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
Psychographic Investor Models
- Barnewall Two Way Model
- Bailard, Biehl, and Kaiser Five-Way Model
Two Way Model
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
Five Way Model
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.
Models to Identify Behavioral Investor Types (BIT) - Pompian
- Bottom Up
- Top Down/Behavioral Alpha Approach
BA Approach - Steps
- Interview the Client and identify active or passive traits and risk tolerance
- Plot the investor on active/passive and risk tolerance scale
- Test for behavioral biases
- Classify the investors into BITS
Types of BITs
- Passive Preserver (PP)
- Friendly Follower (FF)
- Independent Individualist (II)
- Active Accumulator (AA)
PP
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
FF
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
II
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
AA
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
Limitation of Classifying Investors
- 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
How behavioural factors affect adviser-client relations
- 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
How behavioural factors affect portfolio construction
- Inertia and Default
- Naive Diversification
- Company Stock: Investing in familiar - Financial Incentives, loyalty effects, Framing and status quo, Naive extrapolation of past returns, Familiarity and overconfidence effects
- Excessive Trading
- Home Bias
- Behavioral Portfolio Theory
Affect of behavioral factors on analysts
- Overconfidence in forecasting skills
- Influence of Company’s Management on Analysis
- Analyst biases in conducting research
Overconfidence in forecasting skills
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.
Actions for overconfidence and other bias
- 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
Influence of Company’s Management on Analyst
- 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
Remedial actions for the company’s management influence on analyst
- disciplined systematic approach
- Focus on metrics and comparable data
- Framing issue properly, gathering information, and recognising underlying base rate
Analyst bias in conducting research
- too much information can lead to illusion of knowledge and control and also representativeness bias.
- ## Confirmation bias
Gamblers’ Fallacy
- Faulty understanding of the behaviour of probabilities and expecting reversal more often than they actually happen
Remedial actions for bias in conducting research
- 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
How behavioural factors affect committee decision making
Group process can mitigate a bias or exacerbate it
- Social Proof
Social Proof
- Biased to follow the beliefs of a group
Investment Committee Dynamics
- 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
