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Behavioural Finance > Behavioral Finance and Investment Process > Flashcards

Behavioral Finance and Investment Process Flashcards

"a explain the uses and limitations of classifying investors into various types; b discuss how behavioral factors affect adviser–client interactions; c discuss how behavioral factors influence portfolio construction; d explain how behavioral finance can be applied to the process of portfolio construction; e discuss how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases; f discuss how behavioral factors affect investment committee decision making an

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1
Q

Psychographic Investor Models

A
  • Barnewall Two Way Model
  • Bailard, Biehl, and Kaiser Five-Way Model
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2
Q

Two Way Model

A

Types of Investors: Passive & Active
Passive Investors: High level of security need and low risk tolerance. Smaller economic resources more passive
- Active Investors: Actively involved in wealth creation, risk their own capital, higher risk tolerance, know about their investment control n their investments

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3
Q

Five Way Model

A

Two Axes: Level of confidence: Confidence and Anxious
Method of Action - Careful or Impetuous
Five types of investors based on the above levels
1. Adventurer - Confident and take chances unwilling to accept advice
2. Celebrity Center of attraction, have opinions but willing to take advice
3. The Individualist: Confident and take decisions after careful analysis
4. The Guardian: Cautious and concerned about the future . Old age
5. Straight Arrow: Most sensible and secure. They are willing to take some risk provided they are compensated with a return.

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4
Q

Models to Identify Behavioral Investor Types (BIT) - Pompian

A
  • Bottom Up
  • Top Down/Behavioral Alpha Approach
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5
Q

BA Approach - Steps

A
  1. Interview the Client and identify active or passive traits and risk tolerance
  2. Plot the investor on active/passive and risk tolerance scale
  3. Test for behavioral biases
  4. Classify the investors into BITS
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6
Q

Types of BITs

A
  1. Passive Preserver (PP)
  2. Friendly Follower (FF)
  3. Independent Individualist (II)
  4. Active Accumulator (AA)
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7
Q

PP

A

Risk tolerance level: Low
Primary Biases: Emotional
- Wealth - inheritance or high compensation at work
- Short term obessession
- Age and Wealth Increases
Biases: Endowment, Loss Aversion, Status Quo, Regret Aversion, anchoring and adjustment, and mental accounting
Advising: Focus on big picture

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8
Q

FF

A

Risk Tolerance Level: Low to Medium
Primary Bias: Cognitive
- lead from friends and colleagues
- Overestimate their risk tolerance
- Biases: Availability, framing and hindsight, Regret aversion
Advising: Difficult to advise
Careful as they say yes without due analysis
- Guide them through behavioral tendencies
- Education

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9
Q

II

A

Risk Tolerance: Medium to High
Primary Bias: Cognitive
- Self Assured
- Can make decisions without consulting anyone
- Resist following a financial plan
Bias: Conservatism, availability, confirmation and representativeness, Overconfidence and self-attribution
Advising: Willing to listen when shown their intelligence is respected
- Education

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10
Q

AA

A

Risk Tolerance: High
Primary Bias: Emotional
- Most aggressive
- High portfolio turnover rates
- Baises: Overconfidence, self-control, illusion of control
Advising: Most difficult to advise
- Monitor excessive spending
- Take control of the situation

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11
Q

Limitation of Classifying Investors

A
  • Individuals may exhibit both cognitive errors and emotional biases
  • Individuals may exhibit characteristics of multiple investor types
  • Individuals will likely to go through behavioral changes as they age
  • Individuals are likely to require unique treatment even if they are classified as the same investor type because human behavior is so complex
  • Individuals act irrationally at different times and without predictability
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12
Q

How behavioural factors affect adviser-client relations

A
  • Enhanced relationship
  • Investment decisions that are closer to traditional finance
  • How behavioural finance can help in enhancing the relationship
    a. Formulating Financial Goals
    b. Maintaining a consistent approach
    c. Investing as client’s expect
    d. Ensuring mutual benefits
    e. Limitations of traditional risk tolerance questionnaire
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13
Q

How behavioural factors affect portfolio construction

A
  1. Inertia and Default
  2. Naive Diversification
  3. Company Stock: Investing in familiar - Financial Incentives, loyalty effects, Framing and status quo, Naive extrapolation of past returns, Familiarity and overconfidence effects
  4. Excessive Trading
  5. Home Bias
  6. Behavioral Portfolio Theory
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14
Q

Affect of behavioral factors on analysts

A
  • Overconfidence in forecasting skills
  • Influence of Company’s Management on Analysis
  • Analyst biases in conducting research
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15
Q

Overconfidence in forecasting skills

A

Overconfidence bias = illusion of knowledge + self attribution bias.
- Believe in their own judgement, reasoning etc. due to over confidence in knowledge, skills and abilities.
- Overconfidence in contrarian predictions
- Availability and representativeness add to the overconfidence errors.
- Illusion of control + Overconfidence = complex models
- Hindsight adds to the overconfidence bias because the analyst believes that an outcome is more likely as it occurred in the past.

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16
Q

Actions for overconfidence and other bias

A
  • Prompt accurate feedback
  • Structure to reward accuracy
  • Conclusions should be explicit to avoid hindsight bias
  • Search process should include comparable data
  • Bayes formula to be used
  • Systematic review process
17
Q

Influence of Company’s Management on Analyst

A
  • Framing, anchoring and adjustment and availability bias
  • Analyst should recognise the undue importance given to certain information relative to the ratios calculated by them.
  • Recognise the self-attribution bias of the company
  • Overconfidence and illusion of control bias affects the company management
18
Q

Remedial actions for the company’s management influence on analyst

A
  • disciplined systematic approach
  • Focus on metrics and comparable data
  • Framing issue properly, gathering information, and recognising underlying base rate
19
Q

Analyst bias in conducting research

A
  • too much information can lead to illusion of knowledge and control and also representativeness bias.
  • ## Confirmation bias
20
Q

Gamblers’ Fallacy

A
  • Faulty understanding of the behaviour of probabilities and expecting reversal more often than they actually happen
21
Q

Remedial actions for bias in conducting research

A
  • Focus on objective data
  • Evaluate previous forecasts
  • Collect information in a systematic way
  • Comply with standard V ofCFA
  • Assign probabilities
  • Consider the search process - structured
  • Seek contrary facts and opinions
  • Document the decisions
22
Q

How behavioural factors affect committee decision making

A

Group process can mitigate a bias or exacerbate it
- Social Proof

23
Q

Social Proof

A
  • Biased to follow the beliefs of a group
24
Q

Investment Committee Dynamics

A
  • Group may increases the biases
  • Everyone agrees with the group decision maker on the belief that he is right even though he might not be
  • This happens when the past results have been good
25
Q

Techniques for structuring and operating committees

A

Crowd V Committee
- Committee should be comprised of individuals from varied backgrounds
- Chair plays an important role - Assembling a diverse group, culture of dissenting views, sticking to agenda and a clear decision is reached
- Committee members to provide their independent views
- Professional respect

26
Q

How behavioural finance affects market behaviour

A

Biases that contribute to market anomalies

27
Q

Market Anomalies

A
  • Persistent abnormal returns that differ from zero and are predictable in direction
  • If anomalies disappear with a change in the asset pricing model, it is an illusion
  • Some anomalies appear due to : small size, statistical bias in selection or survivorship or data mining
  • Disequilibrium behaviour present in the market
28
Q

Momentum

A
  • Trending effect - future prices are correlated with the past prices (recent)
  • Herding
  • Momentum can be explained by short term underreaction or long term overreaction
  • Availability bias - recency effect
  • Regret can explain year on year trending and contributing to excessive trading - trend chasing effect
  • Disposition effect
    Emotional Biases and irrational belief in mean reversion encourage market trading pattern
29
Q

Herding

A
  • Act as others do and ignore their private information
  • Cognitive dissonance
30
Q

Bubbles and crashes

A
  • Caused by extreme sentiments and mass irrationality
  • Decoupled from economic fundamentals: rise in asset prices + investors expectations
  • Illusion of control bias
    Bubbles: overconfidence: Overtrading, underestimating of risk, failure to diversify and rejection of contradictory information
  • Hindsight bias
  • Regret aversion
    Bubble unwinds: cognitive dissonance
31
Q

Value and growth

A

Behavioral effects the anomalies - halo effect

32
Q

halo effect

A
  • favourable evaluation of certain characteristics to others.

Behavioural Finance (3 decks)

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