QFIP-152: How Behavioral Biases Affect Investment Professionals

Question 1

Describe the behavior bias of heuristics, and provide an example of how it impacts financial advisors and planners

Answer 1

When individuals apply mental shortcuts or rules of thumb when processing large amounts of data or statistics

• Example: Investment professionals may recommend more conservative investment products to married couples because of the assumption that married couples are less risk tolerant
• However, these stereotypes or rules of thumb may be incorrect

Question 2

Describe the behavior bias of anchoring, and provide an example of how it impacts financial advisors and planners

Answer 2

Anchoring is the tendency to have a belief and then apply it as a reference point for making future judgments

• Example: Anchor on a losing investment as a bad experience. This can result in the advisor being excessively risk-averse, resulting in underweighting stocks in the client’s portfolio

Question 3

Describe how the behavior bias of perceived risk impacts financial advisors and planners

Answer 3

Perceived risk includes subjective factors such as heuristics and emotion that can influence how finance professionals assess risk, which can potentially cause investors to be excessively worried about risky investments

Question 4

Describe how familiarity bias impacts financial advisors and planners

Answer 4

Familiarity Bias refers to the preference to own familiar assets, such as domestic assets

• This can result in an under-diversication in investment portfolios and lower performance

Question 5

Describe how the bias of trust and control impacts financial advisors and planners

Answer 5

Trust and control refers to the tendency for clients to place too much trust in professionals and overly allocate control about investment decisions to their financial advisors

• Financial advisors need to establish a balanced relationship of trust and control with their clients

Question 6

Describe how the bias of framing impacts financial advisors and planners

Answer 6

Framing refers to the method by which planners/advisors present an investment product to a client based on specific word association

• Studies have shown that based on how financial professionals frame investment opportunities, the end result is that financial professionals are more conservative in their approach to managing the client’s investments than with their own money

Question 7

Define overconfidence, and describe how it impacts the behavior of financial analysts and portfolio managers

Answer 7

Overconfidence refers to an unwarranted faith in one’s intuitive reasoning and cognitive abilities

• Prediction overconfidence occurs when professionals assign too narrow a confidence interval around their investment forecasts
• Certainty overconfidence occurs when professionals assign too high a probability to their prediction and have too much confidence in the accuracy of their own judgments
• Overconfidence can lead to concentrated investment portfolios with few assets

Question 8

Define herding, and describe how it impacts the behavior of financial analysts and portfolio managers

Answer 8

Herding behavior refers to disregarding one’s own analysis to follow the crowd

• Professionals will invest in assets just because everyone else is
• This could be problematic, though, if a particular investment stock is in a bubble

Question 9

Define loss aversion, and describe how it impacts the behavior of financial analysts and portfolio managers

Answer 9

Loss aversion refers to how investment professionals overweight losses compared to an equivalent gain

• This results in a disposition effect in which professional recommend selling securities too quickly to lock in gains, and recommend retaining securities too long in order to recoup losses

Question 10

Describe confirmation bias, and how it impacts the behavior of financial analysts and portfolio managers

Answer 10

Confirmation bias is the tendency to overweight information that confirms prior beliefs and underweight information that runs counter to prior beliefs

• As a result, the investment recommendations of financial analysts may be biased based on previous recommendations

Question 11

Describe optimism and how it impacts the behavior of financial analysts and portfolio managers

Answer 11

Optimism refers to how analysts and portfolio managers are excessively optimistic in both their earnings forecasts and stock recommendations

• Management prefers optimistic forecasts because these forecasts increase market valuations and therefore management compensation
• This results in analysts having many more Buy recommendations than Sell recommendations

Question 12

Provide three behaviorial reasons for why investors tend to overweight their portfolios in domestic markets, resulting in underdiversification of portfolios

Answer 12

• Overconfidence in judgment and intuition about domestic equities
• Optimism bias about future growth in domestic investments
• Familiarity bias

Question 13

Explain why herding behavior by institutional investors is not necesarily a bad thing

Answer 13

• For most institutions, this herding behavior is actually rational and information-based
• Many of these institutional investors analyze similar information and draw the same conclusions about the fair values of specific securities
• As a result, many of the herding behavior found in institutional investors is unintentional, and thus is price stabilizing instead of price destabilizing