3-7 Behavioral Biases

Question 0

Compare and contrast loss aversion and myopic loss aversion

Answer 0

similarity - myopic loss aversion is a consequence of loss aversion

difference

• loss aversion is about an individual’s behavior
• myopic loss aversion is about the effect on overall market. since investors place stocks in separate mental account rather than looking at overall portfolio, they look at the volatile annual returns and get concerned with its potential for ST losses, they underown risky equities, keeping prices low and causing equity risk premiums to be higher than justified

Question 1

What is Loss-aversion bias?

Consequence for portfolio?

Solution?

Answer 1

Feeling more pain from loss than pleasure from equal gain

Consequences:

• Hold on to losers too long and sell winners too quickly
• holding on to losers can mean taking excessive risk
• Selling for small gains so high turnover and transaction costs

Solution:
-Keep disciplined process based on long-term prospect of investment

Question 2

Identify 2 types of portfolio construction that is not based upon modern portfolio theory (i.e. rational portfolio allocation)

Answer 2

• goal-based investing
• behaviorally modified asset allocation (starts with rational portfolio allocation and then makes adjustments to accommodate behavioral finance considerations

Question 3

Advantages and disadvantages of Goals-based Investing

Answer 3

Advantages

• easy for investor to understand risk
• goals are set in 3 layers, with needs matched with low risk assets, priorities matched with moderate risk and finally aspirations matched with highest risk assets
• layering goals ensures priorities are met while more aspirational goals can afford to take on higher risk

Disadvantages
-doesn’t consider correlation between assets so leads to inefficient portfolio