Ch. 3 Understanding a Client's Risk Tolerance

Question 1

What is the difference between standard finance and behavioural finance?

Answer 1

Standard finance embodies the notion that nvestors are inherently rational economic beings. Behavourial finance holds that investors are human beings, not idealized logical creatures, and therefore their personal beliefs and biases influence their risk tolerance.

Question 2

What is behavioural finance? What are the two subtopics?

Answer 2

Commonly defined as the application of psychology to understand human behaviour in finance or investing.

1. Behavioural Finance Micro, which looks at the irrational behaviour of individual investors
2. Behavioural Finance Macro, which looks at irregularities in the overall market

Question 3

What is Homo economicus?

Answer 3

is a model of human economic behaviour hypothesizing that three principles dictate individuals economic decisions:

1. Perfect rationality
2. Perfect self-interest
3. Perfect information

Academics and practitioners believe in Homo economicus with varying degrees of stringency:

Strong Form: irrational economic traits do not exist

Semi-strong form: There is an abnormally high occurrence of rational economic traits

Weak Form: Irrational economic traits exist but are not strong

Question 4

What does the behavioural Finance Macro contradict?

Answer 4

The efficient market hypothesis

Question 5

Economics like to use Homo Economicus as a model for two primary reasons:

Answer 5

1. It makes economic analysis relatively simple

2. It allows economics to qualify their research findings, making their work easier to tech and disseminate

Question 6

Criticisms of perfect rationality (Homo Economicus)

Answer 6

When humans are rational, they have the ability to make logical and self-interested judgments. However, many would agree that rationality is not the sole driver of human behaviour. In fact, many psychologists believe the human intellect is actually subservient to human emotion. Thus, from this perspective perfect rationality is only a theoretical construct, not a practical occurrence.

Question 7

Criticisms of Perfect Self-Interest (Homo Economicus)

Answer 7

If humans were perfectly self interested, philanthropy nor charity would exist. Volunteering or acts of selflessness would not occur.

Question 8

Criticisms of Perfect Information

Answer 8

It is not possible for every person to have perfect knowledge of every subject in existence.

Question 9

What is the efficient market hypothesis? What are the three forms of it?

Answer 9

Believes that investment prices reflect all information and accurately priced.

Strong Form: All information (including insider information) is fully reflected in current securities price

Semi-Strong Form: All publicly available information is fully reflected in current securities prices; that is, fundamental analysis is of no value

Weak Form: All past market prices and date are fully reflected in current securities prices; that is, technical analysis is of little or no value

Question 10

What are the three main anomalies in markets? That contradict the efficient market hypothesis

Answer 10

Fundamental anomaly- irregularity in a security’s current price when compared to a fundamental assessment of its intrinsic value. Large body of evidence that show that investors consistently overestimate the prospects of growth companies and underestimate the value of out of favour companies.

Technical anomaly- sometimes, technical analysis reveals inconsistencies in the efficient market hypothesis. In general, the majority of research-focused technical analysis trading methods are based on the weak form of the efficient market hypothesis.

Calendar anomaly- irregular security patters that energy during certain times of the year, such as the January effect (markets tend to go up).

Question 11

Successful advisory relationships share at least four fundamental characteristics:

Answer 11

1. The advisor clearly understands the client’s financial goals.
2. The advisor uses a structured, consistent approach to advising the client
3. The advisor delivers what the client expects.
4. Both the client and the advisor benefit from the relationship

Question 12

What is a bias?

Answer 12

A bias can be described as a preference or an inclination or an unfair act or policy stemming from prejudice. In the investment realm, behavioural biases are defined as systematic errors in financial judgement or imperfections in the perception of economic reality.

Question 13

What are the two broad categories of behavioural biases?

Answer 13

Cognitive and emotional- with both yielding irrational judgments

Question 14

What is cognitive biases?

Answer 14

Can be technically defined as basic statistic, informational processing, or memory errors that are common to all human beings. They can also be thought of as “blind spots’ or distortions in the human mind. One of the most common cognitive biases is anchoring bias. Here, clients get anchored to the price of a stock or the level of the market and hold on to it before being willing or able to make an investment decision.

Question 15

What is a good example of cognitive bias?

Answer 15

Say you are researching U.S small cap mutual funds. Even when investors use a research service like Morningstar, which helps screens funds, the information flow is so immense that they inevitably rely on shortcuts, such as “best 12 month return” to make a fund choice. Because cognitive biases stem from faulty reasoning, better information and advice can often correct them.

Question 16

What is emotional biases?

Answer 16

Illogical or distorted reasoning behind a decision that is purely based on emotion. Emotions are physical expressions, often involuntary, related to feelings, perceptions, or beliefs about elements, objects or relations between them. Often, because emotional biases originate from impulse or intuition rather than from conscious calculations, they are difficult to correct.

Question 17

Name 5 cognitive biases and 5 emotional biases

Answer 17

Overconfidence, representativeness, anchoring and adjustment, availability and conservatism for cognitive.

Endowment, self-control, optimism, loss aversion and regret aversion.

Question 18

What findings did the institutional investors journal of wealth management by John Longo and Michael Pompian find between men and women investing

Answer 18

• Women are mort susceptible to the hot hand fallacy than men.
• Men are more overconfident and optimistic than woman
• Women are more likely to buy and hold
• Men are one third more risk tolerant than women

Question 19

What are the three investor personality dimensions

Answer 19

Idealism verus Pragmatism
Framing versus Integrating
Reflecting versus Realism

When we combiner’s the elements of the three dimensions, there are eight possible investor personality types.

Question 20

Explain the following:

Idealism versus pragmatism
Framing verus Integrating
Reflecting versus Realism

Answer 20

Idealism versus Pragmatism

• Idealists overestimate their investing abilities, display excessive optimism about the capital markets and do not see information that contradicts their views. Idealists are susceptible to the following biases: overconfidence, optimism, availability, self-attribution, illusion of control, confirmation, recency and representativeness.
• Pramatists, display a realistic grasp of their own skills and limitations as investors. Not too overconfident demonstrate a healthy dose of scepticism. Pragmatists are not susceptible to the aforementioned biases.

Framing verus Integrating

• Framers tend to evaluate their investments individually and do not consider how each of them fits into an overall portfolio. They are too rigid in their mental approach to analyzing problems. They typically hold unique pots of money (retirement, vacation, educating savings). Framers also anchor with markets and securities. Susceptible to anchoring, conservatism, mental accounting, framing, and ambiguity aversion.
• Integrators are characterized by an ability to contemplate broader contexts and externalities. They correctly view their portfolios as systems whose components can interact and balance one another out. They understand correlations and flexible to prices.

Reflecting versus Realism

• Reflectors have difficulty living with the consequences of their decisions and taking actions to rectify their behaviour. They justify and rationalize incorrect actions and hesitate to own up to decisions that have not worked out. They also suffer from decision paralysis because they dread the sensation of regret should they miscalculate. Susceptible to: cognitive dissonance, loss aversion, endowment, self-control, regret aversion, status quo and hindsight.
• Realists have less trouble coming to terms with the consequences of their choices. they do not tend to scramble for excuses in order to justify incorrect actions and they assume reasonability for their mistakes.

Question 21

What are the two principles for creating a best practical allocation in light of client behavioural biases:

Answer 21

1. Moderate biases in less wealthy clients, adapt to biases in wealthier ones
   - A client who outlives their assets constitutes a far graver investment failure than their inability to accumulate the greatest possible wealth.
2. Moderate cognitive biases, adjust to emotional ones