2017 smart summary, study session 1, reading

Recommended Procedures for Compliance Make reasonable efforts to achieve public dissemination of information.. Recommended Procedures of Compliance M&C with control of client assets sh

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2017 Study Session # 1, Reading # 1

“CODE OF ETHICS AND STANDARDS

OF PROFESSIONAL CONDUCT”

M&C = Members & Candidates

COE = Code of Ethics

DRC = Disciplinary Review Committee

PCS = Professional Conduct Statement

DRC of CFAI BOG ⇒ responsible for PCP & enforcement of code & standards

Circumstances Which Can Prompt Inquiry

Self disclosure by member/candidate on PCS which comprehensively questions professional conduct such as involvement in civil litigation, criminal investigation or any complaint (written) against the member/candidate etc

Written complaints about member/candidate received by professional conduct staff

Evidence of misconduct by member/candidate received by professional conduct staff through public source

A report by CFA proctor of a possible violation during examinations

CFAI designated officer conducts inquiries

Professional conduct staff (in writing) may request explanation from subject member/candidate & may:

Interview the subject member/candidate

Interview the complainant / third party

Collect relevant documents& records

Designated officer may decide:

That disciplinary sanctions are not required

To issue a cautionary letter

To discipline the member/candidate

If disciplinary sanction is proposed, the subject member/candidate may accept the sanction

If sanction is rejected ⇒ matter may be referred to CFAI panel for hearing

Sanctions may include

Condemnation by member’s peers

Suspension of candidate’s continued participation in CFAI program

Los1.b

Act with integrity, competence, diligence, respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues’ in the investment profession, and other participants in the global capital markets

Place the integrity of the investment profession and the interests of clients above their own personal interests

Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities

Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession

Promote the integrity of and uphold the rules governing capital markets

Maintain and improve their professional competence and strive to maintain and improve the competence of other investment professionals

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Standards of Professional Conduct

1 Professionalism 2 Integrity of Capital Markets 3 Duties to Clients 4 Duties to Employers 5 Investment Analysis,

Recommendations& Actions

6 Conflicts of Interest 7 Responsibilities as a CFAI Member or CFAI Candidate

A Knowledge of Law B Independence & Objectivity C Misrepresentation D Misconduct

2 Integrity of Capital Markets

A Material Non-Public Information B Market Manipulation

3 Duties to Clients

A Loyalty, Prudence, and Care

C Suitability

Confidentiality

D Performance Presentation

4 Duties to Employers

Arrangements

C Responsibility of Supervisors

5 Investment Analysis, Recommendations& Actions

A Diligence & Reasonable

Basis

B Communication with Clients & prospective Clients

C Record Retention

6 Conflicts of Interest

A Disclosure of conflicts B Priority of Transactions C Referral Fees

7 Responsibilities as a CFAI Member or CFAI Candidate

A Conduct as Members and Candidates in

the CFA Program

B Reference to CFA Institute, the CFA Designation, and the CFA Program

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2017, Study Session # 1, Reading # 2

“GUIDANCE FOR STANDARDS I-VII”

1 Professionalism

M&C must understand & comply with all applicable laws, rules& regulations (including COE & SOPC)

These rules & regulations pertain to any govt, regulatory organization, licensing agency or professional association governing their professional activities

Must comply with more strict law in case of conflict

M&C must not knowingly participate or assist & must dissociate from any violation of laws

Guidance ⇒ Code & Standards VS Local Law

Members must know laws & regulations related to their professional activity in all countries where they conduct business

Adhere to more strict rule while deciding b/w local laws & Codes & Standards of CFAI

Must comply with local laws related to professional activity

Never violate Codes & Standards even if activity is otherwise legal

Guidance ⇒ Participation in or Association with Violation by Others

Members must dissociate or separate themselves from any ongoing client or employee activity which is illegal or unethical

In extreme case they may have to leave the employer

May, at first, confront the individual involved

Approach supervisor or compliance department

Inaction with continued association may be construed as knowing participation

Recommended Procedures for Compliance-Members

Members must keep themselves updated with applicable laws, rules & regulations

Compliance laws must be reviewed on an ongoing basis in order to ensure that they address prevailing laws, CFAI standards & regulations

Members should maintain current reference material for employees in order to keep them date on laws, rules & regulations

up-to- In doubt, members should seek advice of counsel or their compliance department

Members must document any violation when they disassociate from any prohibited activity

Members must encourage their employers to end such activity

Under some circumstances, it may be advisable or otherwise required by the law to report violations

to governmental authorities

Standards (CFAI) do not require members to report violations to governmental authorities

CFAI encourages members, clients & public to submit written report against a CFA member or candidate involved in violation of the CFA Code & Standards

Recommended Procedure for Compliance-Firms

Members should encourage their firms to:

Develop and/or adopt a code of ethics

Highlight applicable laws and regulations to employees

Establish written procedures for reporting suspected violation of laws, regulations or company policies

Members incharge of supervision, creation and maintenance of investment services should:

Be aware of and comply with regulations and laws in their country of origin

They must be aware of and comply with regulations of countries where products/services will

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1 B Independence & Objectivity

M&C must use reasonable care & judgment to achieve & maintain independence &

objectivity in professional activities

Do not accept any gift, or any type of consideration that may compromise their own or another’s independence & objectivity

Guidance

Investment process must not be influenced by any external sources

Modest gifts by clients are permitted

Allocation of shares in oversubscribed IPO to personal accounts is not permitted

Distinguish b/w gifts from clients & entities seeking influence to the detriment of the client

Gifts must be disclosed to the member’s employer either prior to acceptance or subsequently

Guidance-Investment Banking Relationships

Do not get pressurized from sell-side analyst to issue favorable research on current or prospective investment-banking client

Disclose conflicts and manage these appropriately while working with investment bankers

in “road shows”

Ensure effective “firewalls” b/w research/investment management & investment banking activities

Guidance-Public Companies

Do not limit research to discussions with company management

Use sources like:

Suppliers

Customers

Competitors

Analyst must not be pressured to issue favorable research by the companies they follow

Guidance-Buy Side Clients

Responsibility of portfolio managers to respect and foster intellectual honesty of sell side research

Portfolio managers must not pressurize sell side analysts

They may have large positions in particular securities Rating downgrade may adversely affect portfolio performance

Guidance-Fund Manager Relationships

Members responsible for selecting outside managers should not accept gifts, entertainment or travel that might be perceived to impair member’s independence and/or objectivity

Guidance-Credit Rating Agency

Members employed by credit rating agencies make sure they prevent undue influence by security issuing firms

Members using credit ratings must be aware of potential conflicts of interest& therefore may consider independent validation of the rating granted

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Guidance-Issuer Paid Research

Analyst’s compensation for such researches should be limited

Preference is flat fee

No reward must be attached with report’s recommendation

Guidance-Travel

Best practice ⇒ analysts pay their own commercial travel while attending information events or tours sponsored by the firm being analyzed

Recommended Procedures for Compliance

Protect the integrity of opinions (unbiased opinion of the analyst) & design proper compensation systems

Create a restricted list (remove the controversial company from research universe)

Restrict special cost arrangements (limit the use of corporate aircraft to situations in which commercial transportation is not available)

M&C should pay for commercial transportations & hotel charges

Limit the acceptance of gratuities and/or gifts to token items only

Develop formal policies related to employee purchases of equity or equity related IPOs (strict limits on private placements)

Effective supervisory & review procedures

Ensure that research analysts are not supervised or controlled by any department that could compromise the independence of analyst

Appoint a senior officer with oversight responsibilities for compliance with firm’s COE & all regulations concerning its business

1 C Misrepresentation

M&C must not knowingly make any misrepresentations relating to investment analysis, recommendation, actions or other professional activities

Guidance

Misrepresentation causes mistrust

Do not give false impressions in oral, written& electronic communication

Misrepresentation includes

Guaranteeing investment performance

Plagiarism

Plagiarism ⇒ using someone else’s work without giving him credit

Misrepresentation also includes deliberately omitting information that could affect investment decision

Models and analysis developed by others at firm are the property of members can use them without attributing to developers

firm- A report written by another analyst employed by the firm cannot be released as another analyst’s work

Recommended Procedure for Compliance

Firms should provide employees who deal with clients a written list of firm’s available services and its qualifications

Employee qualification should be accurately presented as well

To avoid plagiarism, firm must keep record of all sources and cite them

Generally understandable and factual information need not to be cited

Members should encourage firms to establish procedures for verifying marketing claims of third parties whose information the firm provides to clients

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1 D Misconduct

M&C must not involve in dishonesty, fraud, deceit or commit any act that reflects adversely on their professional reputations, integrity or competence

Guidance

CFAI discourages unethical behavior in all aspects of members’ and candidates’ lives

Do not abuse CFAI PCP by seeking enforcement of this standard to settle personal, political or other disputes not related to professional ethics

Firms are encouraged to adopt these policies and procedures to:

Develop and adopt a code of ethics and make clear that unethical behavior will not be tolerated

Give employees a list of potential violations and sanctions including dismissal

Check references of potential employees

2 INTEGRITY OF CAPITAL MARKETS

2 A Material Non-Public Information

Guidance

Material information ⇒ if disclosure would impact price of security

If reasonable investor would want the information before making an investment decision

Nonpublic information ⇒ non-available to the marketplace

Analyst conference call is not public disclosure

Selective disclosure causes insider trading

Prohibition against acting on material non public information extends to securities, swaps, and option contracts

Guidance-Mosaic Theory

No prohibition on reaching an investment decision through public and non-material nonpublic information

Make reasonable efforts to achieve public dissemination of information

Encourage firms to adopt procedures to prevent misuse of material nonpublic information

Use a “firewall” within the firm with

Substantial control of relevant interdepartmental communication  through a clearance like compliance/legal department

Review employee trades maintain watch, rumor, and restricted lists

Monitor & prohibit proprietary trading-if a firm is in possession of material non-public information

Prohibiting all proprietary trading may send a signal to the market firm should take the contra side of only unsolicited customers trade

M&C must not act or cause others to act on the information that is material nonpublic (affect the value of investments)

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2B MARKET MANIPULATIONS

M&C must not engage in practices that mislead market participants (distort prices or artificially inflate trading volume)

Guidance

Spreading false rumors is prohibited (which can distort market)

Standard applies to transactions that deceive market

By distorting the price-setting mechanism of financial investments

Securing a controlling position to manipulate the price of a related derivative or the asset

3 DUTIES TO CLIENTS

M&C:

Have a duty of loyalty to clients & must act with reasonable care & exercise prudent judgment

Must act for the benefits of clients & place clients’ interests above employers’ or their own interests

Guidance

M&C must exercise same level of prudence, judgment & care as in management & disposition of their own interests in similar circumstances

M&C should manage pool of assets in accordance with the terms of governing documents (e.g trust documents)

Determine the identity of “client’” to whom duty of loyalty is owed (May be an individual or plan beneficiaries in case of pension plan or trust)

M&C must follow any guidelines set by their clients for the management of their assets

Investment decisions are judged in the context of total portfolio rather than individual investments

Conflict arises when “soft dollars” are not used for the benefit of clients

Cost-benefit analysis may show that voting all proxies may not a beneficial strategy for clients

Recommended Procedures of Compliance

M&C with control of client assets should submit to each client, at least quarterly, a statement showing funds & securities

In doubt, M&C should disclose the questionable matter in writing to client & obtain client approval

M&C should address & encourage their firms to address the following regarding duties to client;

Follow all applicable rules & laws

Establish the investment objectives of the clients

Consider all the information when taking actions

Diversify investments to reduce risk of loss

Carry out regular reviews

Deal fairly with all clients with respect to investment actions

Disclose conflict of interest & compensation arrangements

Maintain confidentiality & seek best execution

3 A Loyalty, Prudence & Care

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3B Fair Dealing

M&C must deal fairly & objectively with clients (when providing investment analysis, making recommendations, taking action or engaging in other professional activities)

Guidance

No discrimination among clients while disseminating recommendations or taking investment decision

Fairly does not mean equally ⇒ difference in timings of emails & fax received by clients are normal course of business

Different services levels are okay as far as they do not adversely affect any client

Disclose different levels of services to all clients and prospects

Premium services should be available to all those who are willing to pay for them

Guidance-Investment Recommendation

All clients must be given fair opportunity to act upon every recommendation

Clients unaware of the change in recommendation  should be advised before the order is accepted

Guidance-Investment Actions

Clients must be treated fairly in the light of their investment objectives and circumstances

Both institutional and individual clients must be treated in a fair & impartial manner

Member/candidates should not take advantage of their position to disadvantage clients (e.g., in IPOs)

Firms are encouraged to establish compliance procedures to treat customers & clients fairly

Communicate recommendations simultaneously within the firm & to customers

M&C should consider the following:

Limit the no of people who are aware that a recommendation is going to be disseminated

Shorten the time frame b/w decision & dissemination

Publish guidelines for pre-dissemination behavior

Simultaneous dissemination (treat all clients fairly)

Maintain a list of clients & their holdings

Develop & document trade allocation procedures

Disclose trade allocation procedures (must be fair & equitable)

Establish systematic account review (no preferential treatment to any client or customer)

Disclose level of services (different levels of services are possible for same or different fees)

3 C SUITABILITY

2.M&C are in advisory relationship 1.When M&C are responsible for a portfolio

with a specific mandate, strategy or style, they must take actions according to the objectives & constraints of the portfolio

Make inquiry into client’s investment experience, risk &

return objectives, financial constraints &

reassess & update this information regularly

Determine investment’s suitability with reference to client’s objective &

constraints &

mandate

Judge the investment suitability in the context of client’s total portfolio

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Guidance

Develop IPS at beginning of the relationship

Consider client’s needs, circumstances & risk tolerance

Consider whether use of leverage is suitable for the client or not

Make sure to abide by the stated mandate

Develop written IPS of each client & take the following into consideration:

Client identification

Investor objectives

Investor constraints

Performance measurement benchmark

Objectives & constraints should be maintained & reviewed periodically to reflect any changes in clients’ circumstances

Suitability test policies

3 D Performance Presentations

M&C must communicate fair, accurate & complete investment performance information

Guidance

Members must avoid misstating performance or misleading clients about investment performance

of themselves or their firms

Members should not misrepresent past performance or reasonably expected performance

Members should not state or imply the ability to achieve a rate similar to that achieved in the past

Indicate if presentation has offered limited information

Brief presentations should be supplemented with information that detailed report is available on request

Apply GIPS standards

Consider the knowledge of audience to whom performance presentation is addressed

Performance of composite rather than single account

Include performance history of terminated accounts

Disclosures that fully explain the performance results should be reported

Maintain data & record used to calculate the performance being presented

3 E Preservation of Confidentiality

M&C must keep information about current, former &

prospective clients confidential unless:

Information concerns illegal activity

Disclosure is required by law

Client or prospective client permits disclosure

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Guidance

If a client is involved in illegal activitiesmembers may have an obligation

to report to the authorities

This standard extends to former clients as well

Standards do not prevent members from cooperating with CFA PCP investigation

Avoid disclosing information received from client except to the authorized colleagues working for the same client

Follow firm’s procedures for storing electronic data

Recommend adoption of such procedures if they are not in place

4 Duties to Employers

M&C:

Must act for the benefit of their employer

Not deprive employer of the advantage of their skills &abilities, divulge confidential information or otherwise cause harm to their employer

Guidance

Do not indulge in the activities that may injure the firm deprive it of profit or advantage of employee’s abilities & skills

Though clients’ interests have priority than firm’s interests but consider the effects

of actions on the firm’s integrity and sustainability

A careful balance b/w managing interests of employer & family manage such obligations with work obligations

Independent practice for compensation is allowed

Provide employer notification fully describing all aspects of service

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Guidance-Leaving an Employer

Continue to act in employer’s best interest until resignation is effective

Activities that may constitute a violation include:

Misappropriation of trade secrets

Misuse of confidential information

Soliciting employer’s client prior to leaving

Self-dealing

Misappropriation of client lists

Employer records on home computers, PDA, cell phones or any other medium are property of firm

After leaving the organization, simple knowledge of names and existence of former clients is not confidential

Member/candidate can use the experience or knowledge gained with former employer at any other organization

Guidance Whistle-blowing

In exceptional cases, duty to the employer may be violated in order to protect

a client for upholding the integrity of capital markets

Whistle- blowing cannot be done for personal gains

Guidance-Nature of Employment

If members/candidates are independent contractors, they still have duty to abide

by the terms of the agreement

4 B Additional Compensation Arrangements

M&C must not accept gifts, benefits, compensation, or consideration that competes with or might reasonably be expected to create a conflict of interest with their employer’s interest unless they obtain written consent from all parties involved

Guidance

Compensation includes both direct & indirect form

Additional benefits are also included

Written consent from employer also includes email communication

Immediately report to employer in written format detailing any proposed compensation and services

Performance incentives should be verified by the offering party

Recommended Procedures for compliance

Competition policy (employer restrictions on offering similar services outside the firm)

Termination policy (how termination is disclosed to clients & staff)

Incident-reporting procedures

Employee classification (e.g full time, part time)

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4 C Responsibility of Supervisors

M&C must make efforts to detect & prevent violations of applicable laws, rules & regulations and Code & Standards by any one subject to their supervision or authority

Guidance

Members must take steps to prevent subordinates from violating laws, rules, regulations or code & standards

Make reasonable efforts to detect violations

Members with supervisory responsibility must ensure that policies regarding investment or non-investment behavior are enforced equally

Guidance-Compliance Procedures

Members with supervisory responsibility must bring an inadequate compliance system to the firm’s attention and recommend corrective action

While investigating a violation it is appropriate to limit suspected employee’s activities

Unless adequate procedures are adopted by the firm, a member must decline in writing from accepting supervisory responsibility

M&C should recommend their employers to adopt a COE

Separate the COE from compliance procedures

Adequate compliance procedures:

Clearly written & accessible manual

Designate a compliance officer to implement compliance procedures

Implement system of checks & balances

Describe the hierarchy of supervision

Outline scope of procedures & permissible conduct

Once a compliance program is in place, a supervisor should:

Disseminate program contents to appropriate personnel & educate them regarding compliance procedures

Professional conduct evaluation as part of employee’s performance review

Review employee’s actions & identify violation

Once a violation is discovered, supervisor should respond promptly, conduct thorough investigation & increase supervision

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5 Investment Analysis, Recommendations and Actions

1.M&C must exercise diligence, independence & thoroughness in investment analysis,

recommendations & actions

Guidance-Reasonable Basis

Level of research for due diligence depends on product/service offered

Prior to making recommendation or investment action consider;

Firm’s financial results, operating history & business cycles stage

Mutual fund’s fee & past performance

Limitation of any quantitative methods used

Appropriateness of peer group comparisons

Guidance-Using Secondary or Third-Party Research

To periodically review quality of third party research use the following:

Review assumptions used

How rigorous was the analysis

How timely the research is

Evaluate objectivity & independence of recommendations

Guidance-Quantitative Research

Able to explain the nature of quantitative methods used

Consider scenarios which are not typically used to assess downside risk

Ensure that both positive & negative results have been used

Guidance-External Advisers

Ensure advisors have adequate compliance and internal controls

They present correct return information

Do not deviate from stated strategies

Policy requiring that research reports, credit ratings & investment recommendations have a reasonable & adequate basis

Develop written guidance for analysts, supervisory analysts & review committees

Develop measureable criteria for research report quality assessment

Written guidance for computer-based models used in developing rating & evaluating financial instruments

Develop measurable criteria for assessing outside providers

Standardized criteria for evaluating the adequacy of external advisers

5 A Diligence & Reasonable Basis

Guidance-Group Research & Decision Making

If the group research has a reasonable basis, do not refuse to

be identified with the report merely on the basis of disagreement with the consensus view

2.M&C must have a reasonable &

adequate basis for investment analysis, recommendation or action (supported by research &

investigation)

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5 B Communication with Clients and Prospective Clients

Always include basic characteristics of security identified

Distinguish b/w facts and opinions

Illustrate investment decision making process utilized

All means of communication should be included not only the research reports

Communicate any specific risk factors associated with securities

Clearly communicate potential gains & losses

Failing to illustrate model’s limitations may be considered as violation

Able to supply additional information if requested maintain relevant information

Maintain records that support conclusion or any investment action

Such records are property of the firm

If regulatory requirements do not recommend, keep records for 7 years

Members who change firms must recreate analysis related documentation – not rely on memory or material created at previous firms

Record-keeping is generally firm’s responsibility

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If servicing as a board member disclose

Disclosure of broker/dealer market making activities is included

Disclosure of holdings in companies that member recommends or clients hold

Members’ compensation structure, if perceived to gain any client must be disclosed

Members working in advisory capacity

Update disclosure in case of significant change in compensation structure

Guidance –Disclosure of Conflicts to Employers

Give employers enough information to judge the impact of conflict

Take reasonable steps to avoid conflict  report promptly if they occur

Prioritize client’s transactions over personal transactions& made on behalf of the member’s firm

Personal transactions may be undertaken after clients and member’s employers have been given adequate opportunity

Personal transaction – member is a “beneficial owner”

Family member accounts should not be disadvantaged to client accounts

Information about pending trades should not be acted upon for personal gains

6 A Disclosures of Conflicts

Special compensation arrangements (bonus, commission etc.) should be disclosed

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Limited participation in equity IPOs by investment personnel

Restrictions on private placements for investment personnel

Establish blackout/restricted periods for investment personnel

Reporting requirements for investment personnel

Disclosure of holdings in which the employee has a beneficial interest

Provide duplicate confirmations of transaction

Guidance

Must inform employers, clients and prospects of benefits received for referral of customers and clients

All types of consideration must be disclosed

Encourage firms to adopt clear procedures regarding compensation for referrals

M&C should update the employer (at least quarterly) regarding nature and value

of referral compensation received The clients should also be notified about approved referral fee programs

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7 Responsibilities as a CFAI Member or CFAI Candidate

7 A Conduct as Members and Candidates in the CFA Program

M&C must not:

Engage in any conduct that compromise reputation or integrity of CFAI or CFA designation

Violate integrity, validity or security or the CFA examinations

Guidance

Must not engage in any activity that undermines the integrity of CFA charter

Standard applies to:

Cheating in CFA or any exam

Revealing anything about the contents & topics of exam

Not following exam related rules & polices of CFA program

Disclosing confidential exam related information to candidates or to public

Improperly using the designation

Misrepresenting information on PCS or CFAI PDP

Members can express their opinion regarding the CFA exam or program but without disclosing actual exam specific information

Members voluntarily participating in the administration of the CFA exam must not solicit or reveal information about:

Exam questions

Grading process

Scoring of questions

7 B Reference to CFA Institute, the CFA Designation, and the CFA Program

M&C must not misrepresent or exaggerate the meaning or implication of membership in CFA institute, holding the CFA designation or candidacy in CFA program

Guidance

Do not over-promise individual competence

Do not over promise future investment result

Sign PCS annually

Pay CFAI membership dues annually

Do not misrepresent or exaggerate the meaning of the designation

No partial designation exists

Acceptable to state candidate successfully completed the program in 3 years ⇒claiming superior ability is not permitted

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“ASSET MANAGER CODE OF PROFESSIONAL CONDUCT”

THE ASSET MANAGER CODE

There are six risk components to the asset manager code

Ethical responsibilities related to six components are:

Always act ethically & professionally

Act independently & objectively

Perform actions using skill, diligence & competence

Act in best interest of the client

Communicate with clients on a regular & accurate manner

Legal & regulatory compliance

PREVENTING VIOLATIONS

Loyalty to Clients Investment Process & Actions

Put the client’s interest before your own

Take actions that would not cause any harm to the client

Never engage in market manipulation of security prices

Fair dealing with all clients

Thoroughly investigate & research different investment options

Trading Risk Management, Compliance & Support

Do not trade or cause others to trade on insider information

Seek best execution for all trades & equitable allocation among clients

Use soft $ commission to provide products & services that aids the portfolio manager in investment decision making process

Place client’s trades before your own

Develop policies & procedures for complying with codes &

standards & regulatory requirements

Appoint a compliance officer & establish a firm wide system for identifying & measuring manager’s risk position

Complete & accurate portfolio information disseminated to clients

Maintain records

Contingency plan in the event of a natural disaster

Disclosure Performance & Valuation

Report investment results in an accurate manner without misrepresentation Use fair MV

Guideline ⇒ follows GIPS

In order to avoid conflict of interest, transfer the responsibility of valuing asset accounts to an independent third party

Disclose the following to the client:

Any information needed to make an informed decision regarding the investment manager or the organization

Potential conflict of interest

Any regulatory or disciplinary action taken against the manager or its personnel

The investment decision-making process & fee schedule

Discussion about soft $ commission

Trade allocation procedures & firm-wide risk management processes

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“THE BEHAVIORAL FINANCE PERSPECTIVE”

1 INTRODUCTION

2 BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES Traditional VS Behavioral Finance

Grounded in neoclassical economics

Individuals are assumed to be rational, risk averse & utility maximizers

Traditional finance believes in EMH

Grounded in psychology

Based on observed financial behavior rather than idealized financial behavior

Classification

Behavioral Finance Micro Behavioral Finance Macro

Describe decision making process of individuals

Cognitive errors & emotional biases

Consider anomalies that distinguish market from efficient markets

2.1 Traditional Finance Perspectives on Individual Behavior

Traditional finance assumes:

Investors are risk averse & self interested

Investors make decisions based on utility theory &

revise expectations consistent with Bayes’ formula

Efficient Markets

2.1.1 Utility Theory and Bayes’ Formula

People maximize the PV of expected utility subject to their budget constraints

Expected utility = weighted sum of the utility values of outcomes × Probabilities

A rational investor make decision based on following axioms of utility theory:

Completeness ⇒ an individual has well defined preferences & can decide b/w two alternatives

Transitivity ⇒ as an individual decides according to completeness axiom, an individual decides consistently

Independence⇒ assumes preference order of two choices combined with third choice maintains the same preference order

Continuity ⇒Indifferent curves (IC) are smooth & unbroken (continuous)

Bayes’ formula:

New information is assumed to update beliefs about probabilities according to Bayes’ formula

Application of conditional probability

Assumes that events are mutually exclusive & exhaustive with known probabilities

⁄ = ⁄

Where P (A/B) & (P (B/A)) = conditional probability of event A, (B) given B, (A)

P (B) = prior probability of event B

P (A) = prior probability of event A

REM = Rational Economic Man

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2.1.2 Rational Economic Man

REM:

Maximize utility given budget constraints & available information

Selfishly seek the personal utility maximizing decision

Tries to minimize economic cost

Govern by perfect rationality, perfect self-interest & perfect information principles

2.1.3 Perfect Rationality, Self-Interest, & Information

Prefect rationality ⇒ REM is a rational thinker (ability to reason & make beneficial judgments)

Prefect self interest ⇒ REM is perfectly selfish

Perfect information ⇒ REM has perfect knowledge of every subject

2.1.4 Risk Aversion Risk Attitudes

Risk Neutral

Investors who prefer a certain alternative over an uncertain one (same expected value)

Diminishing marginal utility of wealth (concave utility function)

Investors are indifferent b/w a certain & uncertain alternative

Constant marginal utility of wealth

Linear utility function

Investors who prefer to invest in uncertain alternatives

Increasing marginal utility of wealth (convex function)

Expected utility theory assumes that investors are risk averse (utility functions are concave & diminishing marginal utility of wealth)

Certainty equivalent ⇒ max sum of money a person would pay

to participate or minimum amount of money a person would accept to not participate in an event with uncertain outcome

2.2 Behavioral Finance Perspectives on Individual Behavior

Behavioral finance challenges assumptions of traditional finance

on the following grounds:

Investors may be unable to make decisions based on utility theory & revise expectations consistent with the Bayes’

formula

Perfect rationality, self interest & prefect information principles’ violation

2.2.1 Challenges to Rational Economic Man

Bounded rationality ⇒ individual’s choices are subject to knowledge & cognitive limitations

REM ignores the fact that people can have difficulty prioritizing short term v/s long term goals

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2.2.2 Utility Maximization and Counterpoint

An IC depicts all possible combination of two goods amongst which an individual is indifferent

For perfect substitutes (complements), the IC is a line with constant slope (L-shaped)

IC analysis fails to consider exogenous factors (e.g risk aversion, individual’s circumstances etc)

2.2.3 Attitudes toward Risk

Risk evaluation depends on the:

Wealth level

Circumstances of the decision maker

Double inflection utility function ⇒ utility function that changes based on level of wealth

Investors are risk averse at & income levels

Investors are risk seeking at moderate income levels

Prospect theory ⇒ Shape of a decision maker’s value function differs for G&L

Value function is normally concave for gains, convex for losses & steeper for losses than for gains

2.3 Neuro-economics

Explain how humans make economic decisions under uncertainty

Neuro-economics explains:

Overconfidence & market overreaction

A panicked rather than analytical response after falling market

Based on expected value & traditional finance assumptions

Expected utility can vary from person to person (based on the worth assigned by the decision maker)

Expected value is same for every one (based on price)

3.2 Bounded Rationality

Subjective expected utility theory ⇒ probability distributions of all relevant variables can be provided by the decision makers

Bounded rationality & satisfice ⇒ situation where people gather some available information, use heuristics to analyze the information & stop at a satisfactory decision

Satisficing ⇒ finding an acceptable solution as opposed to optimizing

Investor takes steps to achieve intermediate goals, as long as they advance the investor towards the desired goals

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3.3 Prospect Theory

Investors analyze risk relative to possible gains & losses rather than relative to expected return

Investors are more concerned with the change in wealth & place greater value on a loss than on a gain of same amount

Phases to Making a Choice

People compute a value function based on potential outcomes

& their probabilities

Where

, = Potential outcomes

, = Probabilities

W = Probability weighting function

V = Function that assigns a value to an outcome

The value function states:

People overreact (underreact) small (mid-sized & large) probabilities events

People are loss averse

Preferences are determined by attitudes towards gains &

Codification

Investor combines those outcomes with identical value

Combination

The riskless component of any prospect

is separated from its risky component

Isolation effect⇒ investors focus on one factor or

outcome while eliminating or ignoring others

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4 PERSPECTIVES ON MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION

EMH assumes:

Market participants are REM

Population updates its expectations as new relevant information appears

Relevant information is freely available to all participants

4.1 Traditional Perspectives on Market Behavior

4.1.1 Review of the Efficient Market Hypothesis

Traditional finance assumes EMH

Forms of Market Efficiency

Consistently excess return is not possible using technical analysis

Reflect all historical price &volume data

All publically available information

is fully reflected in securities prices

Excess return on continuous basis is not possible using technical &

Grossman-Stiglitz paradox ⇒prices must offer returns to information acquisition otherwise the market can’t be efficient

4.1.2 Studies in Support of the EMH

4.1.2.1 Support for the Weak Form of the EMH 4.1.2.2 Support for the Semi-Strong Form of the EMH

Test whether security prices are serially correlated or whether they are random

Studies conclude that security prices are random, (support weak form of the EMH)

Event studies

Announcement of the event (not event itself) appear

to be reflected in prices

4.1.3 Studies Challenging the EMH: Anomalies

4.1.3.1 Fundamental Anomalies 4.1.3.2 Technical

Investor generates excess return based on some fundamental characteristics of the firm

Small cap firms appear to outperform large cap firms

Value stocks appear to outperform growth stocks

Moving average ⇒ if the short (long) moving avg prices rise above the long (short) avg prices, this is an indication of strength (weakness)

Resistance level ⇒ price will climb to the resistance level & then reverse direction (act like a ceiling)

Support level ⇒ floor price (price will move upward after support level reached)

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4.1.3 Studies Challenging the EMH: Anomalies

4.1.3.3 Calendar Anomalies 4.1.3.4 Anomalies: Conclusion

January effect ⇒ stocks deliver abnormally returns during the month of January

Turn-of-the month effect ⇒ stocks earn

returns on the last day & 1st

four days of each month

Markets are neither perfectly efficient not completely anomalous

Meets investor’s objective & constraints

Choose from mean-variance efficient portfolios

4.3 Alternative Models of Market Behaviorand Portfolio

Construction

Behavioral life-cycle theory incorporates:

Self control bias ⇒ short-term satisfaction to the detriment of long-term goals

Mental accounting ⇒ people ignore the fact that wealth is fungible (interchangeable) & assign different portions of their wealth to meet different goals

Framing bias ⇒results in different responses based on how questions are asked (framed)

4.3.1 A Behavioral Approach to Consumption and Savings

Behavioral assets pricing model adds a sentiment premium (stochastic discount factor) to discount rate

Required return on an asset = Rf + fundamental risk premium + sentiment premium

Sentiment premium ⇒ based on analysts’ forecasts

The dispersion of analysts’ forecasts, the sentiment premium, the discount rate & the perceived value of the assets

4.3.2 A Behavioral Approach toAsset Pricing

Uses of probability-weighting function rather than the real probability distribution

Investor’s structure their portfolio in layers & composition of each layer is determined by interaction of following five factors

The importance of the goals

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Revised version of the EMH that considers bounded rationality, Satisficing&

evolutionary principles

The competition & adaptable the participants, the likelihood of not surviving

Five implications:

Risk premiums change over time

Active management can add value

Consistent outperformance is impossible

Investors must adapt to survive

Survival is the essential objective

4.3.4 Adaptive Markets Hypothesis

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“THE BEHAVIORAL BIASES OF INDIVIDUALS”

2 CATEGORIZATIONS OF BEHAVIORAL BIASES

Mechanical or physical limitations (statistical, informational processing

or memory errors)

More easy to correct than emotional biases (moderated)

Behavioral Biases

Cognitive Errors Emotional Biases

Stem from impulse or intuition

Emotional biases are difficult to correct

Result of attitude & feelings

Can be adapted not moderated (decisions are made that adjust for it rather than reduce or eliminate it)

FMP= Financial Market Participants

The tendency to cling to one’s previously held beliefs irrationally or illogically

Closely related to cognitive dissonance ⇒ a conflict b/w beliefs or opinions & reality

To resolve this dissonance people may seek only selective exposure, selective perception & selective retention

3 COGNITIVE ERRORS

Belief Perseverance Biases Processing Errors

Describe irrational or illogical information processing in financial decision making

People place more emphasis on information they used to form their original forecast than on new information

In Bayesian term⇒ people overweight the base rates & under react to new information

3.1.1 Conservatism Bias

Slow to react new information

Tendency to hold winners or losers too long

Cognitive cost ⇒efforts required to analyze new information

Cognitive cost of new information, underweight new information

Guidance for Overcoming

Look carefully at new information

to determine its value

Seek professional advice

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People tend to look for & notice what confirms their beliefs & undervalue the contradict views

It is a natural response to cognitive dissonance

3.1.2 Confirmation Bias

Consider only the +ve information &

ignore –ve information

May be incorrect screening criteria

Under-diversified portfolios

Employees may overweight employer’s stocks

One should seek out information that challenges one’s beliefs

Get corroborating support

Do additional research

If-then heuristic where individuals classify information into subjective categories using heuristics

In Bayesian terms, investors tend to underweight the base rates &

overweight the new information

3.1.3 Representativeness Bias

i) Base-Rate Neglect

Too little weight to the base rate

ii) Sample Size Neglect

Incorrect assumption ⇒ small sample sizes are representative of population

Too much weight to new information

Under reliance on recent performance that results in excessive trading & return

Use a periodic table of investment returns that ensure diversification over return chasing

Consequences

Emphasis is on new information

Use simple classification rather than deal with the mental stress of updating beliefs given complex data (low cognitive cost)

Bias in which people tend to believe that they can control outcomes, when infact they can’t

Subjective probability of personal success is

3.1.4 Illusion of Control Bias

Excessive trading & inferior performance

Less diversified portfolio

Investors should recognize that investing is a probabilistic activity

Seek contrary viewpoints

Keep records including reminders outlining the rationale behind each trade

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Individuals perceive outcomes (past

events) as reasonable & expected

People overweigh their predictions

because they are biased by the knowledge of what actually happened

Carefully record & examine investment decision

Markets move in cycles so expectations must be managed

Investment managers must be evaluated relative to appropriate benchmarks

Individual seem to be anchored to a

value or number & then adjust the number to reflect new information

3.2 Information-Processing Biases

Investors tend to remain focused on &

stay close to their original forecasts

Less weight to historical information

Look at the basis for any recommendations

Individual place each goal & the

wealth, that will be used to meet each goal, into a separate mental account

3.2.2 Mental Accounting Bias

Create a portfolio strategy taking all assets into consideration

Total return consideration

3.2.1 Anchoring and Adjustment Bias

Bias in which a person answers a

question differently based on the way

in which it is asked

Narrow framing ⇒ investors use too

narrow a frame of reference

3.2.3 Framing Bias

More risk averse when presented with a gain frame & more risk seeking when presented with a loss frame (sub optimal portfolios)

Excessive trading

Investors should focus on expected return & risk rather than on gain or losses

When interpreting investment situations, investor should be neutral

& open minded

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Bias in which people estimate the

probability of an outcome based on how easily the outcome comes to mind

Easily recalled outcomes are

perceived as being more likely

Follow a long-term strategic approach

Construct a suitable portfolio through developing an IPS rather than relying

on more readily available information

Categorization

Individual categorize information using classification they are most familiar with

Sources of Availability Bias

Narrow Range of Experience

Limited experience of investor will lead

to narrow focus to frame information

Retrievability

Refers to how easily an idea is

recalled

The easier to retrieve a memory, the

more likely the individuals will use it

Individuals tend to estimate other’s choices using their own choices

3.3 Cognitive Errors: Conclusion

Systematic process to describe problems & objectives, to document decisions & the reasoning behind them& to compare the actual outcomes with expected results will help to reduce cognitive errors

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4 EMOTIONAL BIASES

Harder to correct for than cognitive errors

Recognize these biases & adapt to them

Individuals focus on potential gains &

losses relative to risk rather than

returns relative to risk

Disposition effect ⇒ holding losing

positions too long & selling gaining

positions too quickly

4.1 Loss-Aversion Bias

Hold investments in a loss (gain) position longer (shorter) than justified

by fundamental analysis

Limited upside potential

Excessive trading & riskier portfolio holdings

Framing & loss aversion biases may affect FMPs simultaneously

House money effect ⇒ investors view profits as belonging to someone else & become less risk averse when investing it

Myopic loss aversion ⇒ investors overemphasize short-term gains &

losses & weight losses more heavily than gains

Combine aspects of time horizon based framing, mental accounting & loss aversion

Higher than theoretically justified short-term equity risk premium

If frequency of evaluation is , the probability of observing a loss

is

Disciplined approach of investment based on fundamentals

Base investment decisions on expectations rather than past performance

People feel they know more than they

do because they feel they have more

or better information or better at interpreting information

Too narrow confidence intervals

Poorly diversified portfolios

ii) Certainty Overconfidence

Assign too high probabilities to outcomes

Excessive trading

i) Prediction Overconfidence 4.2 Overconfidence Bias

Self-attribution bias ⇒combination of self enhancing bias (propensity

to claim too much credit for success) & self-protection bias (place failure blame to someone or something else)

Consequences Guidelines to Overcome

Return than market

Review trading records & calculate portfolio performance

Investors should be objective

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Individuals fail to balance the need for

immediate satisfaction with long-term goals

Suboptimal saving-consumption

patterns

Hyperbolic discounting ⇒ human

tendency to prefer small payoff now compared to larger payoffs in the future

4.3 Self-Control Bias

Insufficient savings for the future

Accept too much risk by putting capital base at risk

Asset allocation imbalance problem

Proper investment plan should be in place

Budgets help deter the propensity to over consume

Individual’s tendency to stay in their

current allocation rather than make value enhancing changes

Outcome of the bias may be similar to

endowment & regret aversion bias but reasons differ among these biases

4.4 Status Quo Bias

Portfolio risk characteristics may differ from investors’ circumstances

Fail to explore other opportunities

Education about risk, return &

diversification

Proper asset allocation

One of the more difficult biases to mitigate

Bias in which people value an asset more

when they hold the rights to it than

when they don’t

4.5 Endowment Bias

Fail to replace certain assets when it is necessary

Inappropriate asset allocation

Investors hold familiar assets

Inherited cash should be carefully invested

Research familiar as well as unfamiliar assets the investor may not hold

Familiar assets can be replaced gradually rather all at once

Regret can arise from taking or not

taking action

Error of commission ⇒ investor feel

regret from taking an action

Error of omission ⇒ investor feels

regret for not taking action

Regret aversion can initiate herding

behavior (invest in similar fashion & in the same stocks as others)

4.6 Regret-Aversion Bias

Too conservative attitude ⇒ long term under performance & potential failure to reach investment goals

Herding behavior

Education is primary mitigation tool

Efficient frontier research & proper asset allocation

4.7 Emotional Biases: Conclusion

Focus should be on cognitive aspects of the biases than trying to alter an emotional response

Education about portfolio theory can be helpful

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5 INVESTMENT POLICY ANDASSET ALLOCATION

Two approaches to incorporate behavioral finance considerations into

an IPS are:

Approaches

Goal-Based Investing Approach 5.1 Behaviorally Modified Asset Allocation

Identify an investor’s specific goals & associated risk tolerance

Investors are assumed to be loss averse rather than risk averse

More attractive approach for investors⇒ focused on wealth

preservation

Riskier than appropriate asset allocation

Diversification but not efficient portfolios from a traditional finance

perspective

Risk may better understand but correlations among investments

are not considered

Standard asset allocation program ⇒ rational portfolio allocation (ignores behavioral biases)

Investor’s interest ⇒ asset allocation that suits the investor’s psychological preferences

In creating a modified portfolio:

Distinguish b/w emotional & cognitive biases

Consider investor’s wealth level

If a bias is adapted, the resulting portfolio represents an alteration

Wealthier the client, more likely it is

to adapt the biases

Decision to moderate or adapt biases depends on the type of behavioral bias

Cognitive errors ⇒ moderated

Emotional biases ⇒ adapted

5.1.1 Guidelines for Determining a Behaviorally Modified Asset Allocation

Wealth is determined based on level of assets & lifestyle

Standard of living risk ⇒ risk that a specified life style may not be sustainable

5.1.2 How Much to Moderate or Adapt

To modify an allocation, no of asset classes used in the allocation is important consideration

Least (most) adjustment to the rational portfolio ⇒ low (high) wealth level client with cognitive bias (emotional bias)

Middle of the road ⇒ high (low) wealth with cognitive (emotional) biases (need to both adapt & moderate behavioral biases)

Market participants may move up or down on efficient frontier after considering client’s behavioral make up

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“BEHAVIORAL FINANCE AND INVESTMENT PROCESSES”

2 THE USES AND LIMITATIONS OFCLASSIFYING 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

(classify five investor personalities along two axes) 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

Five Investor Personality Types

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

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

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

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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 client’s longer term goals

BF can enhance the following important areas of every successful advisory relationship

3.1 Formulating Financial Goals

BF helps adviser to understand the reasons for the client’s 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 AFFECTPORTFOLIO 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 & do not ∆ 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)

4.3 Company Stock: Investing in the Familiar

Reasons why employees have a tendency to invest in their company’s stocks:

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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 company’s management frames information can influence how analysts interpret it & include it in their forecasts

Three cognitive biases frequently seen when management reports company results:

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

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 AFFECTCOMMITTEE 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 FINANCEINFLUENCES 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 relative to crashes (due to difference in behavioral factor involved)

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

7.3 Bubbles and Crashes

Studies have identified that the value stocks have outperformed relative

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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“MANAGING INDIVIDUAL INVESTOR PORTFOLIOS”

3 INVESTOR CHARACTERISTICS

Categorizing individual investors based on their situational characteristics

Investor’s basic philosophy & preferences that facilitate the

discussion of investment risk with the investors

CF = Cash Flow

3.1 Situational Profiling

Approaches of Situational Profiling

Manner of acquiring wealth offers insight into an investor’s

risk attitude

Active investors (e.g successful entrepreneurs) exhibit a

higher level of risk tolerance

Reluctant to cede control to a third party

Passive recipients of wealth (e.g inherited wealth) may be

associated with reduced willingness to assume risk

If investor perceives his holdings as small (large), may demonstrate a low (high) tolerance for portfolio volatility

Low return (high return) portfolio as compared to lifestyle is

considered small (large)

Very few investable assets

ii) Accumulation Phase

Income accelerates & gradually reaches its peak

Risk tolerance, wealth &

long-term time horizon

iii) Maintenance Phase

Individual moves into the later

years of life

Risk tolerance & time horizon

Goal ⇒ preserving wealth

iv) Distribution Phase

Accumulated wealth is

transferred to other persons or entities

Tax constraints & transfer

strategies often become important consideration

SAA = Strategic Asset Allocation

MCS = Monte Carlo Simulation

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