Behavioral Finance

Question 1

What behavioural concerns should we have at the outset?

Answer 1

• Overconfidence:
  
  • Individuals exhibit overconfidnce and that people tend to focus on the upside and not the downside. As a result, investors tend to interpret medium investment risk as meaning a lowish chance of loss, ,ore similar to low risk.
  • This suggest a focus on up-front education and the risk/reward trade-off, with careful framing and drawing on insight and evidence.
• Bounder rationality:
  
  • Limited time and cognitive capacity mean people have problems inferring relevant facts when striking decisions even when they have all the relevant information.
  • This means that wide choice and complex investment menus lead to choice overload and leads to outcomes of procratination, reduced satisfaction and less participation.
  • Wealth managers should limit the propositions forwareded to clients, including a small number of carefully though through, properly differentiated offerings.
  • Doing so makes it easier to individuals to select a sutable investment or buying a particular plan.
• Loss aversion:
  
  • Individuals are more concerned with losing value than acquiring gains. It is a potential probelm because it may presage a drop in contributions or opts out of investment. What individuals do as they experience a loss is very important.
  • Relationship between attitude to loss and time is not linear, an enduring loss is more important than otherwise identical one-off loss.
  • 3-year tipping point is found to apply in which investors may stop investing after a run of bad performance. This leads itself to loss aversion strategies such as DAA and CPPI and this also suggests that a wealth manager could focus on communication strategies in order to help mitigate loss avoidance behaviour.
• Socials biases:
  
  • People want to fit in with the group because they believe the group is better informed than they are. As a result, we often do or want to observe other’s actions before we make our own decision.
  • The practical outcome is that influence consumer decision and choice would point out how others like us are already behaving.. Point to stats about popularity, take-up and customer satifaction.

Question 2

What are the behavioural biases at the starting out of investing?

Answer 2

• Endowment effect:
  
  • Finds a tendency to value a good more after it is incorporated into the status quo. This means that a succesful trial period based on regular contributions or a lump sum with smoot and steady gains may contribute to a saving habit and continuation.
  • Suggests a low risk start and is not worth a potentially bumpy start before the investment has gained psycholoical value.
  • A high-risk start may lead to a poor experience and to withdrawing from regular saving or investment which is not in the individuals long-term interest.

Question 3

What are the biases during the client relationship?

Answer 3

• Regret aversion:
  
  • Once people have made decisions, they tend to leave them unchanged.
  • There is also regret aversion meaning that people regret a poor decision more than they take satisfaction from a good decision.
  • As a result, individuals tend to hold on to secutiies to long.
  • Myopia coupled with regret bias means people are unlikely to change asset allocation to manage risk close to retirment or toward the end of the investment planning horizon.
  • BF suggests life styling of investment should be automatically performed as clients near retirment or draw close to meeting a fixed liability.
  • Life styling means giving-up some potential gains in order to more robustly protect against loss.
• Low financial wealth:
  
  • With low financial wealth clients regular savings are likely to constitute a high proportion of her total financial welath and so would be unusual to recommend all of the persons financial wealth is subject to high risk.
  • It is also not unreasonable to assume that the clients human capital is more equity than bond-linke for low incomes as they have greater correlation to the business cycle.
  • In order to diversify away from equity like human capital portfolio theory suggests low risk financial assets
  • A high risk start may lead to a large drop in value that causes the client to stop saving althoughether.
  • Increase risk as the size of assets starts to grow beyond some threshold, perhaps 3-10 years. Then start to move the portfolio into lower risk assets that are a suitable match for the asset that is intentded to be purcahased.
• Low capacity for risk yet a high-risk tolerance:
  
  • Low income people are close to state benefits and this provides a floor to downside risk, or a guaantee, and potentially minitless upside.
  • People on low income with low financial wealth are close to the value of the guarentee and this can, quite rationally, lead to a high-rsik tolerance despite low capacity for risk taking when their total wealth is considered.
  • This option-like characterstic can explain high risk rolerance and so there is little to lose from investment risk taking.
  • People with greater financial wealth have more to lose in absolute terms for they are further away from the guaranteed floor of state benefits.
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Question 4

What explains home bias?

Answer 4

• Overseas transaction costs may be greater than those at home, and custodian and tax charges too.
• Investing at home involves no explicit currency risk and helps with the payment of UK liabilities.
• UK equities are good match for UK inflation and helps becuase defined benfit pension schemes liabilites will be indexed to inflaiton/salaray growth.
• Investors may be using a peer group benchmark rather than a market weight benchmark.
• A great amount of the earnings of large UK listed companies come from overseas in any case.
• UK Investors have familiarity and expertise about their own economy and public listed companies.
• Good corporate governance, regulation and disclosure standards provide a strong case for overweighting the UK relative to other markets.
• UK has a dividend paying culture, this helps meet cash flow demands.

Question 5

What is prospect theory?

Answer 5

• Investors make decisions based on a rule of thumb rather than a statistical mean variance optimisation strategy. Some biases will be hard to change than others or even impossible.
• Identifying various biases at the outset of a client relationship will help the wealth adisor to manage those accordingly.
• To manage loss aversion, show the client different periods of drawdown and understand how the client would react to those losses. By presenting the past information of returns over long period investment to show that losses have been made back.
• Educate clients about different economic cycles of asset classes and different economic factors that may impact returns and volatility.
• Establish the client’s objectives and risk requirements and will help us to structure a more efficient portfolio to meet client requirments by using correlation between assets and various asset allocation stategies.
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