Explain the
1) uses
2) limitations
of classifying investors in personality types
Incorporating behavioural baises into the client’s IPS should result in the following:
- portfolios that are closer to the efficient frontier
- clients who are better able to stay on track with their long-term strategic plans
- better working relationships between the client and advisor
- more satisfied clients
Limitations of classifying investors into behavioural types include the following:
- individuals can display emotional and cognitive errors at the same time
- the same individual may display traits of more than one behavioural type
- as investors age, they become more risk averse and emotional toward investing
- individuals who fall into the same behavioural type shouldn’t necessarily be treated the same
- unpredictability, individuals tend to act irrationally at different times
Discuss how behavioural factors affect advisor-client interactions
4 areas that can be enhanced by incorporating behavioural finance into the relationship:
1) UNDERSTAND: helps the advisor undrestand the reaon for the client’s goals
2) STRUCTURE AND PROFESSIONALISM: BF adds structure and professionalism into the relationship
3) ADVISOR IS BETTER EQUIPPED: to meet the client’s expectations
4) CLOSER BOND: = happier clients and an enhanced practice for the adviser
Discuss how behavioural factors influence portfolio construction:
1) DC plan participants
2) Employees investing in own company stock
3) Overconfidence
4) Disposition effect
5) Home Bias
6) Mental accounting
Defined Contribution plan participants:
- status quo bias: no change to initial asset allocation
- naive diversification: employees allocate an equal proportion to each mutual fund in a plan
Employees investing in their own company’s stock:
- familiarity: underestimate risk, become overconfident in their estimate of the company’s performance
- naive extrapolation: recent good performance is extrapolated out
- framing: if employer’s contribution is in company stock, tend to keep it rather than sell and reallocate
- loyalty: to help the company i.e. prevent takeover by another firm
- financial incentive: tax incentives or ability to purchase the stock at a discount leads to holding too much company stock
Overconfidence: excessive trading by retail investors
Disposition effect: investors tend to sell winners too soon and hold losers too long
Home bias: closely related to familiarity. It leads to staying completely in or placing a high proportion of assets in the stocks of firms in their own country
Mental accounting: construct portfolios in layers
Explain how Behavioural Finance can be applied to the process of portfolio construction
Behavioural finance insights could lead to portfolio construction using:
1) Target funds to overcome status quo bias
2) Layered portfolios that accommodate perceptions of risk and importance of goals to build portfolios the client will stay with
Discuss how behavioural factors affect analyst forecasts and recommend remedial actions for analyst biases
1) Overconfidence
Behavioural biases that contribute to overconfidence
- Illusion of knowledge bias
- Self-attribution bias
- Representativeness
- Availability bias
- Illusion of control bias
- Hindsight bias
Actions that analysts can take to minimize overconfidence
- feedback through self-evaluations: colleagues, superiors, combined with a structure that rewards accuracy. Leads to better calibration
- develop forecasts that are unambiguous and detailed, which help to reduce hindsight bias
- provide one counterargument supported by evidence for why their forecast may not be accurate
- consider sample size and model complexity
- use Bayes’ formula
Discuss how behavioural factors affect analyst forecasts and recommend remedial actions for analyst biases
2) interpreting management reports
Reporting by company management is subject to behavioural biases:
- framing
- anchoring and adjustment
- availability
Analysts need to be aware of the following when a management report is presented:
- results and accomplishments are usually presented first: more importance given
- self-attribution bias in the reporting
- excessive optimism
- recalculated earnings
Actions the analyst can take:
- focus on verifiable quantitative data
- be certain the information is framed properly
- recognise appropriate base rates so the data is properly calibrated
Discuss how behavioural factors affect analyst forecasts and recommend remedial actions for analyst biases
3) Biases in their own research
Analyst bias in own research
- usually related to collecting too much information
- leads to ILLUSIONS OF KNOWLEDGE and CONTROL as well as REPRESENTATIVENESS
- inaccurately extrapolate past data into the future
- can suffer from CONFIRMATION BIAS and GAMBLER’S FALLACY
To prevent biases in research
- ensure previous forecasts are properly calibrated
- use metrics and ratios that allow comparability to previous forecasts
- take a systematic approach with prepared questions and gathering data first before making conclusions
- use a structured process; incorporate new information sequentially assigning probabilities using Bayes’ formula
- seek contradictory evidence and opinions
Discuss how behavioural factors affect investment committee decision making and recommend techniques for mitigating their effects
Committees:
- reflect the biases of the individual members
- and social proof bias (members are reluctant to say what they think, and they feel obligated to go along with the group to avoid giving offence)
Mitigation
- seek members with diverse backgrounds who are not afraid to express their opinions and who respect the other members of the group
Describe how behavioural biases of investors can lead to market characteristics that may not be explained by traditional finance
Market anomalies
1) Momentum effect
Patterns in returns that are caused by investors following the lead of others.
Tend to trade in same direction; herding
2) Financial bubbles and crashes
Panic buying or selling
Overconfidence, confirmation bias, self-attribution bias, hindsight bias, disposition effect
3) Value stocks
