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9 behavioral finance and investment processes (portfolio construction (3…
9 behavioral finance and investment processes
investor types classifying
Barnewall two-way model
a simple non-invasive overview of history
a quick biograhic glance
passive investors
- wealth passively
greater need for security
occupational groups /
smaller economic resources
active investors
- wealth creation
higher tolerance for risk
prefer maintain control
five-way model
confident-anxious axis
careful-impetuous axis
straight arrow: sensible secure
individualist: careful confident
guardian: careful anxious
adventurer: impetuous confident
celebrity: impetuous anxious
not approach all parts of their life with equal axis
patterns may change or lack consistency
:warning:
behavioral investor types
bottom up
too time-consuming or complex
behavioral alpha approach / top-down
1 general type: passive-active
2 risk tolerance style: low-high
3 investment style
4 bias types
passive preserver
3 conservative
4 primarily emotional
endowment/ loss aversion/
status quo/ regret aversion
mental accounting/
anchoring and adjustment
:check:more receptive to big picture advice
focus on what the money will accomplish
friendly follower
3 moderate
4 primarily cognitive
regret aversion
availability/ hindsight/ framing
:check:education on benefits of diversification
offering education in clear unambiguous ways
independent individualist
3 growth
4 primarily cognitive
overconfidence and self-attribution
conservatism/ availability/
confirmation/ representativeness
:check:respects their intelligence
regular discussions during client meetings
active accumulator
3 aggressive
4 primarily emotional
overconfidence/ self-control
illusion of control
to take control of the situation
communicate decisions and results in effective way :check:
:warning:
may exhibit both cognitive and emotional
characteristics of multiple investor types
behavioral changes as they age
individual require unique treatment complex
irrationally at different times / without predictability
portfolio construction
1 inertia and default
autopilot
2 naive diversificaiton
1/n
conditional 1/n
3 company stock: investing in the familiar
familiarity and overconfidence
naive extrapolation of past returns
framing and status que of matching contributions
loyalty effects
financial incentives
4 excessive trading and disposition effect
higher transaction costs and opportunity losses
5 home bias
information costs
behavioral explanations
6 behavioral portfolio theory
formed as layered pyramids
each layer aligned with an objective
investment allocated to discrete layers
without ragard correlations
not have a single attitude toward risk
depending on which part of wealth considered
adviser-client relations
enhanced relationship
both can comfortably adhere
while fulfilling long-term goals
1 formulating financial goals
2 maintaining a consistent approach
3 investing as the client expects
4 ensuring mutual benefits
limitations of traditional risk tolerance questionnaires
ignoring behavioral issues
imprecision
critical to re-evaluate periodically
for individual risk analysis is an emotional process
IPS re-evaluated on regular basis and updated for changes
security analysts
recognizing the lack of information or insight to make a good professional judgment
company's management on analysis
framing anchoring and adjustment
lacks balance in the language
recognize the possibility of self-attribution
companies presenting recalculated earning
profitability growth riskiness perception of the business
maintaining a disciplined and systematic approach
focusing on metrics and comparable data
analyst biases in conducting research
confirmation bias too much unstructured info
gamblers' fallacy
conjunction fallacy - probabilities
using consistent data
evaluating previous forecasts
systematic and structured approach
assigning probabilities
seeking contrary facts and opinions
incorporating evidence sequentially
having prompt feedback
documenting the process
overconfidence in forecasting skills:
more confident when making contrarian predictions
too much emphasis on specific characteristics
neglecting fully consider the impact of environment and other info
additional data that not adding material content
encouraged by complex models
self-attribution bias desire to preserve self-esteem
giving prompt well-structured accurate feedback
develop explicit unambiguous conclusions
systematic review process and structure that reward accuracy
conducting regular appraisals by colleagues and superiors
providing counterarguments
documenting comparable data
committee decision making
group process may mitigate a bias or exacerbate it
social proof:
process of reaching a consensus narrow the range of views
a group more confidence in decisions after discussion
all biases in individuals presented in committee decisions
the chair of committee has an important role
team diverse in skills experience culture
market behavior
view biases as complementary to market efficiency
market anomalies: persistent abnormal returns differ from zero and predictable in direction
temporary disequilibrium behavior: survive for a period and arbitrage and disappear
momentum / trending effects: future price behavior correlates with recent past
fat tail distribution of stock market returns
herding
short-term underreaction to relevant info and long-term overreaction:
faulty learning models within traders - availability bias / recency effect
regret / trend-chasing effect / disposition effect
bubbles and crashes
symptoms:
overconfidence / overtrading / underestimation of risks / failure to diversify / reject contradictory info
confirmation bias and self-attribution bias
hindsight bias
regret aversion
illusion of knowledge
disposition effect
value and growth
value stocks outperformed growth stocks
small-capitalization outperformed large-cap