Reading 9: Behavioural Finance & Investment Process

Question 1

Behavioural Types

Answer 1

Allows the portfolio to be closer to the efficient frontier, (closer to traditional finance), benefits overall client/advisor relationship, trusting and satisfied clients, stay on track with long term. However individuals change over time, can have irrational traits, can have both cognitive and emotional biases, can fit into two behavioural types, can be in the same behavioural type but not treated the same.

Question 2

Behavioural Finance Benefits

Answer 2

Long term goals and reasons for these goals known (client is better understood); consistent approach with client adds structure and professionalism; advisor invests as client expects; closer bond between advisor and client which is mutually beneficial.

Question 3

Pyramid Structure

Answer 3

Each layer has a different level of risk (where traditional finance has portfolio with a single level of risk). Correlation between layers is ignored. Each layer is thought of separately, which is mental accounting.

Question 4

Target Date Funds

Answer 4

Overcome status quo bias and adjusts portfolios as they age.

Question 5

Representativeness

Answer 5

Can be caused by gathering a lot of information. Falsely assuming the probability that the info fits a certain information category then that the category of info fits the conclusion. Can then contribute to overconfidence. E.g. classifying a growth firm based solely on previous high growth in the past without evaluating other factors affecting firms future.

Question 6

Hindsight Bias

Answer 6

I knew it all a long. Regret of not buying a stock or sold a particular investment can fuel a trend-chasing effect. It is an ego defence mechanism for analysts that selectively recall positives about their model and adjust it slightly to make it seem more accurate than it really was, when really it is a bad model.

Question 7

Disposition Effect

Answer 7

Stems from loss aversion and overconfidence in mean reversion. Selling winner too early or holding onto losers for too long. Can lead to excessive trading of winners. Seen in retail broking account. Driven by fear of regret.

Question 8

Bubbles & Crashes

Answer 8

A bubble or crash is a period where prices are 2 standard deviations away from the index’s mean. A crash can be characterised by a 30% drop over a period of several months. Not based on fundamentals but by panic buying and selling.

Question 9

Conditional Naive Diversification

Answer 9

Investor allocates equally among select number of investment choices in company retirement plan.

Question 10

Loss Aversion

Answer 10

If a client has experienced losses they will take more risk to make up the losses.

Question 11

Risk Tolerance Questionnaire

Answer 11

May fail for emotionally bias individuals and works best for institutional investors, they are effective for cognitive based people.

Question 12

Cognitive Bias

Answer 12

Investors with cognitive biases over emotional should be moderated to eliminate these with justification. Then the portfolio will begin to look more like mean-variance portfolio.

Question 13

Committees

Answer 13

Should encourage private information be shared. Social proof can occur where individual are biased to follow beliefs of the group. Can occur when reaching a consensus, narrowing the range of views.

Question 14

Illusion of Control

Answer 14

Can occur when a lot of information has been collected resulting in collection of too much info that doesn’t add accuracy but adds confidence.

Question 15

Gambler Fallacy

Answer 15

Cognitive behavioural bias, wrongly projecting a reversal to a long term trend, shows a faulty understanding about behaviour of random events.

Question 16

Behavioural Models: Barnewall Two-Way Behavioural Model

Answer 16

Only two types of investors, passive investors who have not had to risk their own wealth (accumulate salary or inheritance) and active investor who have had to risk own wealth (starting a company). Active = less risk averse, gather lots of info, feel in control. When control is lost their tolerance for risk decreases a lot.

Question 17

Behavioural Models: Bailard, Beihl, and Kaiser (BBK) Five Way Model

Answer 17

Two dimensions, confidence (confident / anxious) and method of action (careful / impetuous). Adventurer: confident and impetuous, highly concentrated, own decisions, unwilling to take advice, hard to work with. Celebrity: anxious and impetuous, seeks advice. Individualist: confident and careful, own decisions after careful analyses, listen and process info rationally. Guardian: anxious and careful, future concern and protecting assets, seek advice from knowledgeable trusted source. Straight Arrow: average in the middle, take increased risk for increased return.

Question 18

Behavioural Models: Pompian Behavioural Model

Answer 18

Four behavioural investor types (BIT). Passive preserver: low risk tolerance, emotional bias, conservative, respond to high level overviews not quantitative details (Sharpe and SD), trust won over time. Friendly follower: low to moderate risk tolerance, cognitive bias mainly, follow tips from friends etc, overestimate risk tolerance, good to advise about quantitative methods to educate on diversification. Independent individualist: active investor, moderate to high risk tolerance, cognitive bias, strong willed to invest/research by self, contrarian, listens to sound advice, difficult to advise, regular education best approach. Active accumulator: higher risk tolerance, emotional perspective, entrepreneurial, aggressive investor, deep involvement, confident, hardest to advise, advisor to take control of investment process not letting investor control the situation.

Question 19

1/n Diversification Heuristic

Answer 19

Assets divided equally among investment options. According to behavioural finance investor will do this for their defined contribution pension.

Question 20

Herding

Answer 20

Two behavioral biases associated with herding are the availability bias (a.k.a. the recency bias or recency effect) and fear of regret. In the availability bias, recent information is given more importance because it is most vividly remembered. It is also referred to as the availability bias because it is based on data that are readily available, including small data samples or data that do not provide a complete picture. In the context of herding, the recent data or trend is extrapolated by investors into a forecast. Regret is the feeling that an opportunity has passed by and is a hindsight bias.