CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r06 the behavioral biases of individuals summary

Level III The Behavioral Biases of Individuals Summary Behavioral Bias Categories Belief perseverance biases: hold on to original beliefs; react selectively to new information Cognitive Behavioral Biases Emotional Conservatism Confirmation Hindsight Illusion of Control Representativeness Information processing biases: process information incorrectly; memory errors; faulty reasoning Framing Anchoring & Adjustment Mental Accounting Availability Biases influenced by feelings and emotion; avoid pain, produce pleasure Loss-Aversion Overconfidence Self Control Endowment Regret Aversion Status Quo www.ift.world Cognitive Belief Perseverance Biases Bias Description Examples/Implications Conservatism Maintain prior views by • Hold winners or losers too long inadequately incorporating new • Under-react to new information information Confirmation Look for and notice what confirms prior beliefs • Focus on confirmatory/positive information about existing investments • Over-react to confirmatory/positive information Hindsight See past events as having been predictable • Overestimate the degree to which a prior event was predictable Illusion of Control False belief that we can influence or control outcomes • Feeling of control over company where one works Representativeness Classify new information based on past experiences • Look for patterns in new information • Over-optimism about a past winner • Treat small sample as “representative” of entire population • Invest in companies that remind one of successful clients www.ift.world CCHIR Cognitive Information-Processing Biases Bias Description Examples/Implications Framing Answer question differently based on • A and B are similar but A has a 20% chance of loss how it is asked/framed and B has a 80% chance of not resulting in a loss Client picks B Anchoring and Adjustment Incorrect use of psychological heuristics • Place high weight on anchor  under-react to new information • Influenced by purchase price or arbitrary price levels Mental Accounting Treat one sum of money different from other depending on source or use • Current income, assets and PV of future income treated differently • Investing some money very conservatively and the rest in speculative stocks Availability Influenced by how easily outcome comes to mind • Place high weight on easily available information  influenced by advertising • Select alternatives with which one has greater resonance; select alternatives that are easily retrievable FAMA www.ift.world Emotional Biases Bias Description Examples/Implications Loss Aversion Prefer avoiding losses over achieving gains • Hold on to losing stocks too long and sell winning stocks too early (also called “disposition effect”) Overconfidence Unwarranted faith in ones abilities (Illusion of knowledge; self attribution) • Excessive trading • Narrow confidence intervals • Assign high probability of success Self-Control Fail to act in pursuit of long term goals • Focus on short-term satisfaction • Fail to save enough for the future Endowment People value asset more when they hold rights to it • Shares in father’s company a source of family pride Regret Aversion Avoid pain of regret associated with bad decisions • Prior decision which resulted in a loss, stops client from making the same decision; client will be upset if he sell a share and it goes up Status Quo Do nothing rather than make a change • Hold on to securities even if they are inconsistent with risk/return objectives; trade very infrequently www.ift.world LOSERS Moderate Biases Versus Adapt Portfolio to Biases The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends on two factors: 1) Client’s level of wealth • High wealth  low SLR  adapt to biases • Low wealth  high SLR  try to moderate biases 2) Type of behavioral biases the client exhibits • Emotional  adapt to biases • Cognitive  try to moderate biases www.ift.world Level III The Behavioral Biases of Individuals Appendix Cognitive Errors • stem from statistical, information processing or memory errors (e.g inability to complex mathematical calculations) • can arise due to faulty reasoning based on faulty thinking • can be corrected through better information, education, or expert advice Emotional Biases • are influenced by feelings and emotion • are usually related to human behavior (avoid pain and produce pleasure) • arise spontaneously as a result of attitudes and feelings • are less easy to correct relative to cognitive biases www.ift.world Cognitive Errors Belief perseverance biases: being selective in dealing with new information challenging existing beliefs • • • • • Conservatism Bias  Maintain prior views by inadequately incorporating new information Confirmation Bias  Look for and notice what confirms beliefs Representativeness Bias  Classify new information based on past experiences Illusion of Control Bias  False belief that we can influence or control outcomes Hindsight Bias  See past events as having been predictable Information processing biases: processing information in an illogical and irrational way • • • • Anchoring & Adjustment Bias  Incorrect use of psychological heuristics Mental Accounting Bias  Treat one sum of money (or source of return) as different from other Framing Bias  Answer question differently based on how it is asked Availability Bias  Heuristic approach influenced by how easily outcome comes to mind www.ift.world Conservatism bias refers to maintaining prior beliefs or forecasts by improperly incorporating new information How to identify? Individuals suffering from this bias tend to • “under-react” to new information, “react slowly” to new information, underweight the new information • exhibit discomfort or difficulty in processing new information Implications: maintain previous view or earnings forecasts, hold winners or losers too long in portfolios How to overcome: first recognize that bias exists, adequately analyze the impact of new information, seek advice from experts Confirmation bias (selection bias) refers to seeking information that confirms one’s beliefs How to identify? Individuals suffering from this bias tend to • “over-react” to new information • focus on (ignore) confirmatory/positive (negative) information about existing investment • include only those investments in portfolio that meet their criteria Implications: this bias leads individuals to overweight those investments in their portfolios about which they are optimistic, leading to: under-diversified portfolio, excessive exposure to risk, biased screening criteria How to overcome? In order to correct or reduce this bias, individuals should • collect complete information, including contradictory information • use more than one method of analysis • get corroborating support for an investment decision www.ift.world 10 Representativeness bias refers to classifying new information based on past experiences How to identify? Individuals suffering from this bias tend to • look for similar patterns in new information • be overly optimistic about a past winner • treat a small sample as “representative” of entire population Implications: this bias results in long-term underperformance of portfolio due to excessive trading and high manager turnover (owing to focus on short-term performance) How to overcome? In order to correct or reduce this bias, individuals should follow an appropriate asset allocation strategy and avoid chasing returns; use “periodic table of investment returns” whereby asset classes’ returns are ranked over time Illusion of control bias refers the false belief that one has the ability to exert influence over uncontrollable events How to identify? Individuals suffering from this bias tend to invest in companies over which they are perceive to have some control (e.g employer’s company stock) Implications: this bias results in: • long-term underperformance of portfolio due to excessive trading • under-diversified portfolios due to concentrated position in few companies How to overcome? In order to correct or reduce this bias, individuals should document rationale underlying each trade; maintain a long-term perspective rather than chasing returns; seek contradictory viewpoints www.ift.world 11 Mental accounting bias refers to classifying money based on its source [that is, current income (e.g salary), currently-owned assets (e.g bonus), and the present value of future income (e.g inheritance)] or planned use (e.g leisure, necessities) How to identify? Individuals suffering from this bias tend to treat their portfolio as a layered pyramid of assets representing different investment goals • ignore correlations among various assets and not make investment decisions in risk/return context • treat principal and income as non-fungible account and ignore total return (treating returns derived from income differently from that of capital appreciation) Implications: this bias results in suboptimal and poor performing portfolio due to inefficient asset allocation How to overcome? To correct or reduce this bias, individuals should focus on total return by considering correlations among various assets Framing bias refers to tendency of people to respond differently based how questions are asked (framed) How to identify? Individuals suffering from this bias tend to focus on a narrow frame of reference while ignoring larger context (referred to as narrow framing) Implications: this bias results in suboptimal portfolio due to: misidentification of risk tolerances, selection of suboptimal investments, excessive trading How to overcome? In order to correct or reduce this bias, individuals should focus on future prospects of investment (i.e expected risk/return) while making investment decisions rather than referring to gains and losses already incurred; remain neutral & open-minded when interpreting investment-related situations www.ift.world 12 Availability bias involves placing higher weight to information which is readily available or easily recalled There are following four sources of availability biases: retrievability, categorization, narrow range of experience, resonance (overestimating the probability of an outcome that matches with one’s way of thinking) How to identify? Individuals suffering from • “retrievability” tend to select investment or investment advisor based on advertisements (e.g by industry trade groups and from blogs sponsored by the companies), rather than considering additional independent resources or performing proper due diligence • “categorization” tend to focus on a limited set of investments E.g restrict investments to stocks and bonds of one country only • “narrow range of experience” tend to make investment decisions based on their familiarity with the industry or country • “resonance” tend to invest in companies that match their own personal likes and dislikes Implications: this bias results in suboptimal and under diversified portfolio due to inappropriate asset allocation resulting from limited investment opportunity set How to overcome? In order to correct or reduce this bias, individuals should • follow an appropriate and disciplined investment policy strategy consistent with risk/return objectives and constraints • perform a thorough analysis and research while making investment decisions • focus on long-term outcomes rather than chasing short-term results www.ift.world 13 Anchoring & adjustment bias refer to developing estimates based on an “anchor” value (e.g target price) and adjusting decisions up or down based on that value How to identify? Individuals suffering from this bias tend to: under-react to new information, place higher weight to the anchor, be influenced by purchase “points,” or arbitrary price levels or price indexes Implications: due to this bias, individuals remain “anchored to” original estimates (anchor values); investment decisions become difficult to reverse when the new information indicates that a change is advisable How to overcome? In order to correct or reduce this bias, individuals should • avoid making investment decisions based on past /“anchor” value • examine new information objectively End of cognitive biases! Moving to emotional biases… Endowment bias refer to exhibiting an emotional attachment to the asset owned This bias is also related to the “familiarity bias” in which people tend to prefer assets with which they are familiar and view them as less risky How to identify? Individuals suffering from this bias tend to hold on to inherited/purchased securities in order to avoid the feelings of disloyalty associated with selling those securities Implications: this bias results in inappropriate asset allocation How to overcome? In order to correct or reduce this bias, individuals should • treat inherited investments as cash and then invest that cash based on investment goals • objectively review the historical performance of securities www.ift.world 14 Loss-aversion bias is the tendency of people to prefer avoiding losses as opposed to achieving gains Sub-categories of loss-aversion bias are 1) house money effect: exhibiting risk-seeking attitude in dealing with someone else’s money and 2) myopic loss aversion: exhibiting greater sensitivity to losses than to gains How to identify? Individuals suffering from this bias tend to • accept more risk to avoid losses than to achieve gains (myopic loss aversion) • have risk-seeking (convex) utility function for gains and a risk-averse (concave) utility function for losses • suffer from the disposition effect, which is the tendency to realize gains early (selling winning stocks too early) and delay recognizing losses (holding losing stocks too long) • think of outcomes in terms of gains and losses relative to some reference point • treat profit as if it belongs to someone else and thereby take higher risk when investing it (house-money effect) Implications: this bias results in • long-term underperformance of portfolio due to focus on short-term results despite having long-term investment goals, leading to excessive trading, high transaction costs and poor investment returns • riskier portfolio with limited upside potential • suboptimal portfolio returns as a result of holding losing investments and selling winning ones How to overcome? In order to correct or reduce this bias, individuals should • use a disciplined approach based on fundamental analysis • rationally evaluate probabilities of future losses/gains www.ift.world 15 Overconfidence bias is the tendency of people to overestimate one’s ability to accurately process, access, and predict information Overconfidence bias has aspects of both cognitive and emotional errors but emotional aspect dominates Sub-categories: Illusion of knowledge bias refers to misperceiving an increase in the amount of information available as having greater knowledge Self-attribution bias refers to taking too much credit for success (self-enhancing) while denying any personal responsibility or blaming external factors (e.g luck) for failures (self-protecting) How to identify? Individuals suffering from this bias tend to • estimate narrow confidence intervals (known as prediction overconfidence) • assign higher probabilities of success to outcomes (known as certainty overconfidence) • underreact to new information Implications: this bias results in: • excessive trading, leading to higher transaction costs and lower returns • underestimation of risks and overestimation of expected return, leading to poorly diversified portfolios How to overcome overconfidence bias? In order to correct or reduce this bias, individuals should: • critically review trading records • calculate portfolio performance over 2+ years • conduct post investment analysis on both successful and unsuccessful investments • try to gather complete information when making investment decisions www.ift.world 16 Self-control bias refers to tendency of people to spend today rather than save for tomorrow How to identify? Individuals suffering from this bias tend to: focus on short-term satisfaction, save insufficient amount for the future, over-invest in income-producing assets to generate income for meeting present spending needs Implications: this bias results in • excessive risk exposures to generate higher returns for meeting long-term goals, resulting in under-diversified portfolio • long-term underperformance of portfolio due to portfolio’s inability to maintain spending power after inflation How to overcome overconfidence bias? In order to correct or reduce this bias, individuals should • follow an appropriate investment policy strategy consistent with risk/return objectives and constraints • follow a saving plan Status quo bias refers to the tendency of people to nothing and make no change How to identify? Individuals suffering from this bias tend to: hold the existing investments in their portfolios even if currently they are not consistent with their risk/return objectives, exhibit a lack of attention to managing their portfolios, ignore other profitable investment opportunities available as they are generally more comfortable keeping things the same Implications: this bias results in inappropriate asset allocation How to overcome? In order to correct or reduce this bias, individuals should • follow an appropriate investment policy strategy consistent with risk/return objectives and constraints • quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation www.ift.world 17 Regret-aversion bias refers to tendency of people to avoid making decision due to the fear of experiencing the pain of regret Regret can be of two types, i.e regret from action taken (error of commission) and regret from not taking an action (error of omission) How to identify? Individuals suffering from this bias tend to • make conservative investment decisions • hold losing positions for too long • prefer low risk assets • engage in “herding behavior” (following the crowd) • prefer maintaining positions in familiar investments, i.e invest in stocks of well-known companies Implications: this bias results in – sub-optimal portfolio – long-term underperformance of portfolio How to overcome? In order to correct or reduce this bias, individuals should – follow an appropriate investment policy strategy consistent with risk/return objectives and constraints – quantify risk-reducing and return-enhancing advantages of diversification – get education about the investment decision-making process www.ift.world 18 Behavioral biases can be incorporated into an IPS using two approaches: Goal-Based Investment (GBI) Approach: portfolio is constructed in layers, representing investment goals and asset allocation within each layer Under GBI: • portfolio performance is evaluated in terms of portfolio’s ability to achieve investment goals • portfolio risk is evaluated in terms of minimum wealth level or probability of losing money rather than variance • primary objective is wealth preservation / minimizing losses Behaviorally Modified Asset Allocation (BMAA): portfolio is constructed by selecting an asset allocation that satisfies investor’s natural psychological & behavioral preferences Guidelines for Determining a Behaviorally Modified Asset Allocation The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends on two factors: 1) Client’s level of wealth • High wealth  low SLR  adapt to biases • Low wealth  high SLR  try to moderate biases 2) Type of behavioral biases the client exhibits • Emotional  adapt to biases • Cognitive  try to moderate biases www.ift.world 19 ... to biases • Low wealth  high SLR  try to moderate biases 2) Type of behavioral biases the client exhibits • Emotional  adapt to biases • Cognitive  try to moderate biases www.ift.world Level. .. Moderate Biases Versus Adapt Portfolio to Biases The decision to moderate or adapt to a client’s behavioral biases during the asset allocation process depends on two factors: 1) Client’s level of wealth... SLR  adapt to biases • Low wealth  high SLR  try to moderate biases 2) Type of behavioral biases the client exhibits • Emotional  adapt to biases • Cognitive  try to moderate biases www.ift.world