Chapter 3 Flashcards
Understanding a Client's Risk Tolerance
What is the meaning of “homo economiucs”?
“rational economic human being”
Homo economicus is a model of human economic behaviour hypothesizing that these three principles dictate individuals economic decisions:
- Perfect rationality
- Perfect self interest
- Perfect information
What is the difference between standard finance and behavioural finance?
Standard finance is grounded in idealized financial behaviour and behavioural finance in observed financial behaviour.
Successful advisory relationships share what four fundamental characteristics?
- Advisor clearly understands client’s financial goals
- Advisor uses a structured, consistent approach to advising the client
- Advisor delivers what the client expects
- Both the client and the advisor benefit from the relationship
Describe overconfidence bias
- cognitive bias
- an unwarranted faith in one’s intuitive reasoning, judgements, and cognitive abilities
Describe representativeness bias
- cognitive bias
- when confronted with new circumstances that may be inconsistent with existing classification systems, people rely on a “best fit” process to determine which category should house and form the basis for understanding for this new circumstance
- when the classification reflex is wrong it produces an incorrect understanding of the new element that often persists and biases further interactions with that element
Describe anchoring and adjustment bias
- cognitive bias
- if a person is asked to estimate a value in an area they have little to no familiarity with and is presented with an initial default number (anchor) they will typically adjust this figure up or down to reflect subsequent information and analysis
Describe cognitive dissonance bias
- cognitive bias
- when people are presented with information that conflicts with pre-existing beliefs, they usually experience mental discomfort
- a state of mental imbalance that occurs when contradictory cognitions bump into one another
Describe availability bias
- cognitive bias
- a heuristic that allows people to estimate the probability of an outcome based on how prevalent or familiar it appears in their lives
Describe self attribution bias
- cognitive bias
- the tendency of individuals to ascribe their successes to personal traits and to blame their failures on outside influences
Describe illusion of control bias
- cognitive bias
- tendency to believe that you can control random outcomes when in reality you cannot
Describe conservatism bias
- cognitive bias
- a mental state in which people cling to a prior view or forecast and do not acknowledge or obtain new information that might change an existing view
Describe ambiguity aversion bias
- cognitive bias
- people avoid making an investment or taking risks when probability distributions seem uncertain to them because they hesitate in situations of ambiguity
Describe mental accounting bias
- cognitive bias
- people’s tendency to categorize and evaluate economic outcomes by grouping assets into non-fungible mental accounts
Describe confirmation bias
- cognitive bias
- a type of selective perception in which people emphasize ideas that confirm their beliefs and discount ideas that contradict their beliefs
Describe hindsight bias
- cognitive bias
- after the outcome of an event is known, some people believe it was predictable even if it was not
Describe recency bias
- cognitive bias
- causes people to recall and emphasize recent events more prominently than those that occurred in the near or distant past
Describe framing bias
- cognitive bias
- tendency to respond to various situations differently base don the context in which a choice is presented
Describe endowment bias
- emotional bias
- placing more value on an asset you hold property rights to
Describe self control bias
- emotional bias
- tendency to consume today at the expense of saving for tomorrow
Describe optimism bias
- emotional bias
- most people tend to rate themselves as surpassing the population mean for personal traits perceived as positive
Describe loss aversion bias
- emotional bias
- people generally feel a stronger impulse to avoid losses than to acquire gains
Describe regret aversion bias
- emotional bias
- avoid making decisions because you fear in high-sight that whatever you decide will result in a bad decision
Describe status quo bias
- emotional bias
- when faced with a variety of options, people choose to keep things the same
What are the three investor personality dimensions?
- Idealism vs pragmatism
- Framing vs integrating
- Reflecting vs realism
Describe idealism vs pragmatism
I- discern patterns where none exist and believe their their above avg market acumen gives them an exaggerated degree of control over the outcomes of their investments
P- display realistic grasp of their own skills and limitations
Describe framing vs integrating
F- evaluate investments individually and do not consider how each of them fits into an overall portfolio plan
I- characterized by an ability to contemplate broader contexts and externalities
Describe reflecting (T) vs realism
T- have difficulty living with the consequences of their decisions and taking action to rectify their behaviours
R- assume responsibility for their mistakes and move on
Define best practical allocation
Adjusting risk and return levels depending upon the client’s behavioural tendencies (Pompian)
What are the two principles for creating a best practical allocation in light of behavioural biases ?
- Moderate biases in less wealthy clients; adapt to biases in wealthier ones
- Moderate cognitive biases; adapt to emotional ones
