CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r07 behavioral finance and investment processes summary

Uses and Limitations of Classifying Investors into Types Individualist • make decisions after careful analysis • listen to advice • process information in a rational manner Adventu

Level III

Behavioral Finance and Investment Processes

Summary

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Uses and Limitations of Classifying Investors into Types

Individualist

• make decisions after careful analysis

• listen to advice

• process information in a rational manner

Adventurer

• high risk tolerance

• prefer to maintain control over investments

• reluctant to take advice

• hold highly undiversified portfolios

Guardian

• prefer to seek advice

• avoid volatility

• seek preservation of wealth

Celebrity

• prefer following popular investments

• willing to take investment advice

Straight Arrow

Confident

Hint: Retired

or near to

retire people

Investors can be classified by their psychographic profile i.e behavior, personality, attitudes and interests

BB&K (Bailard, Biehl and Kieser) model classifies investors into five types based on two axes of “investor psychology”

rational, balanced, secure and sensible Hint:

self-employed

Behavioral Alpha Process

A top-down approach to bias-identification

1 Interview client to identify active or passive traits

and risk tolerance

2 Plot investor on active/passive scale and risk

tolerance scale

 Active investors: medium to high risk

 Passive investors: low risk

3 Test for behavioral biases to identify behavioral

biases in a client

4 Classify investor into a behavioral investment type

(BIT) to identify biases

Active Investor Traits

• Earned wealth by risking own money (e.g

entrepreneur)

• Maintain control over investment decisions

• Have faith in own abilities

• Prefer risky asset allocation

• Aim for maximization of wealth by foregoing current lifestyle

• Take initiative

• Not reluctant to borrow money

Opposite will be true for passive investor

If an investor is classified as active investor in Step 1 but he exhibits low risk tolerance in Step 2, then assume he/she is a passive investor

Behavioral Investor Type Diagnostic Process

An individual may:

• exhibit both cognitive and emotional biases at the same time

• reflect characteristics of multiple investor types

• exhibit changing behavior over time

• need unique treatment

Limitations of Classifying Investors

Understanding client’s behavioral tendencies allows advisors to:

• better formulate financial goals

• better understand the client before delivering any investment advice

• formulate an appropriate asset allocation for the client

• develop a stronger bond by satisfying clients

How Behavioral Factors Affect Client-Adviser Relations

Biases Associated with Each Behavioral Investor Type (BIT)

BIT Passive Preserver

• dislike losses

• dislike change

• uneasy during times of stress

• probably became wealthy passively (through inheritance)

• under-react to new information

Friendly Follower

• follow others

• invest in popular investments

• believe that their forecasts about future events were more

accurate than they actually were

• respond differently based how questions are framed

• overestimate risk tolerance

Independent Individualist

• overestimate ability to predict

• maintain views on market

• under-react to new information

• do not get corroboration from other sources

• place higher weight to information which is readily available

• make decisions based on personal classification

Active Accumulator

• entrepreneurial

• exhibit over-confidence in their ability to predict or succeed

• do not save for future

• actively involved in decision-making  trade excessively

Emotional

biases

• loss aversion

• status-quo

• endowment

• regret aversion

• regret aversion • overconfidence & self-attribution • overconfidence • self-control

Cognitive

biases

• mental accounting

• anchoring and adjustment • availability • hindsight

• framing

• conservatism

• confirmation

• availability

• representativeness

• illusion of control

Investment

advice

• difficult to advise

• explain effects of investment decisions on various

investment goals

• may listen to advice

• advisors should provide quantitative measures

• may listen to advice

• advisors should provide quantitative measures

• most difficult to advise

• explain effects of investment decisions on various investment goals

Impact of Behavioral Factors on Portfolio Construction

risk tolerance level or other circumstances

amount of money to available investment options regardless

of the different risk profiles of these options

Overconfidence, representativeness

& availability, status-quo, framing,

endowment biases

Investing in the familiar: a classic example is being

overweight in own-company stock

Regret aversion, overconfidence, and

disposition effect (loss aversion)

biases

Excessive trading which results in high transaction costs and

poor portfolio performance

Availability, illusion of control,

endowment, familiarity, and status

quo biases

Investors invest a relatively high portion of their funds in

domestic stocks Home bias

Impact of Behavioral Factors on Analysts

Overconfidence in

forecasting skills

Overconfidence (encouraged by complex models), representativeness, availability, hindsight

Prompt and accurate feedback, structure that rewards accuracy, learn to use Bayes’ formula

Influence of

company’s

management on

analysis

Faming, anchoring and adjustment (analysis influenced by initial default position or anchor), availability (greater importance to more easily available information)

Disciplined and systematic approach

Analyst biases in

conducting

research

Excessive unstructured information  illusion

of knowledge  overconfidence Excessive information feeds representativeness bias (classify new information based on past experiences)

Confirmation bias

Focus on objective data, systematic and structured approach, follow Standard V, seek contrary facts and

opinions

Behavioral Factors and Investment Committees

Social proof bias: Following the view points/decisions of a group

Implications:

• Group members become overconfident among themselves leading to excessive risk exposure

• Group decisions are more vulnerable to confirmation bias

• Group member avoids divergent opinions to avoid unpleasant tensions within a group

Remedial Actions

• Individual views should be collected before the meeting

• Committee composition should have diversity in culture, knowledge, skills, experience and thought processes

• Chair of the committee should be impartial

• Committee members should respect opinions of each other

• At least one member of a group should play a role of “devil’s advocate”

Investor Behavior and Markets

Observed Market Behavior Behavioral Explanation

Momentum or trending

effect

Herding behavior Availability bias: more recent events easily recalled and given relatively high weight (recency effect)

Hindsight bias  regret  trend-chasing effect

to underestimation of risk and over-trading

winners quickly and hold on to losers too long

Value stocks outperform

growth stocks in the

long-run

Halo effect: tendency of people to generalize positive views/beliefs

about one characteristic of a product/person to another characteristic;

related to representativeness bias refers to classifying new information

based on past experiences