Study Session 3: Behavioral Finance: Shahzaib Masud Khan, CFA, ACA, CMA

Study Session 3: Behavioral Finance
Shahzaib Masud Khan, CFA, ACA, CMA
Key Points
Note that the LOSs in this study session are quite open-ended As a result you will feel that there are a lot more abstract ideas than are normally included in a reading even for schweser let alone the CFA curriculum Remember there is no need to memorise any part of SS 3; the emphasis has to be on understanding the concepts Focus on how each bias shows up daily in practice and be able to recognise its implications
The Behavioral Finance Perspective

Behavioral finance is introduced in the first study session on portfolio management because investment decisions are made by humans. It is important to remember that all market participants, regardless of expertise, may be subject to behavioral biasescognitive and emotional. Understanding behavioral biases provides insights into how these biases may influence perceptions and investment decisions. For example, knowledge of behavioral biases may help in understanding client goals, in constructing investment portfolios, and in identifying inconsistencies in the investment decision-making process. Behavioral finance has also provided insights into issues such as market anomalies. The readings argue that integration of behavioral and traditional finance may lead to a better outcome than either approach used in isolation.

Los 7a: contrast traditional and behavioral finance perspectives on investor decision making;
Traditional finance is prescriptive; it explains how investors should act based on mathematical models and theories
All investors are assumed to have the same information and are assumed to interpret it unbiasedly and identically to come to the same individual and market expectations. New information when received results in revised expectations.

REM: will make decisions based on the four rules of utility: Completeness: Aware of all choices; preferences are assigned to each choice so that the decision between two is easily made Transitivity: Consistent application of rankings . A over B and B over C means - A over C Independence: Additive and divisible Utilities A+C over B+C ; A+xC over B+xC Continuity: Smooth and unbroken indifference curves; there must be a proportion x at which REM is indifferent between B and xA+xC





LOS 7b: contrast expected utility and prospect theories of investment
decision making;

decision making;

decision making;

decision making;
Example 50-50 discussion

According to prospect theory investors make decisions based on two phases Editing Phase & Evaluation Phase Editing Phase (6 steps):
Codification: Code outcomes as gains or losses. Reference used is usually negative or positive Combination: Similar values are combined to simplify Segregation: Separates certain and uncertain outcomes to gain a better insight into the risk. Cancellation: Identical outcomes between choices are eliminated Simplification: Tend not to think precisely- 48-52 will become 50-50
decision making;

decision making;
Editing Phase (6 steps) Contd:

Detection of Dominance: elimination of any choice that is dominated by another.

decision making;

decision making;

decision making;

LOS 7c: discuss the effects of cognitive and knowledge capacity limitations on
investment decision making;
Bounded Rationality & Satisficing : In traditional finance REM is assumed to have complete and same information which is interpreted instantly and unbiasedly in making utility maximising decisions. Behavioral finance recognises that real investors are biased and have dissimilar and incomplete information and lack the processing ability to interpret everything. They exhibit Bounded Rationality.

LOS 7c: discuss the effects of cognitive and knowledge capacity limitations on
investment decision making;

LOS 7d: evaluate the impact of biases on investment policy and asset allocation and
discuss approaches to mitigate their effect.
The Price is Right: Asset prices reflect all available information and adjust instantaneously to fully and accurately incorporate the value of any new information. No Free Lunch: Implies that no manager should be able to generate excess returns (Alphas) consistently as the all information is instantly and accurately incorporated in the price then the direction of change and amount of change in the price of an asset is only dependent on the release of new information (which is random hence returns should be random.

Market Efficiency Recap of EMH:







Behavioural Portfolio Theory: Rather than hold well diversified portfolios investors typically have been found to hold portfolios made up of very low risk assets and considerably riskier assets. BPT is used to explain this phenomenon of how investors layer their portfolios to meet different needs and the composition of each layer is based on 5 factors:
Importance of the goals: higher importance less risky assets Required return: higher return riskier assets Investors utility function: more concave more distinct assets Access to information: more privileged information more concentration Loss aversion: Too much cash to provide liquidity; also not liquidate a position to protect against booking a loss

The Behavioral Biases of Individuals

LOS 8a: distinguish between cognitive errors and emotional biases;

LOS 8 b,c,d: discuss commonly recognized behavioral biases and their implications for
financial decision making; analyze an individuals behavior for behavioral biases; evaluate the impact of biases on investment policy and asset allocation and discuss approaches to mitigate their effect.
Cognitive Errors: Belief Perseverance





Cognitive Errors : Information Processing


Impact When investors suffer from framing bias, they are likely to exhibit loss aversion if an outcome is framed in terms of a possible loss or exhibit risk aversion if framed in terms of a possible gain. For example they will tend to take riskier positions in when faced with potential loses. Focusing on gains or losses can lead to incorrectly identifying the risk of the current and potential investments and suboptimal portfolio allocations.
Mitigation
Investors should focus on expected returns and risk, rather than gains or losses. That includes assets or portfolios with existing gains or losses.

There are four causes of availability bias : Retrievability, Categorisation, Narrow Range of experience and resonance.
Impact
Investors might select investments based on advertising because those memories are more easily retrieved and categorised. Might restrict portfolio to a narrow range of assets due to inexperience. Concentrate portfolio in similar industries. Mitigation An IPS should be developed and portfolios should be constructed based on diligent research rather than relying on information that is most readily available.

Emotional Biases



Impact
Investors tend to hold undiversified portfolios because they underestimate the downside while over estimating the upside. They may also trade excessively leading to high costs and underperformance.
Mitigation
Because they are prone to only remembering their better investements investors should keep detailed records of trades alongwith the reason for each trade. As a result the track record developed can also be referenced to either the effectiveness of the strategy or luck (market forces).

Impact Lacking the discipline to balance short term gratification with long-term goals, individuals tend to over consume. When they realise that they have not saved up enough they tend to try make up the shortfall by assuming too much risk. The other alternative is the bias for high current income investments over long term growth. Mitigation
Spending Budgets should be made and strictly adherred to so as to restrict overspending. An IPS clearly showing complete and well defined investment goals should be made and adherred to.

Impact As a consequence of doing nothing usually over time the asset values change resulting in an in appropriate asset allocation and resultant risk. You also loose out on new potential investments and/or hang on to loss makers for too long. Mitigation One of the more difficult biases to eliminate. Investors need to be educated about risk, return and proper asset allocation.

Impact Investors tend to hold on to assets occasionally because they are familiar with them or the assets were inherited. Investors want to maintain an asset holding regardless of the inadequate fit in their overall portfolio from a strategic perspective or the skew introduced. Mitigation
Regardless of how a portfolio or investment is acquired. There should be regular periodic reviews of all assets in an individuals portfolio and each asset should be objectively evaluated as to its appropriateness to the strategy and contribution to the risk return profile of the portfolio.

Investment Policy and Asset Allocation
Attempts have to be made to identify biases and then either mitigate them or accommodate them. Goals based investing for example recognises mental accounting and loss aversion. You could also look at the portfolio as a pyramid.
Behaviorally Modified Asset Allocation Technically speaking will never result in the optimal allocation but will make the investor comfortable and more likely to adhere to the strategy. The modified behavior considers the emotional and cognitive biases of the investor and his current wealth. Generally speaking the wealthier the investor and the less lavish his lifestyle the more behavioral biases can be incorporated in asset allocation and portfolio construction. Also we should be aware that we need to mitigate the cognitive biases and only accommodate the emotional biases.

Behavioral Finances And Investment Processes

Los 9a: Explain the uses and limitations of classifying investors into various types
The goal of looking at client/advisor relationship from a behavioral aspect is that the advisor is supposed to better understand his clients and as a result make better investment decisions More satisfied, trusting and tend to stay on track with investment plan Three Behavioral Models :

Barnewall two way behavioral Model: Classifies into two types passive and active. Passive investors risk averse and need for security (employees, inheritance etc.) Active investors risk own capital (entrepreneurs etc.) risk seeking to control their own future. Bailard, Biehl & Kaiser Five way Model:
The Adventurer, Celebrity, Individualist, Guardian, Straight Arrow



Los 9a: Explain the uses and limitations of classifying investors into various types (Pompian Behavioural Model)

Los 9b: Discuss how behavioral factors affect advisor-client interactions (Risk Tolerance Questionnaires)

Los 9c: Discuss how behavioral finance has been applied to portfolio construction






Los 9d: Discuss how behavioral factors affect analyst forecasts and remedial actions for analyst biases.
Analyst Forecasts are mainly affected by three biases 1) Overconfidence 2) the way management presents information & 3) biased research Overconfidence: Illusion of knowledge bias, availability bias, self-attribution bias (ego defense) - Self Calibration, detailed reasons Management Presentation: Framing, Anchoring, Availability Focus on quantitative data that can be objectively analysed

Los 9d: Discuss how behavioral factors affect analyst forecasts and remedial actions for analyst biases.
Analyst Biased Research: Confirmation Bias, Gamblers Fallacy used structured process to incorporate new information in a structured manner

Los 9e: Discuss how behavioral factors affect investment committee decision making and techniques of structuring operating committees to address behavioral factors
Social Proof Bias late feedback, not attributed to any one persons biases so overlooked, similar background people, strong people dominate Remedies: Diverse backgrounds, equally strong members, responsible chairman who encourages dissenting opinions, mutual respect

Los 9f: Describe how the behavior of investors can lead to market anomalies and observed market characteristics
Momentum Effect herding (availability bias, fear of regret (hindsight bias) Financial Bubbles & Crashes overconfidence, confirmation bias, early stage of bubble burst, post event hindsight bias Value Vs Growth value and growth anomalies are mispricing and not risk adjustments, halo effect, home bias



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Study Session 3: Behavioral Finance

Shahzaib Masud Khan, CFA, ACA, CMA

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

Example 50-50 discussion

The Behavioral Finance Perspective

The Behavioral Finance Perspective

Editing Phase (6 steps) Contd:

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

Market Efficiency Recap of EMH:

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Finance Perspective

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

Cognitive Errors: Belief Perseverance

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

Cognitive Errors : Information Processing

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

Investment Policy and Asset Allocation

The Behavioral Biases of Individuals

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes

Behavioral Finances And Investment Processes