Source - Behavioral Finance and Investment Processes - Michael M. Pompian, Colin McLean and Alistair Byrne
1. Financial service professionals and researchers have been attempting to classify investors by their psychographic characterstics - in other words, by personality, values, attitudes and interests
2. Passive investors have a greater need fo security than they have tolerance for risk. Occupational groups that tend to have passive investors include corporate executives, lawyers with large regional firms, CPA wit large companies, medical and dental non-surgeons, small business owners who inherited the business, politocansm bankers and journalists.
3. The smaller the economic resources an investor has, the more likely the person is to be a passive investor. The lack of resources gives individuals a higher security need and a lower tolerance for risk.
4. A limitation of all categorization schemes is that na individual's behavior patterns may change or loack consistency.
5. When advising emotionally biased investors, advisers should focus on explanining how the investment program being created affects such issues as financial security, retirement, or future generations rather than focusing on such quantative details such as standard deviations and sharpe ratios.
6. Quantative measures work better with cognitively biased investors.
7. Passive Preservers are focused on taking care of their family memebers and future generations, especially funding life-enhancing experiences such as education and home buying. Because the focus is on family and security, PP biases tend to emotional rather than cognitive. This BIT becomes more common as investors' age and wealth level increases.
8.1 Friendly Follower often overestimate their risk tolerance. Advisers need to be careful not to suggest too many "hot" ideas - FFs will likey want to invest in all
8.2 For FF, regret aversion is an emotional bias with an significant impact
9.1 Individual Investor (II) are self-assured abd "trust their gut" when making decisions; however, when they do research on thier own, they may be susceptible to acting on information that is available to them rather then getting corroboration from other sources. II biases are typically cognitive
9.2 II are vulnerable to overconfidence and self-attribution biases
9.3 Most common bias of II -
10. II may be difficult to advise because of their independent mindset , but they are usually willing to listen to sound advice when it is presented in a waty that respects their intelligence. As with FF, education discussions during client meetings.
11. AA is the most aggressive behavioral investor type. AA are quick decision makers but may chase higher risk investments that their friends or associated are suggesting.
12. AA may be the most difficult clients to advise.
13. As Behav Finance gains credibility and acceptance the investment community, advisers and investors are increasingly likey to include behavorial considerations in a clients investment IPS
14. The key result of behavioral-finance enhanced relationship will be portfolio to which the adviser and client can comfortably adhere while fulfulling the client's long-term goals
15. Behav finance can enhance these areas -
1. Formulating Financial Goals - Behav Finance helps advisers why investors set the goals they do. Such insights equip the adviser to deepen the bond with the client, thus producing a better relationship and better investment outcome
2. Maintaing a Consistent Approach - Behav Finance can also add professionalism and structure to the relationship, allowing advisers to better understand the client before delivering any investment advice. Clients will appreciate this step, and it will make the realtionship more successful.
3. Investing as the Client Expects - Behav Finance provides a context in which the adviser can "take a step back" and attempt to explore the motivations of the client. With more thorough understanding of the clients expectations, the aviser is better equipped to help satisfy them.
4. Ensuring Mutual Benefits
16. From Behav finance prespective, risk tolerance questionnaires may work better as a diagnostic tool for institutional investors compared with individual investors. The difference is because institutional investors are familiar with mean-variance optimization and think about risk. For them, risk analysis is a cognitive process. Individual invesors are more likely to have feelings about risk, and for them risk analysis is an emotional process.
17. Althought target date funds can be helpful in countering investor inertia, the potential disadvantage is that they are no "one size fits all" solution that may not match the needs of specific investors.
18. Conditional 1/n strategy - allocate equally among their chosen subset of funds. In other words, once they have selected their funds, they allocate the invested amount equally among the chosen funds.
19. Regret may play a role in explaining naive diversification strategies.
Defining investor objectives in terms of mean and standard deviation may make selecting an asset allocation more difficult for the individual, since it can be see how the choices affect allocation more difficult for the individual
Behav Finance Sucess
1. The adv
Biases
Hindsight - is when the analyst selectively recalls details of the forecast or reshapes it in such a way that it fits the outcome
Availability - Focus on recent results is an example of availability bias
Three cognitive biases when frequently seen when management reports company results - framing, anchoring & adjustment and availability
Soical proof bias is when individuals tend to fllow the beliefs of a group. Group think is when the group setting is very amiable thus leading to little or no conflicting discussions resulting in the group making decisions as if the group was a single individual
Two biases commonly seen in defined contribution retirement plans are the status quo bias and naive diversification aka 1/n naive diversification
An investor whose decisions are impacted by mental accounting will look at investments as seprate, focusing on the risk of investments in isolation, This means that the investor dismisses the effects of correlation, thus leading to more risky portfolios than an investor who does consider correlation.
A representative bias is one in which analyst inaccurately extrapolates past data into future. An example of a representative bias would based on previous high growth classifying a firm as growth firm based sloely on previous high growth without considering other variables affecting the firms future
Representativeness - The analyst incorrectly combines two probabilities (1) the probability that the information fits a certain information category and (2) the probability that the category of information fits the conclusion
Market Anomalies
- Efficient markets should not deliver abnormal returns.
IPO Puzzle
- On average, IPOs appear to be underpriced
- The number of IPOs is highly cyclical.
- The costs of the IPO are very high
- The long-run performance of a newly public company (three to give years from the date of issue ) is poor
- Positive abnormal returns apparent in the 12 months after a stock split
Bubbles
- Stock market bubbles and crashes present a challenge to the concept of market efficieny. The efficient market hypothesis implies the absence of such bubbles.
- There can also be rational explations for some bubbles. Rational Investors may expect a future crash but not know its exact timing.
-In bubbles, investors often exhibit symptoms of overconfidence; overtrading, underestiation of risks, failure to devesify, and rejection of contradictory information.
- At the markeyt level, Volatility also often increases in a market with overconfident traders