Determine type of bias in the client & how to correct for or adapt to the biases.. Passive Preserver PP Low risk tolerance & are subject to emotional biases.. Independent Individualist
Trang 1“ 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)
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
Trang 2Step 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
Trang 3Advising 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
Trang 44 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)
4.2 Naive Diversification
Allocating an equal proportion of assets to each fund alternative
Also called 1/n nạve diversification strategy & often used by
DC plans
Conditional 1/n strategy ⇒ allocation equally among chosen subset of funds
Such strategies minimize future regret from one asset class beating the other
4.3 Company Stock: Investing in the Familiar
Reasons why employees have a tendency to invest in their company’s stocks:
Familiarity bias
Overconfidence
Naively extrapolate past returns
Framing
Loyalty effect & financial incentives
4.4 Excessive Trading
Investors with retail accounts appear to be more active trades (overconfidence which leads to excessive trading)
Disposition effect⇒ selling winners too soon & holding losers too long
4.5 Home Bias
Proportion of assets in the stocks of firms listed in home country
Closely related to familiarity
Trang 55 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:
Framing
Anchoring & adjustment
Availability
Analysts should also look for self attribution bias that arises from the impact of incentive compensation on company reporting
5.2 Influence of Company's Management on Analysis
Biases are usually related to analysts collecting too much information some biases are:
Illusion of knowledge & control
Representativeness bias
Confirmation bias
Gambler’s fallacy⇒thinking that there will be a reversal to long-term mean more frequently than actually happens
Hot hand fallacy ⇒ wrongly project continuation of a recent trend
Endowment bias
5.3 Analyst Biases in Conducting Research
Focus on more objective data
Collect information in a symmetric way
Assign probabilities to base rates
Consider the search process, limits& context of information
Prompt feedback & document decision making
5.3.1 Remedial Actions for Analyst Biases in Conducting Research
Trang 6In 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
Trang 7Bubble & 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:
Overconfidence
Confirmation & self attribution bias
Hindsight
Illusion of knowledge
Disposition effect
Anchoring
7.3 Bubbles and Crashes
Studies have identified that the value stocks have outperformed relative
to growth stocks
Halo affect ⇒ investor transfers favorable company attribute into thinking that the stock is a good buy
Behavioral explanations present the anomalies as mispricing rather than risk
Overconfidence in predicting growth rates (growth stocks over valuation)
Home bias anomaly ⇒ investors favor investing in domestic country as compared to foreign countries
7.4 Value and Growth