Behavioral Finance and Investment Processes Flashcards
Elaborate on Biehl, Kaiser five way model
Individualist (Confident + careful) Guardian (careful + Anxious ) Celebrity (Anxious + Impetuous) Adventurer ( Impetuous + confident) Straight arrow (middle)
Bottom up behaviorally modified assets allocation
Test for behavioral biases to reveal which one(s) accrued to the client then design an appropriate IPS and behaviorally modified assets allocation.
Top-down (behavioral alpha)
1) Interview the client and identify active or passive trait and risk tolerance
2) Once it’s been determined that the client is active or passive, the next step is to identify which one of the 4 BIT she falls into.
(passive) (active)
Those are the extremes are emotionally biased while those in the middle are more cognitively biased
3) When advising emotionally biased, focus on explaining how the IPS impacts issues related to safety, financial security.
4) classify the investor into a BIT
Elaborate on BIT
Passive preserver (PP) passive, low risk tolerance, emotional, more common biases are loss aversion, regret aversion, Status-quo or Anchoring.
Friendly follower (FF) Passive, medium risk and cognitive biases. They tend to follow advices of their entourage and can be cool to advise but are subject to availability, hindsight and framing biases. They also fall prey to regret aversion of not following friend advices.
Independent individualist (II) active, medium to high risk, biases are cognitive. They are independent and self assured, They can be contrarian and may suffer from conservatism, availability bias, overconfidence and self attribution.
Active Accumulator (AA) Very confident, active, high risk, emotional and successful. May suffer from overconfidence, self control biases and illusion of control biases. The best way to deal with them is to take control of the situation.
What are some of the advantage of behavioral finance
Behavioral finance may add professionalism and structure while maintaining consistency. It helps better understand the client motives and satisfy them. The ultimate goal is to develop a stronger bond between clients and advisors.
How behavioral factor affect portfolio construction ?
-Inertia and default: Client stick to their initial default investment setting despite evolving circumstances.
-Naïve diversification: (1/n)
-Investing in familiarity (loyalty effects)
-Excessive trading
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Behavioral Portfolio Theory
People tend to construct their portfolio in a layered form with each layer linked to a goal without considering correlation.
How to deal with overconfidence in analyst and illusion of knowledge bias ?
Prompt and accurate feedback that combines with structure rewarding accuracy can help analyst re-evaluate their process and self calibrate. Appraisal by colleague can help properly recalibrate.
Elaborate on analyst biases in conducting researches
Too much information can lead to illusion of control and representativeness. Another bias is confirmation bias and gambler fallacy.
Elaborate on factor biases that affect decision making
Social proofing —–> follow the opinion of the group
What biases do we witness during crashes and bubbles ?
Overconfidence, regret .aversion, illusion of control.
Hallo Effect
Extend favorable evaluation of some characteristics to other characteristics
