Biases

Question 1

Preference for securities listed on the exchanges of one’s home
country over that for international securities.

Answer 1

Home Bias

However, concentrating portfolio
exposure in home country securities may result in a less diversified, less efficient
portfolio

Question 2

The behavioral biases most relevant in asset allocation (Module 5) include:

Answer 2

1. Loss aversion (emotional bias)
2. Illusion of control (cognitive bias)
3. Mental accounting (information processing bias)
4. Representative/Recency bias (cognitive bias)
5. Framing (information processing bias)
6. Availability bias- home bias & familiarity bias (information processing bias)

Question 3

• the tendency to overestimate one’s ability to control events
• may result in extreme tactial asset allocation, excessive trading, use of leverage, elminiating or shorting an asset class
• It can be exacerbated by overconfidence bias & hindsight bias
• mitigate by: Global market portfolio as the starting point in developing the SAA

Answer 3

Illusion of Control

Cognitive bias

Question 4

• If investors believe they have more or better information than what is reflected in the market, they have (excessive) confidence in their ability to generate better outcomes.
• past mistakes are ignored, accuracy of forecasts is overestimated

Answer 4

Overconfidence Bias

Emotional Bias (Illusion of Control)

Ex:
* Investor is convinced of a return of 12.53%
* excessively precise forecast
* overly confident in ability to provide accurate forecast

Question 5

• the tendency to perceive past investment outcomes as having been predictable
• exacerbates the illusion of control

Answer 5

Hindsight bias

(Illusion of Control) Cognitive Bias

When a bad event occurs, the belief that you “knew it all along,” when it is very likely that the event was unpredictable

Question 6

• People treat one sum of money differently from another sum based solely on the mental account the money is assigned to
• mitigate by: use Goals based investing

Answer 6

Mental accounting

Information-processing bias

Ex:
* Client is considering her $3 million tax-deferred retirement account, her $500,000 account for the girls’ education, and the $400,000 emergency account separately, rather than seeing them all as a combined investable total.
* In doing this, she sets herself up for the possibility of less than optimal allocation

Question 7

• is the tendency to overweight the importance of the most recent observations and information relative to a longer-dated or more comprehensive set of long-term observations and information
• Results of bias: return chasing/overweighting asset classes with strong recent performance
• mitigate by: objective SAA process & strong governance

Answer 7

Representativeness/Recency bias

Cognitive Bias

Ex:
* Client is somewhat reluctant to take money out of stocks to rebalance (keeping stocks overweight)
* Client justifies this by expressing confidence that strong investment returns will continue
* Representative bias results in overweighting asset classes with strong recent performance

Question 8

an information-processing bias in which a person may answer a question differently based solely on the way in which it is asked

choice of asset allocation may be influenced by how risk/return tradeoff is presented

mitigate by: present risk in multiple ways

Answer 8

Framing bias

Question 9

• when people take a mental shortcut when estimating the probability of an outcome based on how easily the outcome comes to mind
• what is easiest to remember is overweighted
• overly influenced by events that left a strong impression
• where investors who personally experience an adverse event are likely to assign a higher probability to such an event occurring again
• mitigate by: using global market portfolio as the starting point for asset allocation, and use objective evidence and analytical procedures

Answer 9

Availability bias (includes familiarity & home bias)

Information-Processing bias

Ex:
* Client refuses the addition of EM to portfolio because they are convinced it is too risky
* This belief of the client is justified by referring to significant losses the family trust suffered during the recent economic crisis
* Client is showing strong preferance for avoiding the asset classes due to a personal adverse event
* Therefore assigning a higher probability of a negative outcome again in the future

Ex:
* Investor “does not want to miss another market low and recommends a large increase to equities”
* Investor is strongly influenced by the past experience of missing a buying opportunity during a market low

Question 10

stems from availability bias: People tend to favor the familiar over the new or different because of the ease of recalling the familiar.

Answer 10

Familiarity bias

Question 11

the first information received is overweighted
Ex: anchoring expectations on the performance of the respective domestic markets

Answer 11

anchoring bias

Question 12

• Predictions are highly influenced by the recent past
• tendency for forecasts to perpetuate recent observations
• Searching for support to support the decision to overallocate to outperforming assets
• Ex: increasing allocation to the US based on recent outperformance
• Results in: managers avoid making changes
• avoid by: being discplined

Answer 12

Status Quo Bias

Emotional Bias

Question 13

• only information supporting the existing belief is considered, and may be actively sought while other evidence is ignored
• searching for evidence to support a favored view

Answer 13

Confirmation Bias

Cognitive Bias

Question 14

• Forecasts are overly conservative to avoid the regret of making extreme forecasts that could end up being incorrect
• mitigated by considering a range of potential outcomes

Answer 14

Prudence Bias

Cognitive Bias

Ex:
* manager has good record of projecting the correct direction of relative performance among markets, but has not translated that into reallocations large enough to add meaningful value

Ex:
* Manager recommends increase to equities. Client fears that this allocation could cause the portfolio to underperform peers significantly
* Concern that recommendation could appear extreme

Question 15

• Repeatedly searching for the information you want, until a statistically significant pattern emerges
• creating random, significant relationships
• Results in: unreliable models
• Avoid by: out of sample test, review econmoic basis for the variables selected

Answer 15

Data Mining
(bias in methodology)

Question 16

• results from the time span of data chosen
• ex: “Small firm effect”
• very sensitive to the choice of sample period

Answer 16

time period bias
(bias in methodology)

Question 17

• investors dislike losses more than they like gains
• Clients assign a greater weight to potential negative outcomes than positive ones
• people tend to strongly prefer avoiding losses as opposed to achieving gains
• interferes with ability to maintain ideal SAA, during times of negative returns
• mitigate through: Goals based investing, high priority goals matched with low risk assets

Answer 17

Loss Aversion

Emotional bias

Ex:
* Client’s strong emphasis on retirement security and her desire to avoid losing money

Question 18

MUST KNOW

• Increased Loss Aversion: retirees are likely to be more loss-averse
• Consumption Gaps: retirees tend to spend less (due to loss aversion & uncertainty about future)
• Annuity Puzzle: individuals tend to avoid buying annuities to meet their spending needs in retirement (due to 1. desire to keep control of assets 2. high cost of annuities)
• Preference for income: retirees prefer to meet their spending needs from investment income rather than liquidating appreciated securities (Due to lack of self-control when it comes to spending)

Answer 18

Behavioral Biases assosiated with Retirees

19.h

Question 19

Occurs when backtesting is applied only to existing companies, overlooking companies that have failed in the past. This will make the strategy appear more effective than it is.

as reconstitution occurs, the losers dissapear from the data set, deleted from historical performance

results in bias of historical return upward= overly optimistic investment returns

Answer 19

Survivorship bias

Question 20

Must know!

• Contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying and buying when most investors are selling
• Opposite of Momentum
  * believes that past losers will tend to win in the future

Berkshire Hathaway Chair and Chief Executive Officer (CEO) Warren Buffett is a famous contrarian investor.

Answer 20

Contrarian Investing

Question 21

occurs when a manager changes their holdings shortly before a reporting date to change the perceived risk exposures of the fund

Answer 21

Window dressing

Question 22

Occurs when a simulation relies on data that was not yet available during the time period being studied

Ex: when predicting stock returns using quarterly earnings announcements for the same year. The earnings announcements would not have been available to an investor for most of the year in which stock returns were measured.

Answer 22

Look-ahead bias