Behavioral Finance

Question 1

Compare and contrast cognitive errors and emotional biases.

Answer 1

Cognitive errors: result from the inability to analyze information or from basing decisions on partial information. Individuals try to process information into rational decisions, but they lack the capacity or sufficient information to do so. Cognitive errors can be divided into belief perseverance errors and processing errors.

Emotional biases: are caused by the way individuals frame the information and the decision rather than the mechanical or physical process used to analyze and interpret it. Emotional bias is more of a spontaneous reaction.

Question 2

Identify and evaluate an individual’s behavioral biases.

Answer 2

Cognitive Errors: Belief Perseverance
* Conservatism bias.
* Confirmation bias.
* Representativeness bias.
* Control bias.
* Hindsight bias.

Cognitive Errors: Information Processing
* Anchoring and adjustment.
* Mental accounting bias.
* Framing bias.
* Availability bias.

Emotional Biases
* Loss aversion bias.
* Overconfidence bias.
* Self-control bias.
* Status quo bias.
* Endowment bias.
* Regret-aversion bias.

Question 3

Conservatism Bias

Answer 3

Cognitive

Impact: Slow to react to new information or avoid the difficulties associated with analyzing new information.

Mitigation: Look carefully at the new information itself to determine its value.

Question 4

Confirmation Bias

Answer 4

Cognitive

Impact: A bias of individuals to focus on information that supports their views, while ignoring or downplaying information that contradicts their beliefs.

Mitigation: Actively seek out information that seems to contradict your opinions and analyze it carefully. Obtain more information to support your views.

Question 5

Representativeness Bias

Answer 5

Cognitive

Impact: A belief perseverance bias resulting in people interpreting new information based on past experiences. Placing too much emphasis on a perceived category of new information. Likely to change strategies based on a small sample of information.

Mitigation: Consciously take steps to avoid base rate neglect and sample size neglect. Consider the true probability that information fits a category. Use the Periodic Table of Investment Returns, and hold a well-diversified portfolio.

Question 6

Illusion of Control Bias

Answer 6

Cognitive

Impact: A belief that individuals can influence outcomes that are outside of their control. The illusion of control over one’s investment outcomes can lead to excessive trading with the accompanying costs. Can also lead to concentrated portfolios.

Mitigation: Seek opinions of others. Maintain a long-term perspective and recognize that many factors are outside of your control. Keep records of trades to see if you are successful at controlling investment outcomes.

Question 7

Hindsight Bias

Answer 7

Cognitive

Impact: The probabilities of past events that have occurred are seen as more certain than they actually were, with hindsight. Overestimating the accuracy of forecasts and taking too much risk.

Mitigation: Keep detailed record of all forecasts, including the data analyzed and the reasoning behind the forecasts. Recognize your past mistakes honestly and try to learn from them.

Question 8

Anchoring and Adjustment Bias

Answer 8

Cognitive

Impact: Failure to properly update an initial outcome, estimate, or probability (the anchor) for new information. Tendency to remain focused on and stay close to original forecasts or interpretations.

Mitigation: Give new information thorough consideration to determine its impact on an original forecast or opinion.

Question 9

Mental Accounting Bias

Answer 9

Cognitive

Impact: Caused by treating equal-sized monetary amounts differently according to the mental account it is assigned to. Portfolios tend to resemble layered pyramids of assets. Subconsciously ignoring the correlations of assets. May consider income and capital gains separately rather than as parts of the same total return.

Mitigation: Look at all investments as if they are part of the same portfolio to analyze their correlations and determine true portfolio allocation. Focus on total return rather than income or price appreciation in isolation.

Question 10

Framing Bias

Answer 10

Cognitive

Impact: A bias where a person answers a question differently depending on how it is framed (asked). This is particularly evident when questions are framed in terms of gains or losses. A narrow frame of reference; individuals focus on one piece or category of information and lose sight of the overall situation or how the information fits into the overall scheme of things.

Mitigation: Investors should focus on expected returns and risk, rather than on gains or losses. That includes assets or portfolios with existing gains or losses. Investors should focus on whether they are framing decisions as gains or losses and be aware of the impact of loss aversion on their willingness to take risk.

Question 11

Availability Bias

Answer 11

Cognitive

Impact: An information processing bias where the probability of an outcome is affected by how easily the outcome comes to mind. The four causes are retrievability, categorization, narrow range of experience, and resonance. Selecting investments based on how easily memories are retrieved and categorized. Narrow range of experience can lead to concentrated portfolios.

Mitigation: Develop an investment policy statement (IPS) to promote long-run focus and construct a suitable portfolio through diligent research.

Question 12

Loss Aversion Bias

Answer 12

Emotional

Definition: A tendency to prefer the avoidance of losses over achieving gains. Results from a bigger decrease in utility caused by a loss relative to an increase in utility caused by a similar-sized gain.

Impact: Focusing on current gains and losses. Continuing to hold losers in hopes of breaking even. Selling winners to capture the gains.

Mitigation: Perform a thorough fundamental analysis. Overcome the mental anguish of recognizing losses.

Question 13

Overconfidence Bias

Answer 13

Emotional

Impact: Caused by individuals’ unwarranted belief in their own skill and reasoning. Holding under-diversified portfolios; underestimating the downside while overestimating the upside potential. Trading excessively.

Mitigation: Keep detailed records of trades, including the motivation for each trade. Analyze successes and losses relative to the strategy used.

Question 14

Self-Control Bias

Answer 14

Emotional

Impact: Lacking self-discipline to balance short-term gratification with long-term goals. Tendency to try to make up the shortfall by assuming too much risk.

Mitigation: Maintain complete, clearly defined investment goals and strategies. Budgets help deter the propensity to over-consume. Asset allocation focused on achieving long-term goals and a savings plan should be implemented.

Question 15

Status Quo Bias

Answer 15

Emotional

Impact: A bias where individuals’ familiarity and comfort in the current status quo result in reluctance to make changes. Risk characteristics of the portfolio change. Investor loses out on potentially profitable assets.

Mitigation: Education about risk and return and proper asset allocation. Difficult to mitigate.

Question 16

Endowment Bias

Answer 16

Emotional

Impact: Ownership of an asset endows it with added value, resulting in greater value being assigned to assets that are owned than to equivalent assets that are not owned. Sticking with assets because of familiarity and comfort or because they were inherited.

Mitigation: Determine whether the asset allocation is appropriate. Consider moving toward an acceptable asset allocation via a series of small, unfamiliar purchases rather than all in one go.

Question 17

Regret Aversion Bias

Answer 17

Emotional

Impact: A bias that results in individuals avoiding making decisions out of fear that those decisions may turn out to be incorrect. Staying in low-risk investments. Portfolio with limited upside potential. Staying in familiar investments or “following the herd.”

Mitigation: Education regarding the benefits of diversification, proper asset allocation, and the long-term benefits of holding risky assets within a portfolio are the primary mitigation tools.

Question 18

Explain the uses and limitations of classifying investors into personality types.

Answer 18

Incorporating behavioral biases into clients’ IPS should result in the following:
* Portfolios that are closer to the efficient frontier.
* More satisfied clients.
* Clients who are better able to stay on track with their long-term strategic plans.
* Better working relationships between the client and adviser.

Limitations of classifying investors into behavioral types include the following:
* Individuals can display emotional and cognitive errors at the same time.
* The same individual may display traits of more than one behavioral investor type.
* As investors age, they become more risk averse and emotional toward investing.
* Individuals who fall into the same behavioral type shouldn’t necessarily be treated the same.
* Unpredictably, individuals tend to act irrationally at different times.

Question 19

Discuss how behavioral factors affect adviser–client interactions.

Answer 19

There are four areas of the adviser–client relationship that can be enhanced by incorporating behavioral finance into the relationship:
1. Behavioral finance helps the adviser understand the reasons for the client’s goals.
2. Behavioral finance adds structure and professionalism to the relationship.
3. The adviser is better equipped to meet the client’s expectations.
4. A closer bond between them results in happier clients and an enhanced practice for the adviser.

Question 20

Discuss how behavioral factors and biases influence portfolio construction exhibited by defined contribution (DC) plan participants.

Answer 20

Status quo bias: Investors make no changes to their initial asset allocation.

Naïve diversification (1/n naïve diversification): Employees allocate an equal proportion of their retirement funds to each mutual fund in the plan.

Question 21

Discuss how behavioral factors influence portfolio construction for employees investing in their own company’s stock.

Answer 21

Familiarity: They underestimate its risk; they become overconfident in their estimate of the company’s performance.

Naïve extrapolation: The company’s recent good performance is extrapolated into expected future performance.

Framing: If the employer’s contribution is in company stock, employees tend to keep it rather than sell it and reallocate.

Loyalty: Employees hold company stock in an effort to help the company (e.g., to prevent a takeover by another firm).

Financial incentive: Tax incentives or the ability to purchase the stock at a discount leads to holding too much company stock.

Question 22

Discuss how behavioral factors influence portfolio construction due to Home Bias.

Answer 22

It is closely related to familiarity. It leads to staying completely in or placing a high proportion of assets in the stocks of firms in their own country.

Question 23

Discuss how behavioral factors influence portfolio construction due to Mental accounting.

Answer 23

Investors tend to construct portfolios in layers (pyramids). Each layer is used to meet a different goal. Investors see each layer as having a separate level of risk and ignore correlations of assets in the different layers.

Question 24

Discuss how behavioral factors influence portfolio construction due to overconfidence.

Answer 24

Retail investors trade their brokerage accounts excessively. The result can be lower returns due to trading costs.

Disposition effect: Investors tend to sell winners too soon and hold losers too long.

Question 25

Explain how behavioral finance can be applied to the process of portfolio construction.

Answer 25

Behavioral finance insights could lead to portfolio construction using:
* Target funds to overcome status quo bias.
* Layered portfolios that accommodate perceptions of risk and importance of goals to build portfolios the client will stay with.

Question 26

Discuss how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases.

Answer 26

Analysts typically exhibit 3 biases:
1. overconfidence
2. interpreting management reports
3. biases in their own research

Question 27

Discuss how behavioral factors affect analyst forecasts and recommend remedial actions for overconfidence analyst biases.

Answer 27

Behavioral biases that contribute to overconfidence:
* The illusion of knowledge bias.
* The self-attribution bias.
* Representativeness.
* The availability bias.
* The illusion of control bias.
* Hindsight bias.

Actions analysts can take to minimize overconfidence:
* Get feedback through self-evaluations, colleagues, and superiors, combined with a structure that rewards accuracy, leading to better self-calibration.
* Develop forecasts that are unambiguous and detailed, which help to reduce hindsight bias.
* Provide one counterargument supported by evidence for why the forecast may not be accurate.
* Consider sample size and model complexity.
* Use Bayes’ formula.

Question 28

Discuss how behavioral factors affect analyst forecasts and recommend remedial actions for interpreting management reports analyst biases.

Answer 28

Reporting by company management is subject to behavioral biases:
* Framing.
* Anchoring and adjustment.
* Availability.

Analysts should be aware of the following when a management report is presented:
* Results and accomplishments are usually presented first, giving more importance to that information.
* Self-attribution bias in the reports.
* Excessive optimism.
* Recalculated earnings.

Actions the analyst can take to prevent undue influence in management reports:
* Focus on verifiable quantitative data.
* Be certain the information is framed properly.
* Recognize appropriate base rates so the data are properly calibrated.

Question 29

Discuss how behavioral factors affect analyst forecasts and recommend remedial actions for biases in their own research analyst biases.

Answer 29

Analyst biases in research:
* Usually related to collecting too much information.
* Lead to illusions of knowledge and control as well as representativeness.
* Inaccurately extrapolate past data into the future.
* Can suffer from confirmation bias and gambler’s fallacy.

To prevent biases in research:
* Ensure previous forecasts are properly calibrated.
* Use metrics and ratios that allow comparability to previous forecasts.
* Take a systematic approach with prepared questions and gather data first before making conclusions.
* Use a structured process; incorporate new information sequentially assigning probabilities using Bayes’ formula.
* Seek contradictory evidence and opinions.

Question 30

Discuss how behavioral factors affect investment committee decision making and recommend techniques for mitigating their effects.

Answer 30

Committees often make poor decisions. They reflect the biases of the individual members as well as social proof bias (members are reluctant to say what they think, to go along with the group to avoid giving offense).

To mitigate these problems, seek members with diverse backgrounds who are not afraid to express their opinions and who respect the other members of the group.

Question 31

Describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance.

Answer 31

Market anomalies:
* Momentum effect: Patterns in returns that are caused by investors following the lead of others; they tend to trade in the same direction, which is referred to as herding.
* Financial bubbles and crashes: Periods of unusual positive or negative returns caused by panic buying or selling. They can be defined as periods of prices two standard deviations from their historical mean.
*  Value stocks: Low price-to-earnings, high book-to-market, low price-to-dividend ratios. Growth stocks have the opposite characteristics.