2018 Study Session # 3, Reading # “BEHAVIORAL FINANCE AND INVESTMENT PROCESSES” THE USES AND LIMITATIONS OFCLASSIFYING INVESTORS INTO TYPES 2.1 General Discussion of Investor Types Models of Investor Psychographics 2.1.1 Barnewall Two-Way Model Passive Investors 2.1.2 Bailard, Biehl, and Kaiser Five-Way Model (classify five investor personalities along two axes) Active Investors Confident axis Investors who have become wealthy passively Risk averse and have a greater need for security Risk own capital to gain wealth Prefer to maintain control of own investments Risk tolerance How confidently investor approaches life Emotional choices Five Investor Personality Types The Adventurer Careful-impetuous axis Whether then investor is methodical, careful & analytical in his approach to life Method of action can range from carful to impetuous The Celebrity Might hold highly concentrated portfolios Willing to take chances & likes to make own decisions Advisors find them difficult to work with Like to be the center of attention Might have opinions but recognizes limitations Willing to seek & take advice about investing The Individualist The Guardian Confident & careful Listen & process information rationally Likes to make own decisions after careful analysis Cautious & concerned about the future Concerned about protecting their assets Seek advice of someone they perceive as more knowledgeable The Straight Arrow Sensible & secure Willing to take risk for expected return 2.1.3 Behavioral Finance and Investment Processes Behavioral Investor Types Two Methods Bottom-Up Approach Test for all behavioral biases in the client Create an appropriate IPS & behaviorally modified asset allocation May be time consuming or complex Top-Down Approach Called behavioral alpha approach Simple & more efficient than a bottom-up approach Determine type of bias in the client & how to correct for or adapt to the biases Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # BF = Behavioral Finance BB = Behavioral Biases Step in Top-Down Approach Step ⇒ interview the client & identify active or passive traits & risk tolerance Step ⇒ the investor on the active/passive & risk tolerance scale Step ⇒ tests for behavioral biases Step ⇒ Classify investor into a behavioral investor type Passive Preserver (PP) Low risk tolerance & are subject to emotional biases Emphasis on financial security & preserving wealth Most common emotional biases to PPs: Endowment, loss aversion, status quo & regret aversion Cognitive errors: Anchoring & adjustment & mental accounting Advising Passive Preserver Difficult to advice (driven mainly by emotion) Receptive to “big picture” advice Friendly Follower (FF) Passive investors with low to medium risk tolerance Cognitive biases Prefer popular investments Overestimate risk tolerance Influenced by availability, hindsight, framing & regret aversion biases Advising Friendly Followers Difficult to advise (overestimate their risk tolerance) Education is usually the best course of action (cognitive errors) Independent Individualist Active investor with medium to high risk tolerance Strong willed & independent thinker (maintain their opinions) Most likely to be contrarian & typically subject to cognitive errors Advising Independent Individualists Difficult to advice but usually willing to listen to sound advice Regular educational discussion is effective Active Accumulator Active investor with high risk tolerance Most aggressive investors & primarily subject to emotional biases Quick decision makers with risky investments Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # Advising Active Accumulator Most difficult client to advise (like control) May lack self control Best approach to deal ⇒ take control of the situation 2.2 Limitations of Classifying Investors into Various Types Individuals may simultaneously display both emotional & cognitive biases Might display traits of more than one behavioral investor type As investors age, they will most likely go through behavioral changes Two individuals with same behavioral investor type are likely to require unique treatment Individuals, tend to act irrationally at unpredictable time HOW BEHAVIORAL FACTORS AFFECT ADVISER- CLIENT RELATIONS Goal of the client/adviser relationship ⇒ construct a portfolio with which a client is comfortable Portfolio should serve the client’s longer term goals BF can enhance the following important areas of every successful advisory relationship 3.1 Formulating Financial Goals BF helps adviser to understand the reasons for the client’s goals 3.2 Maintaining a Consistent Approach BF adds structure & professionalism to the relationship 3.3 Investing as the Client Expects Area that can be most enhanced by incorporating BF Adviser is fully awared of what actions to perform & what information to provide 3.4 Ensuring Mutual Benefits Incorporating BF into client/adviser relationship act as a closer bond b/w them 3.5 Limitations of Traditional Risk Tolerance Questionnaires Risk tolerance questionnaires: Ignore behavioral issues Can generate different results when applied repeatedly May not be revised Adviser may interpret the results of such questionnaire too literally May work better for institutional investors Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # HOW BEHAVIORAL FACTORS AFFECTPORTFOLIO CONSTRUCTION BB affects how investors construct portfolio from the securities available to them 4.1 Inertia and Default In most DC plans members show inertia & not ∆ their asset allocation Target date funds ⇒ fund that automatically switch from risky assets to fixed income assets as the plan member nears the intended retirement date Standardized strategy (one size fits all solution) 4.2 Naive Diversification Allocating an equal proportion of assets to each fund alternative Also called 1/n naïve diversification strategy & often used by DC plans Conditional 1/n strategy ⇒ allocation equally among chosen subset of funds Such strategies minimize future regret from one asset class beating the other 4.3 Company Stock: Investing in the Familiar Reasons why employees have a tendency to invest in their company’s stocks: Familiarity bias Overconfidence Naively extrapolate past returns Framing Loyalty effect & financial incentives 4.4 Excessive Trading Investors with retail accounts appear to be more active trades (overconfidence which leads to excessive trading) Disposition effect⇒ selling winners too soon & holding losers too long 4.5 Home Bias Proportion of assets in the stocks of firms listed in home country Closely related to familiarity Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # BEHAVIORAL FINANCE AND ANALYST FORECASTS 5.1 Overconfidence in Forecasting Skills Undue faith in forecasting ability Several behavioral biases that contribute to overconfidence: Illusion of knowledge bias Self attribution bias Representativeness bias Availability bias Hindsight bias 5.1.1 Remedial Actions for Overconfidence and Related Biases Self calibration ⇒ process of remembering previous forecasts more accurately Well structured feedback, unambiguous forecasts & systematic review process can reduce hindsight bias Counter arguments, appraisal by colleagues, superiors as well as self appraisal can help to control overconfidence Incorporate additional information with a Bayesian approach 5.2 Influence of Company's Management on Analysis The way a company’s management frames information can influence how analysts interpret it & include it in their forecasts Three cognitive biases frequently seen when management reports company results: Framing Anchoring & adjustment Availability Analysts should also look for self attribution bias that arises from the impact of incentive compensation on company reporting 5.3 Analyst Biases in Conducting Research Biases are usually related to analysts collecting too much information some biases are: Illusion of knowledge & control Representativeness bias Confirmation bias Gambler’s fallacy⇒thinking that there will be a reversal to long-term mean more frequently than actually happens Hot hand fallacy ⇒ wrongly project continuation of a recent trend Endowment bias 5.3.1 Remedial Actions for Analyst Biases in Conducting Research Focus on more objective data Collect information in a symmetric way Assign probabilities to base rates Consider the search process, limits& context of information Prompt feedback & document decision making Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # HOW BEHAVIORAL FACTORS AFFECTCOMMITTEE DECISION MAKING In a group setting, the individual biases mentioned before can be either diminished or amplified with additional biases being created Social proof bias ⇒ bias in which individuals are biased to follow the beliefs of a group Typically a group will have more confidence in its decisions (leads to overconfidence bias) 6.1 Investment Committee Dynamics Committee decision can be improved by carefully analyzing & learning from past decisions & good quality feedback Changing committee membership can be unhelpful 6.2 Techniques for Structuring and Operating Committees to Address Behavioral Factors Committee should be made up of members from diverse backgrounds Ensure professional respect & analysts self esteem Collect individual views in advance of discussion (can suppressed privately held information) HOW BEHAVIORAL FINANCEINFLUENCES MARKET BEHAVIOR Anomalies are identified by persistent abnormal returns that differ from zero & are predictable in direction Some apparent anomalies may be explained by: Small sample involved Selection or survivorship bias Data mining 7.2 Momentum Momentum effect ⇒ pattern of returns that is correlated with the recent past Return are +vely correlated in short term (up to years) & -vely correlated in long term (revert to the mean) Several forms of Biases Herding Availability bias (extrapolate trends) Hindsight bias (trend chasing effect) Disposition effect (mean reversion at longer periods of three to five years) Copyright © FinQuiz.com All rights reserved 2018 Study Session # 3, Reading # 7.3 Bubbles and Crashes Bubble & crashes ⇒ respectively periods of unusual +ve or –ve return Bubbles typically develop more slowly relative to crashes (due to difference in behavioral factor involved) A no of cognitive & emotional biases during such periods are: Overconfidence Confirmation & self attribution bias Hindsight Illusion of knowledge Disposition effect Anchoring 7.4 Value and Growth Studies have identified that the value stocks have outperformed relative to growth stocks Halo affect ⇒ investor transfers favorable company attribute into thinking that the stock is a good buy Behavioral explanations present the anomalies as mispricing rather than risk Overconfidence in predicting growth rates (growth stocks over valuation) Home bias anomaly ⇒ investors favor investing in domestic country as compared to foreign countries Copyright © FinQuiz.com All rights reserved ... reversion at longer periods of three to five years) Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 3, Reading # 7 .3 Bubbles and Crashes Bubble & crashes ⇒ respectively periods... too literally May work better for institutional investors Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 3, Reading # HOW BEHAVIORAL FACTORS AFFECTPORTFOLIO CONSTRUCTION BB affects... firms listed in home country Closely related to familiarity Copyright © FinQuiz. com All rights reserved 20 18 Study Session # 3, Reading # BEHAVIORAL FINANCE AND ANALYST FORECASTS 5.1 Overconfidence