)the probability that the information fitsacertain

informationcategory,and(2)the probability that thecategoryof information fits the

conclusion

Ananalyst exhibits the availability bias when he gives undue weighttomorerecent,

readily recalled data Being abletoquickly recall information makes the analystmore

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

likelyto“fit”itwithnewinformation and conclusions The representativenessandavailabilitybiasesarecommonly exhibitedin reactionsto rare events.

To subconsciouslyprotecttheiroverconfidence,analysts utilizeegodefense mechanisms

Oneegodefense mechanismistheself-attributionbias Analysts take credit for their

successesand blame othersorexternalfactors for failures Self-attribution biasisan egodefensemechanism,becauseanalystsuseittoavoid the cognitive dissonance associatedwith havingtoadmit makingamistake

The relationship between self-attributionbias,illusion of knowledge, and overconfidencearefairly obvious Byaligningpast successeswith personaltalent,the analyst addstothefeeling of complete knowledge, whichinturnsfuels overconfidence

Hindsight biasisanotheregodefense mechanism.In effect,theanalyst selectivelyrecalls detailsof the forecastorreshapesit insuchawaythatitfits theoutcome.Inthisway,theforecast,eventhoughittechnicallywasofftarget, serves tofuel the analyst’soverconfidence.Hindsightbias then leadstofuture failures Bymakingtheir priorforecasts fitoutcomes,analysts failtoproperly recalibrate their models

Thereareseveralactionsanalystscantaketominimize(mitigate) overconfidence

intheirforecasts.Forexample, theycanself-calibrate better.Self-calibrationistheprocessof remembering their previous forecastsmoreaccuratelyinrelationtohowclose theforecastwas tothe actualoutcome.Gettingpromptand immediate feedbackthroughselfevaluations,colleagues,and superiors, combined witha structurethatrewardsaccuracy,should leadtobetter self-calibration Analysts’ forecasts should beunambiguous anddetailed,which will help reduce hindsight bias

To helpcounteracttheeffects ofoverconfidence,analysts should seekatleastone counterargument,supported byevidence,for why their forecastmaynotbeaccurate.

Analysts should also considersamplesize.Basing forecastsonsmall samplescanlead

tounfounded confidenceinunreliable models Lastly, Bayes’ formulaisauseful toolfor reducing behavioral biases when incorporatingnewinformation.Bayes’ formulaisdiscussedinthe topicreview,The BehavioralFinancePerspective

Influence byCompany ManagementThewayacompany’smanagement presents(frames)informationcaninfluence howanalysts interpretitandincludeitintheirforecasts The problemstemsfromcompanymanagersbeing susceptibletobehavioral biases themselves Therearethree cognitivebiases frequentlyseenwhenmanagement reportscompany results:(1)framing,(2)anchoring and adjustment, and(3)availability

Framing refersto aperson’s inclinationtointerpret thesameinformation differentlydependingonhowit ispresented Weknow,for example, that simplychangingtheorderinwhich informationispresentedcanchange the recipient’s interpretation of theinformation.Inthecaseofcompany information,analysts should beawarethatatypical

management report presentsaccomplishments first

Anchoring and adjustment referstobeing “anchored”to aprevious data point.

Being influencedby(anchoredto)the previousforecast,analystsarenotabletofully

incorporateormakeanappropriateadjustmentintheirforecasttofully incorporate the

effect ofnewinformation Thewaythe informationisframed (presenting thecompany’s

accomplishmentsfirst),combined with anchoring (being overly influenced by the first

informationreceived),canleadtooveremphasis of positiveoutcomesinforecasts

Availability referstotheeasewith which informationisattainedorrecalled The

enthusiasm with which managersreportoperating results and accomplishments makes

the informationveryeasily recalledand, thus, moreprominentinananalyst’s mind The

moreeasily the informationis recalled,themoreemphasis (weight)it isgiveninthe

forecastingprocess

Analysts should also look for self-attribution biasinmanagement reportsthatisa

direct result of thestructuresofmanagementcompensationpackages.Forexample,

managementtypicallyreceivessalaryincreasesand bonuses basedonoperating results

Managementisthus inclinedto overstateresults (overemphasize the positive),aswellas

theextent towhich their personalactionsinfluenced the operating results.Thus,

self-attribution naturally leadstoexcessiveoptimism(overconfidence)

Analystsmustalso bewaryof recalculated earnings, which donotnecessarily incorporate

accepted accounting methods Again,sincemanagementcompensation isbased largely

onoperatingresults,thereisamotivationto presentthe best possible data The analyst

should be particularlysensitivetoearnings thatarerestatedina morefavorable light

than originally presented

To help avoid the undue influenceinmanagement reports,analysts should focuson

quantitativedata thatisverifiableand comparable rather thanonsubjectiveinformation

provided bymanagement.Theanalyst should also becertainthe informationisframed

properly and recognize appropriate baserates(starting points for thedata)sothe datais

properly calibrated

AnalystBiases inResearch

Biasesspecifictoanalysts performing researchareusually relatedtothe analysts’

collectingtoomuchinformation,which leadstotheillusionsofknowledgeand control

andtorepresentativeness, allofwhich contributetooverconfidence.Two othercommon

biases foundinanalysts’ researcharetheconfirmationbias and the gamblersfallacy

The confirmation bias(relatedtoconfirmingevidence) relatestothe tendencytoview

newinformationasconfirmationofanoriginal forecast It helps the analyst resolve

cognitive dissonance byfocusingonconfirminginformation,ignoring contradictory

information, orinterpreting informationinsuchawaythatitconformstothe analyst’s

wayof thinking The confirmation biascanalso beseen inanalysts’ forecasts where they

associateasoundcompanywithasafeinvestment, eventhough the stock price and the

currenteconomic environmentwould indicate otherwise

The gambler’s fallacy,ininvestingterms,isthinkingthat there will beareversaltothe

long-termmean morefrequentlythan actually happens.Arepresentative biasis one in

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

which theanalyst inaccurately extrapolatespastdataintothefuture.Anexample ofa

representative bias would beclassifyingafirmas agrowth firm based solelyonprevioushighgrowth withoutconsideringothervariablesaffectingthe firm’sfuture

Professor’sNote:Thegambler’sfallacycanbe effectively demonstrated withacoin tossexample Consideranindividual whoiswatchingacoinbeing tossed.Heknowsintellectuallythat theprobabilityofheadsortails turningupinanysingle

tossis50%.Beforethecoin istossed thefirsttime,hemaintainsthis 50%/50%

priorprobability.Now,assumethecoin istossedfivetimes,and headsturnsupallfivetimes.Knowing that thelong-termmeanis50% heads and 50%tails,the individualstarts tofeelthe probabilityoftailsturninguponthenext tosshas increased above 50% Infact,iftherunofheadsincreases,the individual’ssubjective probability that tails willcomeuponthenext tosswill alsoincrease, eventhough the probabilityofeither headsortailsstays at50% witheverytoss.

Therearemany actions ananalystcantaketo preventbiasesin research, someofwhicharethesameaswhen theyareinterpretingmanagement reports.Forexample,analysts should beawareof the possibility of anchoring and adjustment when theyrecalibrateforecasts givennewinformation They shouldusemetricsandratiosthatallowfor comparabilitytoprevious forecasts They should takeasystematicapproachwith prepared questions and gather data before forminganyopinionsormakinganyconclusions

Analysts shoulduse astructured process by incorporatingnewinformation sequentiallyand assigning probabilities using Bayes’ formulatohelp avoid conclusions with unlikelyscenarios.They should seek contradictoryevidence,formulatingacontradictory opinioninsteadof seekingmoreinformation that proves their initial hypothesis They shouldget promptfeedback that allows themtore-evaluate their opinions and gain knowledge forfuture insight, all the while documenting theentire process

INVESTMENTCOMMITTEES

LOS8.f:Discusshow behavioralfactors affectinvestment committeedecision

makingand recommendtechniquesfor mitigating their effects

CFA®ProgramCurriculum,Volume2,page 136Manyinvestmentdecisionsaremadeinagroupsetting(e.g., stock recommendations byresearchcommittees,analysts workingina teamsetting, pension plan decisions beingapproved byaboardoftrustees,oran investmentclub deciding which stockstobuy)

The thinkingisthat the collective expertise of the individual members will contributeto

betterinvestmentdecision making Inagroup setting, the individual biases mentionedbeforecanbe either diminishedoramplified with additional biases being created

Socialproofbias iswhenapersonfollows the beliefsofagroup.Research has shownthat theinvestmentdecisionmakingprocess inagroup settingisnotoriouslypoor

Committeesdonotlearnfrompastexperience because feedback from decisionsisgenerallyinaccurateandslow,sosystematicbiasesarenotidentified

The typical makeup ofacommitteecoupled withgroupdynamics leadstothe problems

normallyseenwithcommittees.Committeesaretypically comprisedofpeoplewith

similarbackgroundsand, thus,they approach problemsin thesame manner.Inagroup

setting, individualsmayfeel uncomfortable expressingtheir opinionifitdiffers with

othersor apowerful member of thegroup.Theremedyisforcommitteestohave the

following features:

• Comprised of individuals with diverse backgrounds

• Members whoare notafraidtoexpresstheir opinionsevenifitdiffersfrom others

• Acommitteechair who encourages memberstospeakout evenifthe member’sviews

arecontrarytothegroup’sviews

• Amutualrespectforall members of thegroup

BEHAVIORALFINANCEANDMARKETBEHAVIOR

LOS8.g:Describe how behavioral biasesofinvestorscanleadtomarket

characteristics that maynotbe explained by traditional finance

CFA®Program Curriculum, Volume2,page138

Inanefficientmarket, oneshouldnotbe abletoconsistentlygenerate excess returns

usingany form of information Once informationisknownto investors,itshould

beinstantaneously and fully incorporatedinto prices Butthis doesnot meanthat all

apparentpricing exceptionstothe efficient market hypothesisareanomalies

• Anexcess returnbeforefees andexpensesthatdisappears after properly reflectingall

costsrequiredtoexploitit isnot ananomaly

• Someapparentanomaliesaresimplyareflectionofaninadequate pricingmodel.If

another model withanadditional riskfactorremovestheexcess return,it maynot

beananomaly

• Apparent anomaliescanjustbe small samplesize.Justbecause flippingacointhree

timesgeneratesthreeheads, doesnotmaketheoddsonthenextflip anythingmore

than50/50

• Ananomalymayexistforonlytheshort-run and disappearonceit becomesknown

and exploited

• Someapparentanomaliesare arational reflectionof relevanteconomicfactors

Year-end tradinganomalies may just reflect rationalbehaviortoreducetaxes.

Butother deviationsfrom theEMHand rationality do persist and behavioral finance

canoffer insightintothese

MomentumEffect

AH forms of the EMHasserttechnical-price-based tradingrulesshouldnotadd value

Yetstudiescontinuetoshow evidenceof correlation in pricemovement.Apattern

ofreturnsthatiscorrelated with therecent pastwouldbeclassifiedas a momentum

effect This effectcanlast upto twoyears,after whichitgenerallyreversesitself and

becomesnegativelycorrelated,withreturnsrevertingto themean.Thiseffectiscaused

byinvestorsfollowingtheleadofothers,whichatfirstis notconsideredtobe irrational

Thecollectivesum of those investorstradinginthesamedirection resultsinirrational

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

behavior,however Thereareseveralforms ofmomentumthatcantake place, whicharediscussed in thefollowing

Herdingiswheninvestorstrade in thesamedirectionorin thesame securities,andpossiblyeventradecontrary tothe informationthey haveavailabletothem.Herdingsometimes makes investors feelmorecomfortable becausetheyaretrading with the

consensusofagroup.Two behavioral biases associated with herdingarethe availabilitybias(a.k.a.therecencybiasor recencyeffect)andfear ofregret.In the availabilitybias,recentinformationisgivenmoreimportancebecauseit ismostvividlyremembered

Itis alsoreferredto astheavailabilitybiasbecauseit isbasedondatathatarereadilyavailable,including small data samplesordata that donotprovideacompletepicture

Inthecontextof herding, therecentdataortrendisextrapolated byinvestors intoaforecast

Regretisthefeelingthatanopportunity haspassed by andis ahindsightbias.The

investorlooksbackthinking they shouldhaveboughtorsoldaparticularinvestment(notethatinthe availabilitybias,theinvestormosteasily recalls therecentpositiveperformance) Regretcanleadinvestorstobuyinvestmentstheywishtheyhadpurchased,which inturnfuelsatrend-chasingeffect.Chasing trendscanleadtoexcessivetrading, whichinturn createsshort-term trends

Financial Bubbles and Crashes

Financialbubbles and subsequentcrashes areperiodsofunusualpositiveornegativereturnscausedbypanicbuying and selling, neither of whichisbasedoneconomicfundamentals The buying (selling)isdrivenbyinvestorsbelievingtheprice oftheassetwill continuetogoup(down).Abubbleorcrashisdefinedas anextended periodofprices thatare twostandard deviationsfrom themean.A crashcanalso becharacterized

as afallinassetpricesof30%or moreoveraperiod of severalmonths,whereas bubblesusually take much longertoform

Typically,inabubble,the initial behavioristhoughttobe rationalasinvestorstradeaccordingtoeconomicchangesorexpectations.Later,theinvestorsstart todoubtthefundamental valueof theunderlyingasset, atwhichpoint the behavior becomesirrational.Recent bubbleswereseen in thetechnology bubble of 1999-2000 andincreased residential housing pricesin the United Kingdom,Australia,and the UnitedStates

Inbubbles, investors sometimesexhibitrationalbehavior—theyknowtheyarein

abubble butdon’tknow where thepeakof the bubbleis Or,thereare nosuitablealternativeinvestmentsto get into,makingitdifficultto get outofthecurrentinvestment.For investment managers,there could beperformanceor careerincentivesencouraging themto stayinvested in theinflatedassetclass

Thereareseveral differenttypesof behavior thatareevident during bubbles.Investorsusuallyexhibitoverconfidence,leadingto excessivetradingandunderestimatingtheriskinvolved.Portfolios become concentrated,andinvestorsreject contradictoryinformation Overconfidenceislinkedtotheconfirmationbias, inwhichinvestorslookfor evidence that confirms their beliefs and ignore evidence that contradicts their beliefs

©2014 Kaplan,Inc.

Page 200

Self-attributionbiasisalsopresentwheninvestorstake personal credit for thesuccessof

their trades (they makeno attempt tolinkex postperformancetostrategy)

Hindsight biasispresentwhen theinvestorlooks backatwhat happened andsays,“I

knewitallalong.” Regretaversionispresentwhenan investordoesnot want to regret

missingoutonall the gainseveryoneelseseemstobe enjoying The dispositioneffectis

prevalent wheninvestorsaremorewillingtosellwinnersand holdontolosers,leadingto

theexcessivetrading of winning stocks

Asthe bubble unwindsintheearlystages,investorsareanchoredtotheirbeliefs,causing

themtounder-react because theyareunwillingto acceptlosses Astheunwinding

continues,the disposition effect dominatesasinvestorsholdontolosing stocksinan

effortto postpone regret.

Valuevs Growth

Two anomalies discussed by Fama andFrench7areassociated with value and growth

stocks Value stocks have low price-to-earningsratios,high book-to-marketvalues,and

lowprice-to-dividendratios,withgrowthstockshavingthe opposite characteristics In

their 1998 study, Fama and French found that value stocks historically outperformed

growth stocksin12of 13 marketsovera20-yearperiod from 1975to1995 They also

found that small-capitalization stocks outperformed large-capsin 11of 16 markets

Additionally, they contend thatintheir threefactormodel,comprised ofsize,value,

and marketbeta,the value stock mispricing anomaly disappears andisinstead dueto

risk exposures of companies withaparticularsizeand book-to-market value beingmore

vulnerable duringeconomicdownturns

Other studies have offered behavioral explanations, identifying the value and growth

anomaliesas amispricing rather thananadjustment for risk.Forexample,inthe halo

effect,theinvestortransfersfavorable company attributesintothinking that the stock

isagood buy.Acompany withagood record of growth and share priceperformance

isseen as agoodinvestmentwith continued high expectedreturns.Thisisaform of

representativenessinwhichinvestorsextrapolatepastperformanceintofuture expected

returns,leading growthstockstobecome overvalued

The home biasanomalyis onewhereinvestorsfavor investingintheir domesticcountry

ascomparedtoforeigncountries.This also pertainstocompanies thatarelocated closer

totheinvestor.This biascanbe relatedto aperceived information advantageorthe

comfortonefeelsfrom being closertothe home officeorexecutivesof thecompany

Analystsmayseethisashavingeasieraccess tothoseindividuals, oradesireof the

investortoinvest intheircommunity

Fama,EugeneF and Kenneth R French,1998.“Value t versus Growth: The International

7.

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

LOS8.a:

Incorporating behavioral biasesintothe client’s IPS should resultinthe following:

• Portfolios thatareclosertothe efficient frontier

• Moresatisfied clients

• Clientswhoarebetter ableto stayontrack with theirlong-termstrategic plans

• Betterworking relationships between the client and adviser

Limitationsofclassifyinginvestors intobehavioraltypesinclude thefollowing:

• Individualscandisplay emotional and cognitiveerrorsatthesametime

• Thesameindividualmaydisplaytraitsofmorethanonebehavioralinvestortype.

• As investors age,they becomemoreriskaverseand emotional toward investing

• Individuals who fallintothesamebehavioraltypeshouldn’t necessarily be treatedthesame

• Unpredictably, individuals tendto actirrationallyatdifferenttimes

LOS8.b:

Therearefourareasof the client/adviser relationship thatcanbe enhancedbyincorporating behavioral financeintothe relationship:

1 Behavioral finance helps the adviser understand thereasonsfor the client’s goals

2 Behavioral finance addsstructureand professionalismtothe relationship

3 The adviserisbetter equippedto meetthe client’s expectations

4 Acloser bond between them resultsinhappier clients andanenhanced practice forthe adviser

LOS8.c:

Behavioral biases exhibited by defined contribution(DC)plan participants:

• Statusquobias:Investorsmakenochangestotheir initialassetallocation

• Naivediversification(1/n naivediversification): Employees allocateanequalproportionof theirretirementsfundstoeach mutual fundinthe plan

Reasonsemployeesinvest intheirowncompany’s stock

• Familiarity: They underestimateits risk;they become overconfidentintheirestimate

of thecompany’sperformance

• Naiveextrapolation: The company’srecentgood performanceisextrapolatedintoexpected future performance

• Framing: If the employer’s contributionis in company stock,employees tendtokeep

itrather than sellitand reallocate

• Loyalty: Employees hold company stockinanefforttohelp the company (e.g.,to prevent atakeover by anotherfirm)

• Financialincentive:Taxincentives ortheabilitytopurchase the stockat adiscountleadtoholdingtoomuch company stock

Duetooverconfidence,retailinvestorstrade their brokerageaccountsexcessively Theresultcanbe lowerreturnsduetotradingcosts.Dispositioneffect:Investorstendtosellwinnerstoosoonand hold loserstoolong

Homebiasisclosely relatedtofamiliarity It leadstostayingcompletelyinorplacinga

high proportion ofassetsinthe stocksof firmsintheirowncountry.

Mentalaccounting: Investorstendto constructportfoliosinlayers (pyramids) Each layer

isusedto meet adifferent goal.Investorsseeeach layerashavinga separatelevelof risk

and ignore correlations ofassetsinthe different layers

LOS8.d

Behavioral financeinsightscouldleadtoportfolioconstructionusing:

• Targetfundstoovercomestatusquobias

• Layered portfolios that accommodate perceptions of risk and importance of goalsto

build portfolios the client willstaywith

LOS 8.e:

Analysts typically exhibit three biases:(1)overconfidence;(2)interpretingmanagement

reports;and(3)biasesintheirownresearch

Behavioral biasesthat contributetooverconfidence:

• The illusion of knowledge bias

• Theself-attribution bias

• Representativeness

• The availability bias

• The illusion of control bias

• Hindsightbias

Actionsanalystscantaketominimizeoverconfidence:

• Getfeedback through selfevaluations,colleagues, and superiors, combined witha

structurethat rewardsaccuracy,leadingtobetter self-calibration

• Develop forecasts thatareunambiguous anddetailed,which helptoreduce

hindsight bias

• Provideone counterargumentsupported by evidence for why their forecastmaynot

beaccurate.

• Consider samplesizeand model complexity

• UseBayes’ formula

Reporting bycompanymanagementissubjecttobehavioral biases:

• Framing

• Anchoring and adjustment

• Availability

Analysts should beawareof the following whena management reportispresented:

• Results and accomplishmentsareusually presentedfirst,givingmoreimportanceto

that information

• Self-attribution biasinthereports.

• Excessive optimism

• Recalculated earnings

Actionsthe analystcantaketo preventundue influenceinmanagement reports:

• Focus onverifiable quantitative data

• Be certainthe informationisframed properly

StudySession 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

Analyst biasesinresearch:

• Usually relatedtocollectingtoomuch information

• Leadstoillusionsofknowledgeandcontrolaswellasrepresentativeness

• Inaccurately extrapolatepastdataintothefuture

• Cansuffer fromconfirmationbias and gambler’sfallacy

Topreventbiasesinresearch:

• Ensureprevious forecastsareproperly calibrated

• Usemetricsandratiosthat allow comparabilitytoprevious forecasts

• Takeasystematicapproach with prepared questions and gathering data first beforemaking conclusions

• Useastructured process; incorporatenewinformation sequentially assigningprobabilities using Bayes’ formula

• Seek contradictory evidence and opinions

LOS8.f:

Committeeforecastsareusuallynobetter thananindividual’s Incommitteesindividualbehavioral biasescanbe diminishedoramplified Socialproof biasiswhenapersonfollows the beliefsofagroup

Committees aretypically comprised of people with similar backgrounds; they tendtoapproach problemsinthesamemanner.Individualsmayfeel uncomfortable expressingtheir opinions Toovercomethese problems,constructcommitteeswith individuals whohavediversebackgrounds,arenotafraidtoexpresstheir opinions, and haverespectforthe other membersof the group

LOS 8.g:

Market anomalies:

• Momentumeffect.Patterns inreturnsthatarecaused byinvestorsfollowing the lead

ofothers;they tendtotradeinthesamedirection,whichisreferredto asherding

• Financial bubbles and crashes Periods of unusual positiveornegativereturnscaused

by panicbuyingorselling.Theycanbe definedas aperiod of pricestwostandarddeviationsfrom their historicalmean Acrashcanalso be characterizedas afallinassetprices of 30%or moreover aperiod of severalmonths;bubbles usually takemuch longertoform Behavioral biases exhibited during bubblesareoverconfidence,confirmationbias,self-attributionbias,hindsightbias,regret aversion,and thedisposition effect

• Valuestocks.Lowprice-to-earnings,highbook-to-market,low price-to-dividendratios.Growth stocks have the opposite characteristics

CONCEPT CHECKERS

Identify threeusesand three limitationsof classifyinginvestors intobehavioral

types.

1.

Listandexplaintwoareasthatareconsidered criticalto asuccessful client/

adviser relationship and how incorporating behavioral financecanenhance the

relationship

2

Whichof the followingisleast indicativeof the pyramidstructureseenwhen

individualscreateportfolios?

A The correlation between theassetsinthe pyramidisignored

B Individuals subconsciouslyviewthe pyramidashavingasingle level of risk

C People tendtoplace theirmoney intodifferent“buckets,”whichisreferred

to asmental accounting

Behavioral finance wouldsupportbuilding portfolios using which of the

following techniques?

A Inapyramid with low priorityinvestmentgoals funded with low riskassets.

B Inabalanced fund with stocks and bonds

C Usingtargetdate funds

3

4

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

Explain why and how hindsight biasisusedinananalyst forecasts

5

Whichof the followingisthe least desirabletraittohaveinaninvestmentcommittee?

A Thecommitteememberscomefromdiverse backgrounds

B Thecommitteemembersaregenerallyinconsensuswithoneanother

C The chairperson of thecommittee encouragesindividualstospeakout.

Explain whatcausesbubbles andcrashesandlisttwoways ofquantitativelyidentifying them

6

7

©2014 Kaplan,Inc.

Page 206

ANSWERS - CONCEPT CHECKERS

Uses ofclassifyinginvestors into behavioral types include:

• Portfolios that are closer to the efficient frontier and more closely resemble ones

based ontraditionalfinance theory.

• More trustingand satisfiedclients.

• Clients who are better able to stay on track with theirlong-termstrategicplans

• Better overallworking relationshipsbetween the client and adviser.

1.

Limitations ofclassifyinginvestors into behavioral types include:

• Individuals maydisplayboth emotional and cognitive errors at the same time, with

either behavior appearing irrational.

• The sameindividualmaydisplaytraits of more than one behavioral investor type

at the same time; therefore, the investment adviser should not try to classify the individual into only one behavioral investor type.

• As investors age, they will mostlikelygothrough behavioral changes,usually

resultingindecreasedrisk tolerance,alongwithbecomingmore emotionalabouttheir investing.

• Eventhoughtwo individuals may fall into the same behavioral investor type, each

individualwould not be treated the samedueto their unique circumstances.

• Individualstend to act irrationally atdifferenttimes,seemingly without

predictability

A successful client/adviserrelationshipcan be defined in four areas, with each onebeing

enhanced by anunderstandingof how behavioral finance canplayan important part in

therelationship

• Theadviser understandsthelong-termfinancialgoalsof the client Behavioral

financehelpsthe adviser understand the reasons for the client’sgoals, makingthe client feel like they are better understood.

• The adviser maintains a consistent approach with the client Behavioral finance

addsstructureand professionalismto therelationship,whichhelpstheadviserunderstand the client before investment advice is given.

• The adviser invests as the client expects Once the adviser understands the

motivations for theclient’s goals,theadviseris betterequippedto meet theclient’sexpectations.

• Both client and adviser benefit from therelationship.The primary benefit of

incorporating behavioral finance into the client/advisorrelationshipis a closer bond between them,resultingin happier clients and an enhanced practice for the adviser.

2.

3 B In thepyramidstructure, investors view each separate layer or investment within

thatlayerashavinga separate level of riskassociatedwith thegoal theyare trying to

accomplishwith that investment It is in the traditional financetheory approachof

portfolioconstruction where all the investor’s assets are viewed as onecomplete portfolio

with asinglelevel of risk In thepyramidstructure, the correlation between the assets

in thepyramidisignored,whereas in thetraditionalfinanceportfolioconstruction,

the correlation between the assets is taken into consideration In thepyramidstructure,

individuals tend to think of each layerseparately,which is referred to as mental

accounting.

4 C Target datefunds overcomethestatus quo bias ofindividuals and adjusttheportfolio

astheyage Asimple balanced approach doesnot make theadjustmentand apyramid

approachissuggested,but low prioritygoalscan be funded withhigherrisk assets.

Study Session 3

Cross-Reference to CFA InstituteAssigned Reading#8-Behavioral Finance and Investment Processes

Hindsightbias is an ego defense mechanismanalystsuse to protect themselves againstbeingwrong in their forecast It is used by selectivelyrecallingwhatactuallyhappened,allowingthe analyst toadjusttheir forecastaccordinglyandmakingit look like theirforecastwas more accurate than itactuallywas.Hindsight biasispossible whentheoriginalforecast is vagueand ambiguous,a poorforecastingtrait,allowingthe forecast

to beadjusted

5

6 B Committee membersalways beingin consensus with each other is an undesirable trait of

a committee, which could lead to poor investment decisionmaking.It is more desirable

to have a committeecomprisedofindividualswithdiverse backgroundswho areencouraged, andnot afraid, to voice their opinions, evenifthe opiniondiffersfrom the others These traits lead to better overall decisionsbeingmade.

Financial bubbles and crashes areperiodsof unusual positive or negative returns caused

bypanicbuyingandselling,neither of which are based on economic fundamentals In a bubble, thebuyingis due to investorsbelievingthe price of the asset will continue to go

up Another way ofdefiningabubbleor crash is aperiodof prices for an asset classthat

is twostandarddeviations away from the priceindex’smeanvalue.A crash can also be characterized as a fall in asset prices of 30% or more over aperiodof several months.

7.

©2014 Kaplan,Inc.

Page 208

SELF-TEST: BEHAVIORAL FINANCE

Usethe following information forQuestions1through 6

Frank Brooks and Peter Timmonsareportfolio managers for thelargestmutual fundof

Liberty FinancialAdvisers,which providesavarietyof mutual funds for both individuals

andinstitutions.Brooks has beenaportfolio manager for eightyearsand hasseenboth

bull and bear markets.Timmons ishisassistantand has beenatLiberty Financial Advisers

for thetwoyearsfollowinghisgraduationfromaprestigious Master ofScience inFinance

program

In theirdiscussionoverlunch,Brooks andTimmonsdiscuss the latest quarterly earnings

announcementsfor several firmsintheir portfolio Despite optimistic projections for

some firms,most announcementswere quitedisappointing Timmonsstatesthat heisnot

convinced that theirprospectsareasgrimastheannouncements suggest.

Thenextday, Brooks andTimmonsprovideapresentationtoLiberty Financial Advisers’

clients Theirguest presenterisStephenDavis,an economistatthe local university who

frequendy provideseconomiccommentaryfor national media outlets During his

presentation,Davisstatesthatit islikely the UnitedStateswillenter arecessionnextyear

Herecommends that the clients shift theirassetsinto investmentgrade bonds and

noncyclical stocks Hestatesthat he has been successfulinpredictingrecessionsoverthepast

15yearsandis certainof his forecasts.Hestatesfurther that the onlytimehe has been wrong

inpredicting the business cycleiswhen Congress unexpectedly increased spending beyond

that expected.Hestatesthatif that hadnothappened, his prediction ofamildrecession

would have beencorrect,insteadof the mildexpansionthat actually occurred

During the afternoonsession,Brooks discusses thevariousstrategiesatLiberty Financial

Advisers In the value/neglected firmstrategy,Liberty Financial Advisers seeksoutfirms

tradingatreasonable valuations withnoanalystfollowing.Brooksstatesthat several

academic studies showed these firmstobe goodinvestmentsovera3-year timehorizon

from Julyinyeart=0toJune30 ofyeart =+3,following their identificationonJune30 of

yeart= 0.Brooksstatesthat he has adopted thisstrategyfor his portfolio

Laterthat eveningatdinner, Brooks,Timmons,andDavisdiscuss the day’sevents.

Commentingon investmentstrategies,Davisstatesthat he focusesongrowth stocks with

6-quarter earnings growth andmonitorshis portfolioon aquarterly basis.Davisalso

statesthat when the short-term moving averagerisesabove thelong-termmoving average,

this signalsanopportunetimetotrade

Whichof thefollowingbest describes Timmons’s behavioral characteristic?

Self-Test: Behavioral Finance

Whichof the following best describes Davis’s behavioral characteristic?Davis:

A usesframe dependence

A uses abottoms-up approachto assesshis skills

B issusceptibletocognitive dissonance

C issusceptibletofeelings ofregret.

Whichof the following best explains Davis’s defense of hispastinaccurateforecast?Davis isexhibiting the behavioral bias of:

SELF-TEST ANSWERS: BEHAVIORAL FINANCE

Timmons usesanchoring.Despite thedisappointingearnings announcements, he states

that he is not convinced that the firms’ prospects are as grim Heunder-adjuststo new

informationbecause hisbeliefs about the firms areanchoredinhisprevious optimistic

forecasts.

1 B

2 B Davis isoverconfident.He states that he is certain of his forecastsandreports a

remarkable (andperhapsnot fully disclosed)performancerecord.

3 B Whenprofessionalsare overconfident,theytend to besusceptibleto cognitive

dissonance Theprofessionalwill ignore information that conflicts with his image of

beingsuccessful Davis admits only one pastforecastingmistake in15years, which he

then blames on an eventoutsideof his control.

4 A Davis states thatif Congresshad notunexpectedly increased spendingabove what

he hadexpected,then hispredictionwould have been correct He isexhibitingself

attribution bias, in which theanalysttakes credit for successes and blames external

events for failures, byclaimingtheir forecast would have been accurate if the factors that

wereincorporatedinto theforecasting model hadn’t changed.Theillusionofknowledge

bias is whenanalyststhinktheyare smarter thanthey actuallyare, which can befueled

by collectingalargeamount of data The representativeness bias is when theanalyst

judgestheprobabilityof a forecastbeingcorrect based on how much the available data

represents the outcome.

5 A This is the sort of odd question you do see occasionally on the exam.Itis based more on

thegeneralCFA curriculum than on thespecific reading.It iscompletelyunpredictable,

and the most important issue is to notspendtoolongon it.Ifyou do not think of an

answer, guess and move on.

First, recognize Brooks’s strategy is to buy out of favorcheapstocks Second, notice all of

the answer choices are technical analysischartingterms Third, think creatively to select

or eliminate answers A support level refers to a price moving down and thenrallying

back up Itvaguelyfits in withbuyingalow-pricestock.Nothingin thedataor question

relates to a moving average of price So eliminate answer“B”.A resistance levelmight

refer to aceilingor floor on a price chart It is not a wrong answer but “A” is the best-fit

answer.

6 B Davis isdescribingthe moving averagetradingtactic inwhichtheshort-termmoving

average isabovethelong-termaverage,indicatingabuy signal

The following is a review of the Private Wealth Management principles designed to address the learning

outcome statements set forth by CFA Institute This topic is also covered in:

ToanswerIPS questionssuccessfully,youmust:

Befamiliar with and understandalarge numberofpotentialissuesthat mightapplyinagivensituation.Thesearecoveredinthe SchweserNotes andinthe CFAreadings Thereisnosubstitutefor reading the material

1.

Carefully read and understandthefactsof thecase todetermine whichissues from

#1abovearerelevant.Becauseeachcaseis unique, youcannot expect topassjust

by repeating whatyousaw astheanswer to apreviousquestion.CFA Institute saysthat the LevelIIIexamisuniqueinrequiringahigh level of judgment andit isthesequestionswherethatmost comesintoplay.You willhave the opportunitytopracticethisas yougo forward in the Schweser material

2.

Recognize that thereisaprocessatworkinconstructinganIPSand doingastrategic

assetallocation(SAA).TheCFAmaterial provides examples of theoutputfrom thisprocess and discussestheinputs butdoesnotfocusontheconstructionprocess

However,theexamhasrequired candidatesto construct anIPSandthen use it.Wefocusonthis in our material

3

4 The laststageisto construct awrittenanswerthat reflects#1, #2,and #3 This has

notbeenrequiredonother levelsoftheexam.The morningsession isgenerallyreferredto asessay,however,themorepreciseterm isconstructedresponse.Thekeypoints thatshouldappear in your answer have been decided,andyour answer

isevaluated strictlyintermsofhow wellit makesandsupportsthosepoints incoherent fashion.Practicewritinganeffective constructedresponseanswermanytimesbefore theexam.

1 Terminologyusedthroughoutthis topic review is industry convention aspresentedinReading8 of the 2015 CFA Level III exam curriculum.

©2014 Kaplan,Inc.

Page 212

5 Asignificantpercentageof Level III candidates find thissectionfrustrating because

itdoesnot meettheir personalsenseof consistency.Past answersarequiteconsistent

onthemain,importantissues (withafew exceptions,wewill discussthese)

But they also includearange ofrandom, unimportantcomments.The random

commentsarefrustratingtocandidates whotry to repeatwhatthey haveseen inpast

answers.Trytomovepastthat and learn whatisexpected Upto now,the CFAexam

process has primarily focusedonprecise mathematicaltechniques The

Level III material willcontinuetodrawonthose skills.However,thisexamwill

likelytestyourabilitytofind what another trained professional would have been

expectedtofind andwrite,when confronted withsometimescontradictoryissues

Thenextpageswill layout avarietyofissueswith whichyouareexpectedtobe familiar

Theymayormaynotbe relevantto agiven portfolio question Theexamwilllikelytest

theabilitytodetermine whatisrelevantto aparticularcaseand then applyit

INVESTOR PROFILINGANDRISKTOLERANCE

LOS 9.a:Discusshowsourceofwealth,measureofwealth,andstageof life

affectanindividualinvestor’srisk tolerance

LOS9.b: Explainthe role of situational andpsychological profilingin

understandinganindividual investor’sattitude towardrisk

CFA®ProgramCurriculum,Volume2,page 162Duetothe variety of individualcircumstances,the advisermayutilize situational

profilingas astarting pointinunderstanding the client and his needs Situational

profiling begins with determining the investor’ssourceofwealth, measureof perceived

wealthversus needs,andstageof life Thesecanprovide insightintothe individual’s risk

tolerance andreturnobjectives

Source of Wealth

Generally, wealthiscreated either activelythroughentrepreneurialactivities or

passively.Passivewealth mightcomefrominheritance, windfall, orthrough long,secure

employment andconservative investment.Themannerinwhichanindividual has

accumulated wealth provides clues about his psychological makeup and his willingnessto

take risk

Activewealthcreation.Wealth that hasbeen accumulatedthrough entrepreneurial

activitymaybe the resultof considerable risk taking.Thus, anindividual classifiedasan

entrepreneurcould exhibitasignificant willingnesstotake risk Keepin mind, however,

thatentrepreneursmight be willingto acceptbusiness risk because they feelincontrol

of the firm and their futures The method of wealth acquisitioncanleadtodifferent

attitudes towardinvestmentrisk

The bottom lineisthat whensomeone isclassifiedasanentrepreneur,itmayindicate

Study Session4

Cross-Reference to CFA Institute Assigned Reading #9—Managing Individual Investor Portfolios

statementsand/oractionsthat confirm the assumptionormight indicate otherwise

Willingnesscanbe indicated by bothstatementsandactions.

Passivewealthcreation.Wealth acquired through windfallorinheritance could indicate

alackofknowledge relatedtoand discomfort with makinginvestmentdecisions.Theseindividualsmayhave below-average willingnesstotoleraterisk Duetotheir lackofinvestmentexperience, theseinvestorsgenerally have little confidenceintheir abilitiesto

regaintheirwealthshouldthey experience significant losses and thuscanhavea strongdesireto protect it.

Anindividualwho hasaccumulatedwealththroughconservativeconsumptionandsavingsover alifetime of secureemploymenthasprobably demonstratedapolicy

of delayed consumption andcareful,low-riskinvestments.This individual hasdemonstratedadesirefor long-term financialsecurityand would be classifiedashavingbelow-average willingnesstotake risk

Measureof WealthGenerally,thereis apositive correlationbetweenaclient’s perception of wealthandhiswillingnesstotakeinvestment risk.Ifan investor perceiveshis wealthassmall, hewillhave low risk tolerance and wish tohold only low-volatilityinvestments The oppositeis

ofcourse trueforanindividual who perceives his wealthaslarge

Stage of LifeAccordingtoconventionalwisdom,investors in theearlierstagesof life havetheability

toaddtotheirportfolios through employment-relatedincomeandhavetime to recoverfrom short-term marketdownturns Theyareabletotolerategreaterportfolio volatilityandtake risk

Lifestages are aprogression and the normal progressionis:

• Foundationphasewhenindividualsareseekingtoaccumulatewealththroughajoband savings, seekingeducation,orbuildingabusiness.Theirlongtimehorizoncan

allow considerable risk taking.However,they often have little financial wealthtorisk,and thismayreduce abilitytotakerisk On theotherhand, thosewho inheritwealthcanoften assumehighrisk given theirlongtimehorizon Theconclusionwilldependonthe specificsof theinvestor’scircumstances

• Accumulation phase when earningsorbusinesssuccessriseand financialassets canbeaccumulated Financialdemands,suchasbuyingahouseoreducatingchildren, mayalso rise.This could bea timeof maximum savingsandwealthaccumulationwitha

higher abilitytobear risk

• Maintenancephase, whichoftenmeansretirement.Preserving wealth andlivingoff the portfolioreturnoften become important The abilitytobear risk will bedecliningbut isprobablynotlow Lifeexpectancy canbelong,withaneedtomaintainpurchasingpower.Beingtooconservativecould leadto adeclineinstandardof living

• Distributionstage means assetsexceedanyreasonable levelof need for the individualandaprocessof distributingassets tootherscanbegin This might involve giftsnow

ormaking plansfordistributionatdeath.Forthe wealthy, financial objectivesmay

©2014 Kaplan,Inc.

Page214

extend beyond their deathsothat thetimehorizonremainslong and abilitytobear

risk couldremainhigh, dependingonthe overallsituation

This progressionisnotalways linear Setbacksorwindfalls along thewaycouldmove

someoneaheadorback,regardless of thesimplepassageoftime

Professor’sNote:Individual client characteristicscandramatically alter the

generalitiespreviously described.Aretired individual withverylow needsrelative

towealthcanhave high abilitytotake risk An elderly client with significant

wealth and goalstopassthison tofuturegenerationsmay chooseasignificantly

moreaggressiveportfolio allocationthan would be implied by naively considering

stageof life.

TRADITIONAL FINANCEVS.BEHAVIORAL FINANCE

Traditional finance(i.e.,modern portfolio theory)assumes investorsexhibit three

characteristics:

1 Riskaversion.Investors minimizeriskforagiven level ofreturn ormaximizereturn

foragiven level of risk andmeasureriskasvolatility

2 Rationalexpectations.Investors’ forecastsareunbiased andaccurately reflect all

relevant information pertainingto assetvaluation

3 Assetintegration Investorsconsider the correlationofapotentialinvestmentwith

their existing portfolios They focusonthe impact of addinga new asset onthe

returnand risk of the total portfolio

Basedonthese assumptions,it canbe expectedassetprices will reflecteconomic factors,

and portfolioscanbe constructed holistically—thismeansby lookingatweighted

averagereturnsand risk calculations thatrelyoncovariance (and correlation)

Incontrast,behavioral financeassumesotherfactorsmayalso be relevant.Decision

modelsalso needtoconsider:

Professor’sNote:Consider thisa cursory reviewoftermsthatarebetter coveredin

other StudySessions.Wesuggestyoufocusonthedifferencebetween the listsfor

traditional and behavioralfinance.

1 Lossaversionoccurswhen the framing ofadecisionas againorlossaffects the

decision For example, givenachoice between(1)asmall known lossof $800 and

(2)a50/50 chance of losing$1,600 or$0(which is,onaverage,losing$800),

individuals chooseuncertaintyand choose the 50/50.Butrephrase thisasgains and

they choosecertainty Forexample(1)asmall known gain of $800or (2)a50/50

chanceof gaining$1,600or$0(whichis, onaverage,gaining$800),individuals

choose certainty and take thesure$800 Phrasedas again,they take certainty,

whichis consistentwith traditional finance Phrasedas aloss,they take uncertainty,

hopingtoavoidaloss,hence thetermlossaversion

Cross-Reference to CFA Institute Assigned Reading #9-Managing Individual Investor Portfolios

2 Biasedexpectationsare acognitiveerrorthatcanoccurfrom overconfidenceinpredicting the future Someexamples include assuming the results of theaveragemanager will be those ofaparticular manager, excessivelyfocusingonoutlierevents,

andmistakenly lettingoneasset representanotherasset.

3 Asset segregation occurswheninvestors viewassetsinisolation and donotconsidertheeffect of correlation with otherassets.Asaresult:

• Asset prices will reflect bothunderlyingeconomicsand theinvestorssubjectivefeelings

• Portfolioconstructionwill be segmented by layers with each layer reflecting thepriority ofitsgoalstothatinvestor Assetswill be selected by layer

INVESTOR PSYCHOLOGYANDPERSONALITY TYPES

LOS 9.c:Explainthe influenceofinvestorpsychologyonrisk tolerance andinvestmentchoices

CFA®ProgramCurriculum,Volume2,page166Behavioral models indicatethat theinvestmentvaluation and decision process

incorporatesmorethan the traditional fundamental financial variablesseeninportfoliotheory Behavioral financeassumes investorsalso include individualpreferences based

onpersonaltastesand experiences Thatis,individuals value personal andinvestmentcharacteristics thatmay or maynotbe consideredintraditional finance valuationprocesses

Additionally, individuals tendto constructportfoliosone asset at atimeratherthan usingadiversified portfolio(i.e.,assetintegration)approach Wealthcreation

isdeterminednotfromanoverall portfolio perspective but by makinginvestmentdecisions that relatetospecific goals (e.g., pyramiding)

Investorattitudesareaffected bynumerouspersonalfactors,includingsocioeconomicbackground, experiences,wealth,andevenframe of mind Through theuseofquestionnaires that focusonnon-investment-related questions concerning personalattitudes and decision making,investorscanbecategorizedwithin broadpersonality

types.

The personality typing questionnaire should be considered onlyafirststep.The results

of the questionnaire should be usedas astarting pointindetermining the client’s risktolerance and attitude toward and understanding ofinvestmentdecision making Having

abetter understanding of the client helps themanageranticipate the client’sconcerns, structure adiscussionof the client’sinvestmentprogramintermstheclient willunderstand,andconstruct arelevant IPS