Reading 7 Behavioral Finance and Investment Processes

Question 1

Barnewall Two-Way Model

Answer 1

• distinguishes two relatively simple investor types: passive and active.
• passive investors include corporate executives, lawyers with large regional firms, certified public accountants (CPAs) with large CPA companies, medical and dental non-surgeons, small business owners who inherited the business, politicians, bankers, and journalists.
• the smaller the economic resources an investor has, the more likely the person is to be a passive investor. The lack of resources gives individuals a higher security need and a lower tolerance for risk.
• Active investors have a higher tolerance for risk than they have need for security.
• By their involvement and control, they feel that they reduce risk to an acceptable level, which is often fallacious

Question 2

BB&K Five-Way Model

Answer 2

• BB&K model features some of the principles of the Barnewall model, but by classifying investor personalities along two axes—level of confidence and method of action—it introduces an additional dimension of analysis.
• The Adventurer: Adventurers may hold highly undiversified portfolios because they are confident and willing to take chances. Their confidence leads them to make their own decisions and makes them reluctant to take advice. This presents a challenge for an investment adviser.
• The Celebrity: Celebrities like to be the center of attention. They may hold opinions about some things but to a certain extent recognize their limitations and may be willing to seek and take advice about investing.
• The Individualist: Individualists are independent and confident, which may be reflected in their choice of employment. They like to make their own decisions but only after careful analysis. They are pleasant to advise because they will listen and process information rationally.
• The Guardian: Guardians are cautious and concerned about the future. As people age and approach retirement, they may become guardians. They are concerned about protecting their assets and may seek advice from those they perceive as being more knowledgeable than themselves.
• The Straight Arrow: Straight arrows are sensible and secure. They fall near the center of the graph. They are willing to take on some risk in the expectation of earning a commensurate return.

Question 3

Behavioral Investor Types

Answer 3

• Pompian (2008) identifies four behavioral investor types (BITs).
• Pompian (2008) introduces a behavioral alpha (BA) approach.
• It is a “top-down” approach to bias identification that may be simpler and more efficient than a bottom-up approach.​

The Behavioral Alpha Process: A Top-Down Approach

• Step 1*: Interview the client and identify active or passive traits and risk tolerance.
• Step 2*: Plot the investor on the active/passive and risk tolerance scale.
• Step 3*: Test for behavioral biases.

Question 4

Biases Associated with Each Behavioral Investor Type

Answer 4

Passive Preserver (PP)

Basic type: Passive

Risk tolerance level: Low

Primary biases: Emotional

Advising Passive Preservers: Passive Preservers may be difficult to advise because they are driven mainly by emotion. Although this characterization is true, PPs still need good financial advice.

Friendly Follower (FF)

Basic type: Passive

Risk tolerance level: Low to medium

Primary biases: Cognitive

Advising Friendly Followers: Friendly Followers may be difficult to advise because they often overestimate their risk tolerance. Risky trend-following behavior occurs in part because FFs often convince themselves that they “knew it all along” when an investment works out well, which increases future risk-taking behavior.

Independent Individualist (II)

Basic type: Active

Risk tolerance: Medium to high

Primary Biases: Cognitive

Advising Independent Individualists: Independent Individualists may be difficult clients to advise because of their independent mindset, but they are usually willing to listen to sound advice when it is presented in a way that respects their intelligence. IIs have faith in themselves and their decisions, but may be unaware of their tendency to take a contrarian position.

Active Accumulator

Basic type: Active

Risk tolerance: High

Primary Biases: Emotional

Advising Active Accumulators: Active Accumulators may be the most difficult clients to advise. They like to control, or at least get deeply involved in, the details of investment decision making. They tend to be emotional and display overconfidence, which often manifests itself as optimism.

Question 5

Biases of PP

Answer 5

Emotional:

• Endowment
• Loss aversion
• Status quo
• Regret aversion

Cognitive:

• Mental accounting
• Anchoring and adjustment

Question 6

Biases of FF

Answer 6

Emotional:

• Regret aversion

Cognitive:

• Availiability
• Hindsight
• Framing

Question 7

Biases of II

Answer 7

Emotional:

• Overconfidence and self-attribution

Cognitive:

• Conservatism
• Availiability
• Confirmation
• Representativeness

Question 8

Biases of AA

Answer 8

Emotional:

• Overconfidence
• Self-control

Cognitive:

• Illusion of control

Question 9

Limitations of Classifying Investors into Various Types

Answer 9

The limitations of behavioral models include the following:

1. Individuals may exhibit both cognitive errors and emotional biases.
2. Individuals may exhibit characteristics of multiple investor types.
3. Individuals will likely go through behavioral changes as they age.
4. Individuals are likely to require unique treatment even if they are classified as the same investor type because human behavior is so complex.
5. Individuals act irrationally at different times and without predictability.

Question 10

How Behavioral Factors Affect Adviser–Client Relations

Answer 10

Every successful relationship shares a few fundamental characteristics, including the following as outlined by Pompian (2006):

1. The adviser understands the client’s financial goals and characteristics. These are considered when developing the investment policy statement.
2. The adviser maintains a systematic (consistent) approach to advising the client.
3. The adviser invests as the client expects. Results are communicated on a regular basis and in an effective manner that takes into account the client’s characteristics.
4. The relationship benefits both client and adviser.

Question 11

Naive Diversification

Answer 11

• 1/n diversification strategy - evidenced by invesors` behavior
• Not all researchers support the idea that investors follow a 1/n strategy. However, they do find evidence of members following a conditional 1/n strategy, by allocating equally among their chosen subset of funds. In other words, once they have selected their funds, they allocate the invested amount equally among the chosen funds.

Question 12

Company Stock: Investing in the Familiar

Answer 12

Explanations given for investment in employer’s stock include the following:

1. Familiarity and overconfidence effects
2. Naive extrapolation of past returns
3. Framing and status quo effect of matching contributions
4. Loyalty effects
5. Financial incentives

Question 13

Excessive Trading

Answer 13

The main findings are that investors trade too much—damaging returns—and tend to sell winners and hold on to losers—the disposition effect.

Question 14

Home Bias

Answer 14

A large body of literature exists showing that many investors maintain a high proportion—­often 80 percent or more—of their investments in securities listed in their own country

Question 15

Behavioral Portfolio Theory

Answer 15

• The theory is intended to reflect how investors actually form portfolios rather than how traditional theory suggests they should
• Investments are allocated to discrete layers without regard for the correlations among these investments.
• The failure to consider diversification benefits is an implication of the mental accounting bias.

Question 16

Cognitive dissonance

Answer 16

Cognitive dissonance arises when new information conflicts with previously held beliefs or cognitions.

Question 17

Social proof

Answer 17

Social proof is a bias in which individuals are biased to follow the beliefs of a group.

Question 18

The gamblers’ fallacy, conjunction fallacy

Answer 18

The gamblers’ fallacy, a misunderstanding of probabilities in which people wrongly project short-run reversal to a long-term mean, is a related cognitive bias

Conjunction fallacy - inappropriately combining probabilities

Question 19

Overconfidence in Forecasting Skills, Remedial Actions

Answer 19

• Dealing with overconfidence is difficult, but prompt and accurate feedback combined with a structure that rewards accuracy can help analysts to re-evaluate their processes and self-calibrate.
• Where resources and organizational structure permit, appraisal by colleagues, superiors, or systems can also help calibrate forecasts and control overconfidence.
• Well-structured feedback can also reduce hindsight bias. An analyst should document a decision or forecast and the reasons for that judgment.
• To address hindsight bias and other biases, analysts should make the conclusion as explicit as possible
• One method that can help reduce overconfidence is for an analyst to be required to provide at least one counterargument in the report.
• To counter the risk of inaccuracy and excess confidence based on specific characteristics of the subject of the analysis, analysts should consider whether the sample size is too small. Ensuring that a search process includes onlycomparable data is also helpful to reducing overconfidence.

Question 20

Remedial Actions for Analyst Biases in Conducting Research

Answer 20

• Making forecasts, analysts should evaluate previous forecasts and be wary of anchoring and adjustment.
• Collect information in a systematic way and, where possible, use metrics and ratios that allow comparability—­comparability in both analysis with previous calculations and also, where possible, benchmarked against current similar calculations.
• It is important when gathering information to use a systematic approach with prepared questions. Information should be gathered before analysis is done and a conclusion has been made. In conducting analysis, CFA Institute members and candidates are expected to comply with Standard V of the Standards of Practice Handbook.
• Once base rates or events are assessed with other than 0 or 100 percent likelihood, a Bayesian approach to combining evidence will force the conclusion away from unlikely scenarios.
• Analysts need to consider the search process, the limits of information, and the context of the information. A structured process for information gathering and processing can help analysts deal with search biases. A search process should involve seeking contrary facts and opinions.
• Having a structured search process and a clear way of incorporating evidence sequentially, either as decision rules (trees) or using Bayes’ formula, can encourage much faster adaptation of forecasts. Prompt feedback not only allows re-evaluation but also helps analysts to gain knowledge and experience that can be drawn on in the future, either consciously or unconsciously (intuitively).
• Although analysts should document their decision making to assist later evaluation, some of the documentation may be best done once the analysis is complete.

Question 21

How Behavioral Factors Affect Committee Decision Making

Answer 21

• Group judgments are potentially better than individual ones, but biases mean that the group may not perform optimally. Typically, a group will have more confidence in its decisions after discussion that leads to an overconfidence bias.
• Committees are often made up of individuals with similar backgrounds who are likely to approach decisions in a similar way.
• The chair of a committee has an important role in ensuring the effectiveness of the committee’s decision making. As noted earlier, this responsibility includes assembling a diverse group of individuals with relevant skills and experiences and creating a culture in which members can express dissenting views. The chair is also responsible for ensuring that the committee sticks to the agenda and making sure a clear decision is reached after the various opinions have been heard. The chair should actively encourage alternative opinions so that all perspectives are covered. In turn, committee members have a responsibility to actively contribute their own information and knowledge and not simply fall into line with the consensus for the sake of harmony.

Question 22

Definine Market Anomalies

Answer 22

• Anomalies (apparent deviations from the efficient market hypothesis) are identified by persistent abnormal returns that differ from zero and are predictable in direction.
• Also, from time to time, markets can present temporary disequilibrium behavior, unusual features that may survive for a period of years but ultimately disappear.

Question 23

Momentum

Answer 23

• Momentum or trending effects in which future price behavior correlates with that of the recent past
• Herding occurs when a group of investors trade on the same side of the market in the same securities, or when investors ignore their own private information and act as other investors do.
• Momentum can be partly explained by short-term underreaction to relevant information, and longer-term overreaction. Investors’ bias to sell winners reflects anchoring on the purchase price.
• Studies have identified faulty learning models within traders, in which reasoning is based on their recent experience. Behaviorally, this is availability bias. The availability bias in this context is also called the recency effect, which is the tendency to recall recent events more vividly and give them undue weight.
• Regret is the feeling that an opportunity has been missed, and is typically an expression of hindsight bias.
• Trend-chasing effect - in terms of selecting investments, investors have a bias to buy investments they wish they had owned the previous year.
• The disposition effect, which includes an emotional bias to loss aversion, will encourage investors to hold on to losers, causing an inefficient and gradual adjustment to deterioration in fundamental value

Question 24

Bubbles and Crashes

Answer 24

• A more objective modern definition specifies periods when a price index for an asset class trades more than two standard deviations outside its historic trend.
• Bubbles and crashes are, respectively, periods of unusual positive or negative asset returns because of prices varying considerably from or reverting to their intrinsic value. Typically during these periods, price changes are the main component of returns.
• A crash would typically be a fall of 30 percent or more in asset prices in a period of several months.
• In bubbles, investors often exhibit symptoms of overconfidence; overtrading, underestimation of risks, failure to diversify, and rejection of contradictory information.

Question 25

Value and Growth Anlomalia

Answer 25

• Value stocks are typically characterized by low price-to-earnings ratios, high book-to-market equity, and low price-to-dividend ratios.
• The halo effect, for example, extends a favorable evaluation of some characteristics to other characteristics.