Professional Documents
Culture Documents
Submitted By:
Rakhee Jalan
Roll No. 242
(PGDM 2015-2017 )
Under the Guidance of Prof. Sameer Lakhani
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CERTIFICATE
This is to certify that Ms. Rakhee Jalan, student of N.L Dalmia Institute of
Management [PGDM].
This project is the record of authentic work carried out during the academic year
2015-2017.
Date: _________________
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DECLARATION
__________________
(Rakhee Jalan)
MMS 2015-17
Roll no: 242
Date:
Place:
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ACKNOWLEDGEMENTS
First and Foremost I would like to thank University of Mumbai, for giving me
an opportunity to do the project on “Role of Behavioural Finance in
Investment Advice”. This project proved as an excellent opportunity for
me to apply the concepts learnt in the course of my program at the
institute, for which I am extremely grateful.
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Contents:
1. Introduction………………………………………………………………………..6
2. Behavioural Finance…………………………………………………………….7
3. Literature Review………………………………………………………………..9
4. Impact of Behaviour on investment decision……………………….12
5. Types of biases………………………………………………………………………………16
6. Research methodology………………………………………………………………….18
7. Practical allocation of behavioural finance in asset management………21
8. Case Studies…………………………………………………………………………27
9. Conclusion……………………………………………………………………………38
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Introduction:
Classical investment theories are based on the assumption that investors always
act in a manner that maximizes their return. Yet a number of research show that
investors are not always so rational. Human become puzzled when the
uncertainty regarding investment decision engulfs them. People are not always
rational and markets are not always efficient. Behavioural finance explains why
individual do not always make the decisions they are expected to make and why
markets do not reliably behave as they are expected to behave. Recent research
shows that the average investors make decisions based on emotion, not logic;
most investor’s buy high on speculations and sale low on panic mood.
Psychological studies reveal that the pain of losing money from investment is
really three times greater than the joy of earning money. Emotions such as fear
and greed often play a pivotal role in investor’s decision; there are also other
causes of irrational behaviour. It is observed that stock price moves up and down
on a daily basis without any change in fundamental of economies. It is also
observed that people in the stock market move in herds and this influence stock
price. Theoretically markets are efficient but in practice, they never move
efficiently. For example, a reputed company announces a mega investment in an
emerging area over next few years, the stock price of the company starts moving
up immediately without looking into the prospects, return or the amount of
investment to be made in this project. That is how the behaviour of investor
moves the stock price.
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Behavioural finance:
Behavioural finance is a relatively new field that seeks to combine behavioural
and cognitive psychological theory with conventional economic and finance to
provide explanations for why people make irrational financial decisions. It is very
popular in stock market across the world for investment decisions.
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fundamentals and make investment based on emotions. Swell (2005) asserts that
behavioural finance is the study of the influence of psychology on the behaviour
of financial practitioners and the subsequent effect on markets. Further in 2007,
he has stated that behavioural finance challenges the theory of market efficiency
by providing insights into why and how market can be inefficient due to
irrationality in human behaviour. Forbes (2009) has defined behavioural finance
as a science regarding how psychology influences financial market. This view
emphasizes that the individuals are affected by psychological factors like
cognitive biases in their decision making, rather than being rational and wealth
maximizing. Thus, behavioural finance is the application of scientific research on
the psychological, social and emotional contributions to market participants and
market price trends. It also studies the psychological and sociological factors that
influence the financial decision making process of individual groups and entities.
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Literature review:
Behavioural Finance is a new emerging discipline that studies the irrational
behaviour of the investors. Perhaps the literatures consisting of behavioural
finance can be best explained by the works of Tversky and Kahneman who were
recognized as the fathers of behavioural finance. Their literary works include:
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Bandgar (1998) in his study found that investors are educated in investment
decision making.
Study by Rafael La Porta et al., (2000) reveals that a strong investor protection
is a manifestation of the security of property.
Gupta (1991) argues that designing a portfolio for a client is much more than
merely picking up securities for investment. The portfolio manager needs to
understand the psyche of his client while designing his portfolio. According to
Gupta, investors in India regard equity debentures and company deposits as
being in more or less the same risk category, and consider mutual funds,
including all equity funds, almost as safe as bank deposits.
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investors in efficient market. The two building blocks of behavioural finance
are cognitive psychology (How People Think) and the limit of arbitrage (when
market will be inefficient).
Simon Gravis (2009) in “Behavioural Finance; Capital Budgeting and Other
Investment Decision”, he has made a survey of literature on the effects of
behavioural biases on capital budgeting.
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Impact of Behaviour on investment decision making:
The most crucial challenge faced by the investors is perhaps in the area of taking
investment decisions. Every investor differs from the others in all aspects due to
various factors like demographic factors, socio-economic background, marital
status, educational attainment level, age, gender etc. An educated person’s
decision making towards investment differs from an uneducated one. A young
bachelor, for instance, prefers to invest in risky avenues; where as a matured
person with a family dependability prefers less risky and stable income
generating avenues. Similarly, rural /urban background of individuals, availability
of information, accessibility of avenues, and investment companies/colleagues
also influence individuals in developing their perceptions. Investment behaviour
is the study of the decision making. Behavioural finance attempts to explain and
increase understanding of the reasoning patterns of investors, including the
emotional processes involved and the degree to which they influence the
decision making process. Essentially, behavioural finance attempts to explain the
what, why, and how of finance and investing, form a human perspective. For
instance, behavioural finance studies financial markets as well as providing
explanations to many stock market anomalies. It endeavours to bridge the gap
between neoclassical finance and cognitive psychology. It looks at the individual
investor’s decision making formula as well as at their behaviour, which, in turn,
sheds light on the observed departures from the traditional finance theory. Thus,
behavioural finance is the application of scientific research on the psychological,
social, and emotional contributions to market participants and market price
trends. It also studies the psychological and sociological factors that influence the
financial decision-making process of individuals, groups. Human decisions are
subject to several cognitive illusions. These can be grouped into two –
1. HEURISTICS: it refers to rules of thumb which investor’s exercise to make
decisions in complex, uncertain environments. The certainty, the investor’s
decision making processes are not strictly rational one. Thought the investors
have collected the relevant information and objectively evaluated, in which the
mental and emotional factors are involved. It is very difficult to split. Sometimes
it may be good, but many times it may result in inferior decision outcomes. It
includes: Representative ness, Over Confidence, Anchoring, Gamblers Fallacy
etc...
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2. PROSPECT THEORY This theory has been developed by Kahneman and Tversky.
The key concepts they discussed are Loss Aversion, Regret Aversion, Mental
Accounting, and Self Control etc... Cognitive Psychology is the study of all
knowledge related (mental) behaviours. The Attention, Perception,
Memory/Comprehension, and Decision Making links are the various aspects of
cognitive psychology that play an important role in investment behaviour of
investors. The second psychological discipline has theories to explain the
personality, attitudes, motivations, and behaviours of the individual influence
and influences by social groups. Research studies have been carried out to
examine the investment preferences and practices of the individual investors,
their investment related characteristics and investment avenues. Behavioural
Finance is a new emerging science that studies the irrational behaviour of the
investors. Behavioural finance attempts to identify the behavioural biases
commonly exhibited by investors and also provides strategies to overcome them.
Behavioural finance seeks to find how investor’s emotions and psychology affect
investment decisions. It is the study of how people in general and investors in
particular make common errors in their financial decision due to their emotions.
It is nothing but the study of why otherwise rational people take some really
thumb investment decisions. Decision making is a process of choosing best
alternatives among a number of alternatives. This decision has come out after a
proper evaluation of all the alternatives. Decision making is the most complex
and challenging activity of investors. Every investor differs from the others in all
aspects due to various factors like demographic factor, socioeconomic
background, educational level, sex, age and race. An optimum investment
decision plays an active role and is a significant consideration. Investor is a
rational being who will always act to maximize his financial gain. Yet we are not
rational being; we are human being; an integral part of this humanness is the
emotion within us. Indeed, we make most of our life decisions on purely
emotional considerations. In the financial world, investor’s sometimes base their
decisions on irrelevant figures and statistics, e.g., some investor may invest in the
stock that have witnessed considerable fall after a continuous growth in recent
past. They believe that price has fallen which is only due to short term market
movements, creating an opportunity to buy the stock cheap. However, in reality,
stocks do quite often also decline in value due to changes in their underlying
fundamentals. Cognitive dissonance is the perception of incompatibility between
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two cognitions, which can be defined as any element of knowledge including
attitude, emotion, belief or behaviour. The theory of cognitive dissonance holds
that contradicting cognition serve as a driving force that compels the mind to
acquire or invent new thoughts or beliefs or to modify existing beliefs, so as to
reduce the amount of dissonance (conflict) between cognition. Festinger theory
of cognitive dissonance states that individual attempts to reduce inner conflict in
one of the two ways: (i) he changes his past values, feelings or options; and (ii) he
attempts to justify or rationalize his choice. This theory may apply to investors
and traders in the stock market who attempt to rationalize contradictory
behaviours, so that they seem to follow naturally from personal values or view
point. In “Financial Cognitive Dissonance”, we change our investment styles or
beliefs to support our financial decisions. For instance, investors who followed a
traditional investment style (fundamental analysis) by evaluating companies
using financial criteria such as, profitability measures, especially, profit/earnings
ratios, started to change their investment beliefs. Many individual investors
purchased retail internet companies in which these financial measures could not
be applied. Since these companies has no financial track record, very little
revenues and no net losses. These traditional investors rationalized the change
in their investment style (past beliefs) in two ways: the first argument by many
investor is the belief (argument) that we are now in a “new economy” in which
the traditional financial rules no longer apply. This is usually the point and the
economic cycle in which the stock market reaches its peak. The second action
that displays cognitive dissonance is ignoring traditional form of investing and
buying these internet stock simply based on price momentum. Regret theory
states that an individual evaluates his or her expected reactions to a future event
or situations. Psychologists have found that individuals who make decision that
turn out badly have more regret when that decision was more unconventional.
This theory can also be applied to the area of investor psychology within the stock
market, whether an investor has contemplated purchasing a stock or mutual fund
which has declined or not, actually purchasing the intended security will cause
the investor to experience an emotional reaction. Investors may avoid selling
stocks that have declined in value in order to avoid the regret of having made a
bad investment choice and the discomfort of reporting the loss. In addition, the
investor sometimes finds it easier to purchase the “hot or popular stock of the
week”. In essence, the investor is just following “the crowd”. Therefore, the
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investor can rationalize his or her investment choice more easily if the stock or
mutual fund declines substantially in value. The investor can reduce emotional
reactions or feelings since a group of individual investors also lost money on the
same bad investment. In investing, the fear of regret can make investor either
risk averse or motivate them to take greater risk. Prospect theory deals with the
idea that people do not always behave rationally. There are different
psychological factors which motivate people in investment decision under
uncertainty. It considers preference as a function of “decision weights” and it
assumes that these weights do not always match with probabilities. It further
suggests that decision weights tend to overweigh small probabilities and under-
weigh moderate and high probabilities. Prospect theory demonstrates that if
investors are faced with the possibility of losing money, they often take on riskier
decision at loss aversions. They tend to reverse or substantially alter their
revealed disposition towards risk.
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Types of biases:
Anchoring
The assumption of rationality says that our thoughts and opinion should always
base on relevant and fact. In reality, however, this is not always so rather. People
have a tendency to attach or “anchor” their thoughts to a reference point even
though that may hardly have any logical association with the decision at hand.
Although the company is making more money, its stock price does not rise
because investor assume that the change is earning is only temporary. Thus, the
investor remain anchored to their previous view of the company’s potential
profitability because they have under-reacted to the new, positive information.
This does not mean that investors will never move away from their initial
reference point or anchor. They will realize that the company is likely to continue
to be more profitable in the future and that its stock is probably an attractive
potential investment.
Overconfidence
People are generally overconfident regarding their ability and knowledge. They
tend to underestimate the imprecision of their beliefs or forecasts, and they tend
to overestimate their ability. Terrence Odean I his research found that
overconfident investors generally conduct more trade as they believe they are
better than others at choosing the best stocks and best times to enter or exist a
position. Thus, overconfidence can cause investors to under-react to new
information and that leads to earn significantly lower yields than the market.
Herd Behaviour
Herd behaviour is the tendency of individual to follow the actions (rational or
irrational) of a larger group. This herd mentality is the result of two reasons.
Firstly, there may be a social pressure of conformity. Most people do not want to
be outcast from the group they belong. Secondly, there is a common rational that
a large group is unlikely to be wrong. Purchasing stocks based on price
momentum while ignoring basic economic principles of supply and demand is
known in the behavioural finance arena as herd behaviour and that leads to faulty
decision. In the late 1990s, Venture capitalist and private investors were
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frantically investing huge amount of money into internet related companies,
even though most of them did not have financially sound business models.
Loss Aversion
It means that investor is risk seeker when faced with respect of loss, but becomes
risk averse when faced with the prospects of enjoying gains. Khaneman has said
that investors are “Loss aversion”. This ‘Loss Aversion’ means that people are
willing to take more risks to avoid loss than to realize gain.
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Research methodology:
Project objective:
1. To assess the relation relationship between risk tolerance and
overconfidence of an investor
2. To assess the relationship between risk tolerance and propensity of
maximisation of an investor
3. To assess the relationship between risk tolerance and propensity of regret
of an investor
Type of research: Causal
Data collection: Through primary source (questionnaire)
Sample design
A questionnaire was designed for investors and their responses were recorded.
Population investors
Sampling Unit investors
Sample size 75
Sampling Technique Convenience sampling
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Correlations
risktolerancetow overconfidence
ardsportfolio
N 75 75
Correlations
risktolerancetow propensityofma
ardsportfolio ximization
N 75 75
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Correlation between propensities of regret and risk tolerance:
Propensity for regret matters to financial advisors because all financial choices,
from the choice to buy one stock to the choice to sell all stocks, open the door to
regret. Portfolio heavy in stocks and other relatively volatile securities might open
the door wider than portfolios heavy in cash, but portfolios heavy in cash do not
afford perfect shield from regret. Investors are likely to complain to advisors if
their portfolios idle in cash while stocks zoom. Still, low-risk portfolios shield
advisors from lawsuits by investors who may claim, in hindsight, that advisors
recommended to them unsuitable portfolios.
Correlations
risktolerancetow regret
ardsportfolio
N 75 75
We find that a propensity for regret is not associated with risk tolerance. This
indicates that the propensity for regret is distinct from risk tolerance even though
the two are often commingled.
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Practical allocation of behavioural finance in asset management:
Almost anyone who knows from experience the challenge of wealth
management also knows the potential for less-than-rational decision making in
finance. Therefore, many private-client advisors, as well as sophisticated
investors, have an incentive to learn coping mechanisms that might curb such
systematic miscalculations. The overview of behavioural finance research
suggests that this growing field is ideally positioned to assist these real-world
economic actors. However, only a few of the biases identified in behavioural
finance research today are common considerations impacting asset allocation.
Why does behavioural finance remain underutilized in the mainstream of wealth
management? First, because no one has ever contextualized it in an
appropriately user-friendly manner. Researchers have worked hard to reveal
behavioural biases, which are certainly usable; but practitioners would benefit
not merely from an academic discourse on discovered biases, but also from
lessons on how to go about detecting biases themselves and advising their clients
on how best to deal with these biases. Second, once an investor’s behavioural
biases have been identified, advisors lack pragmatic guidelines for tailoring the
asset allocation process to reflect the specific bias. Here we intends not only to
familiarize financial advisors and investors with 20 of the major biases unearthed
in behavioural finance research, but to do so in a lexicon and format that is
applicable to asset allocation. It establishes a knowledge base that serves in the
following chapters, wherein each of 20 specific biases is reviewed in detail. The
central question for advisors when applying behavioural finance biases to the
asset allocation decision is: When should advisors attempt to moderate, or
counteract, biased client reasoning to accommodate a predetermined asset
allocation? Conversely, when should advisors adapt asset allocation
recommendations to help biased clients feel more comfortable with their
portfolios? Furthermore, how extensively should the moderate-or-adapt
objective factor into portfolio design? This chapter explores the use of
quantitative parameters to indicate the magnitude of the adjustment an advisor
might implement in light of a particular bias scenario. This chapter, which reviews
the practical consequences of investor bias in asset allocation decisions, might,
with any luck, sow the seeds of a preliminary thought process for establishing an
industry-standard methodology for detecting and responding to investor biases.
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Here we first examine the limitations of typical risk tolerance questionnaires in
asset allocation; next, introduces the concept of best practical allocation, which
in practice is an allocation that is behaviourally adjusted; then identifies clients’
behavioural biases and discusses how discovering a bias might shape an asset
allocation decision; finally, reviews a quantitative guideline methodology that can
be utilized when adjusting asset allocations to account for biases.
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guidelines for asset allocation and should only be used in concert with other
behavioural assessment tools.
From the behavioural finance perspective, in fact, risk tolerance questionnaires
may work well for institutional investors but fail regarding psychologically biased
individuals. An asset allocation that is generated and executed based on mean-
variance optimization can often result in a scenario in which a client demands, in
response to short-term market fluctuations and the detriment of the investment
plan, that his or her asset allocation be changed. Moving repeatedly in and out of
an allocation can cause serious, long-term, negative consequences. Behavioural
biases need to be identified before the allocation is executed so that such
problems can be avoided.
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Guidelines:
The authors offer two propositions for guiding practitioners in identifying the
best practical allocation for their clients while considering behavioural biases:
Proposition I: The decision whether to moderate or adapt to a client’s
behavioural biases during the asset allocation process depends fundamentally on
the client’s level of wealth. Specifically, the wealthier the client, the more the
practitioner should adapt to the client’s behavioural biases. The less wealthy, the
more the practitioner should moderate a client’s biases.
Rationale: A client’s outliving his or her assets constitutes a far graver investment
failure than a client’s inability to amass the greatest possible fortune. In the
former case, the client’s standard of living may be jeopardized; in the latter, the
client’s standard of living will remain in the 99.9th percentile. In other words,
then, if bias is likely to endanger a client’s standard of living, moderating is the
best course of action. But if only a highly unlikely event such as a market crash
for those clients with market-created wealth could jeopardize the client’s
standard of living, bias becomes a lesser consideration, and adapting may be the
more appropriate action.
Proposition II: The decision whether to moderate or adapt to a client’s
behavioural biases during the asset allocation process depends fundamentally on
the type of behavioural bias the client exhibits. Specifically, clients exhibiting
cognitive biases should be moderated, while those exhibiting emotional biases
should be adapted to.
Rationale: Behavioural biases fall into two broad categories, cognitive and
emotional, though both types yield irrational decisions. Because cognitive biases
stem from faulty reasoning, better information and advice can often correct
them. Conversely, because emotional biases originate from impulsive feelings or
intuition —rather than conscious reasoning—they are difficult to correct.
Cognitive biases include heuristics, such as anchoring and adjustment,
availability, and representativeness biases. Other cognitive biases include
selective memory and overconfidence. Emotional biases include regret, self-
control, loss aversion, hindsight, and denial. These biases will be described in
more detail in the next section of the paper.
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Propositions I and II can, for some clients, yield a blended recommendation. For
instance, a less wealthy client with strong emotional biases should be both
adapted to and moderated. Chart 1 illustrates this concept. Additionally, clients
may exhibit the same biases, but should be advised differently. The cases of three
hypothetical investors— Mrs Smith, Mr Jones, and the Adams family—will add
clarity to these complexities, while illustrating how practitioners can apply these
propositions to determine best practical allocation
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percent equities composition and a 30 to 50 percent fixed-income composition.
Given here is a basic algorithm for determining how sizable an adjustment could
be implemented by an advisor without departing too drastically from the
pertinent mean-variance-optimized allocation.
Method for Determining Appropriate Deviations from the Rational Portfolio
1. Subtract each bias-adjusted allocation from the mean-variance output.
2. Divide each mean-variance output by the difference obtained in Step 1. Take
the absolute value. 3. Weight each percentage change by the mean-variance
output base. Sum to determine bias adjustment factor.
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Case studies:
CASE A: MRS. ADIRONDACK
Mrs. Adirondack (hereafter “Mrs. A”) is a single, 70-year-old retiree living a
modest lifestyle. Her only income is generated by her investment portfolio, which
totals $1 million. Mrs. A was referred to you by your Aunt Sally’s friend Mabel,
and you’ve known her for about three years. Your advisory relationship reveals
that Mrs. A’s primary investment goal is for her assets to sufficiently support her
for the rest of her life. She does not, under any circumstances, want to lose
money, because she recalls that her relatives lost money in the crash of 1929.
You have noticed that Mrs. A is also stubborn and inflexible in her thinking,
especially on the topic of financial markets.
Analysis
One day, you reflect on your relationship with Mrs. A and realize that, despite
your recommendations to the contrary, she has never once altered her portfolio.
Mrs. A owns only municipal and government bonds, and you are concerned that
inflation will eventually cause her to outlive her assets. You suspect her
discomfort at the prospect of re-allocating her portfolio is due to one or more
behavioural biases, and you ask Mrs. A if she is willing to take a 30-minute
diagnostic test to examine her investor personality. Mrs. A refuses, but she
ultimately agrees to a 10-minute test. To save time, you flip through this book
and administer only the questions pertaining to the biases that you most suspect
Mrs. A displays: loss aversion, anchoring, and status quo. Mrs. A’s responses
confirm your instincts. She demonstrates:
Loss aversion bias (the tendency to feel the pain of losses more acutely
than the pleasure of gains).
Anchoring and adjustment bias (the tendency to automatically rely on
present market levels as neutral benchmarks for predicting future market
trends).
Status quo bias (the desire to keep things as they are).
As part of your allocation review, you also administer a risk tolerance
questionnaire to Mrs. A. Her score helps you generate a mean variance optimized
portfolio recommendation: 70 percent bonds, 20 percent stocks, 10 percent
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cash. So, now that you know Mrs. A can theoretically tolerate a riskier portfolio
than the one she carries, you become more convinced than ever that behavioural
biases are interfering. Your job is now to answer these three questions:
1. What effect do Mrs. A’s biases have on the asset allocation decision?
2. Should you moderate or adapt to her biases?
3. What is the best practical allocation for Mrs. A?
Effects of Biases
Mrs. Adirondack’s biases are very consistent and lead to a clear allocation
preference. Because Mrs. A does not tolerate risk (loss aversion) and does not
like change (status quo), she would naturally prefer the safe, secure asset
allocation (100 percent bonds) that she now possesses. Also, since the market
has dropped recently, Mrs. A will likely make faulty conclusions regarding
current and expected prices (anchoring and adjustment) and will therefore
feel wary of any exposure to equities. Thus, if you, as her advisor, presented
her with a recommended allocation of 100 percent bonds, she would be likely
to immediately agree to that recommendation. However, you need to bear in
mind Mrs. A’s bias toward such an allocation.
Moderate or Adapt?
You’re concerned that Mrs. A might outlive her assets if she adheres to her
present allocation, and your financial planning software confirms your fears.
Mrs. A’s level of wealth, while adequate at present, isn’t substantial enough
to afford her the (dubious) luxury of an unbalanced allocation of funds in the
long run. So, if you adapt to her biases—consent to stick with 100 percent
bonds—then Mrs. A’s only critical, financial goal becomes jeopardized.
However, Mrs. A’s biases are principally emotional (status quo, loss aversion)
and typically cannot be corrected with advice and information. This will
complicate things if you attempt to moderate her biases. Now that you know
that Mrs. A’s wealth level isn’t excessive and that her biases are principally
emotional, you have all the information that you need in order to “plot” her
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case. As you can see, Mrs. A’s case yields a blended recommendation: you
should moderate and adapt to her biases.
This course of action, which might appear contradictory, is really more about
compromise. A complete moderation of Mrs. A’s biases would imply a mean-
variance optimized breakdown: 70 percent bonds, 20 percent equities, 10
percent cash. A complete adaptation, meanwhile, would preserve the
allocation of 100 percent bonds. Moderating and adapting means negotiating
some middle ground. Taking into consideration Mrs. A’s wealth level and bias
profile, you now begin to draft a best practical allocation.
Best Practical Allocation Decision
You decide that an allocation of 75 percent bonds, 15 percent stocks, and 10
percent cash would approximate the mean-variance optimizer while also
offering some concessions to Mrs. A’s conservatism. The first thing you do is
to check your financial planning software to ensure that Mrs. A, if she adopts
this allocation, will not outlive her money. Indeed, the software calculates
that the new allocation suffices. Next, you run your behaviourally modified
portfolio through the Behavioural Asset Allocation Adjustment Factor Model
(BAAAF) and verify that the adjustment factor doesn’t exceed 20 percent (see
Chapter 3 for guidelines). Indeed, you’ve only corrected Mrs. A’s portfolio by
10 percent, so you are happy with that result. You present your
recommendation to Mrs. Adirondack, and you administer a continuing
program of investor education on the risk of outliving one’s assets.
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CASE B: MR. BOULDER:
Mr. Boulder (hereafter “Mr. B”) is a single 50-year-old, hard-charging
pharmaceutical executive earning $250,000 per year. He lives extravagantly
and occasionally overspends, but he has saved approximately $1.5 million.
Mr. B had a mild heart attack last year but now has a clean bill of health. His
primary financial goal is to retire comfortably at 65 and to donate $3 million
to his alma mater (he cannot obtain adequate life insurance to cover the gift).
You have been working with Mr. Boulder for less than a year. You’ve drafted
a financial plan but have yet to modify Mr. B’s pre-existing allocation (nearly
100 percent equities). However, you have developed a good working
relationship with Mr. B, who listens intently and seems receptive to your
recommendations. You believe that Mr. Boulder is a well-grounded person
and is self-aware, but you also believe that he has some behavioural issues to
deal with.
Analysis
30
good investor, and you are worried that such a change might cause him to
regret not being more aggressive. He agrees to complete a comprehensive
behavioural bias questionnaire, and his results show susceptibility to:
■ Overconfidence bias (the tendency to overestimate one’s investment
savvy).
■ Regret aversion bias (the tendency to avoid making a decision for fear that
the decision may cause regret later on).
■ Self-control bias (the tendency to spend today rather than save for
tomorrow). The mean-variance optimized allocation you initially calculated
for Mr. B was 70 percent stocks, 25 percent bonds, 5 percent cash—Mr. B’s
risk tolerance better suits a more balanced portfolio.
You also have obtained confirmation of the specific behavioural biases that
are probably causing the distortion in Mr. B’s portfolio. Your job is now to
answer these questions:
1. What effect do Mr. B’s biases have on the asset allocation decision?
2. Should you moderate or adapt to his biases?
3. What is the best practical allocation for Mr. B?
Effect of Biases
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Moderate or Adapt?
Considering his overall level of wealth, Mr. Boulder does not run a serious
standard-of-living risk with his present allocation, even in the event of a major
market downturn, given his high level of salary. His behavioural biases are also
principally emotional (regret aversion, self-control). You decide to adapt your
recommendation. It’s important to note that adapting doesn’t mean setting
aside all behavioural considerations. You’ll create a portfolio more aggressive
than the mean-variance optimizer suggests, and this will help Mr. B to adhere
comfortably to his allocation. However, at the same time, you’ll run a cash
flow analysis to ensure that your plan won’t leave Mr. B’s living expenses at
risk if the market turns sour. You will also advise him to keep a comfortable
cash reserve.
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CASE C: THE CATSKILL FAMILY
The Catskill family includes a financially well-informed couple, both aged 36,
and two children aged 4 and 6. The family is financially sound but suffered
badly during the tech meltdown in 2000. The couple’s total income is
$120,000, which, like the family itself, is not expected to grow significantly.
The Catskills have managed to save $150,000, which they hope might serve
as a financial foundation from which to send their children to college and,
later, to fund a comfortable retirement. You have been working with the
Catskills for five years. You update a financial plan for them annually and
recommend an asset allocation. Last year, you suggested the allocation that
the mean-variance optimizer generated: 70 percent equities, 25 percent
bonds, 5 percent cash. At that time, the Catskills, however, chose to be more
aggressive. This year, when you recommended the same mean-variance
optimized allocation, the couple actually desired a more conservative
position, requesting 50 percent equities, 45 percent bonds, 5 percent cash.
Analysis
You have noticed this pattern before and believe that the Catskills are trend
followers. Susceptible to short-lived market fads, the Catskills also tend to
move in and out of asset classes in an effort to control their financial destiny.
Predictably, however, they have not been too successful with their
investments. This couple is typically not receptive when you advise them to
“stay the course.” Currently, they have the idea that they should be in risk
averse investments (bonds), which have come into fashion following the tech
meltdown. You decide to administer a behavioural bias test (for simplicity’s
sake, imagine that the Catskills complete the test jointly and share the same
behavioural profile). You find that the Catskills suffer from:
■ Illusion of control bias (the superstition that they can control, or at least
influence, outcomes beyond their control).
■ Recency bias (mentally emphasizing more recent events unduly with
respect to less recent events).
■ Availability bias (the tendency to believe that what is easily recalled is more
likely to happen).
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As stated, the Catskills’ mean-variance optimized portfolio recommendation
is 70 percent stocks, 25 percent bonds, and 5 percent cash. Given the biases
they exhibit, you consider these three questions:
1. What effect do the Catskills’ biases have on the asset allocation decision?
2. Should you moderate or adapt to their biases?
3. What is the best practical allocation for the Catskills?
Effect of Biases
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Moderate or Adapt?
Illusion of control bias, recency bias, and availability bias are all cognitive
biases—suggesting that they can be moderated with a campaign of
information. Furthermore, your financial planning software suggests that an
insufficient equity allocation, given the Catskills’ modest level of wealth,
might fail to cover college and retirement. You decide to moderate the
Catskills’ biases, with the objective of increasing their equities allocation.
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Best Practical Allocation Decision
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Conclusion:
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Risk tolerance questionnaire with behavioural biases
The following questionnaire is to determine your risk tolerance and behavioural biases towards
investing money. This is purely for academic purpose.
1. Gender:
a. Male b. Female
2. Age :
a. 25-35
b. 36-45
c. 46-55
d. 55+
3. Marital status:
a. Single b. married
4. Qualification :
a. Graduate b. undergraduate
b. Post- graduate
5. Saving Profile (Lifestyle): After paying all my current expenses and EMIs, I
a. Am unable to save currently.
b. Save up to 15% of my monthly income.
c. Save up to 30% of my monthly income.
d. Save up to 50% of my monthly income.
e. Save substantial portion (50% or above) of my monthly income.
Please answer all the questions by selecting one of the options. Choose the option that best
indicates how you feel about each question. If none of the options is exactly right for you, choose
the option that is closest.
7. Compared to others, how do you rate your willingness to take financial risks?
a. Extremely low risk taker.
b. Very low risk taker.
c. Low risk taker.
d. Average risk taker.
e. High risk taker.
f. Very high risk taker.
g. Extremely high risk taker
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8. How easily do you adapt when things go wrong financially?
a. Very uneasily.
b. Somewhat uneasily.
c. Somewhat easily.
d. Very easily.
9. If you had to choose between more job security with a small pay increase and less job
security with a big pay increase, which would you pick?
a. Definitely more job security with a small pay increase.
b. Probably more job security with a small pay increase.
c. Not sure.
d. Probably less job security with a big pay increase.
e. Definitely less job security with a big pay increase.
10. When faced with a major financial decision, are you more concerned about the possible
losses or the possible gains?
a. Always the possible losses.
b. Usually the possible losses.
c. Usually the possible gains.
d. Always the possible gains.
11. Imagine you were in a job where you could choose to be paid salary, commission or a mix of
both. Which would you pick?
a. All salary.
b. Mainly salary.
c. Equal mix of salary and commission.
d. Mainly commission.
e. All commission
12. How much confidence do you have in your ability to make good financial decisions?
a. None.
b. A little.
c. A reasonable amount.
d. A great deal.
e. Complete.
13. Suppose that you are given an opportunity to replace your current investment portfolio with
a new portfolio. The new portfolio has a fifty-fifty chance to increase by 50% your standard
of living every year during your lifetime. However, the new portfolio also has a fifty-fifty
chance to reduce to X% your standard of living every year during your lifetime. What is the
maximum X% reduction in standard of living you are willing to accept?
_________
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14. Suppose that 5 years ago you bought stock in a highly regarded company. That same year
the company experienced a severe decline in sales due to poor management. The price of
the stock dropped drastically and you sold at a substantial loss. The company has been
restructured under new management and most experts now expect it to produce better
than average returns. Given your bad past experience with this company would you buy
stock now?
a. Definitely not.
b. Probably not.
c. Not sure.
d. Probably.
e. Definitely.
15. Investments can go up and down in value and experts often say you should be prepared to
weather a downturn. By how much could the total value of all your investments go down
before you would begin to feel uncomfortable?
a. Any fall in value would make me feel uncomfortable.
b. 10%.
c. 20%.
d. 33%.
e. 50%.
f. More than 50%
16. Some people believe that they can pick stocks that would earn higher-than-average returns.
Other people believe that they are unable to do so. Please indicate your belie by circling the
number on a scale ranging from “strongly believe I cannot pick higher than average stocks
“to from “strongly believe I can pick higher than average stocks “. Rate the following
questions on the scale of 1-5 (1- being strongly believe I cannot pick higher than average
stocks, 5- strongly believe I can pick higher than average stocks)
a. 1
b. 2
c. 3
d. 4
e. 5
17. Answer the following question based on degree of your agreement towards the statement;
“I always want to have the best. Second best is not good enough for me.”
Rate the above question on the scale of 1-5 (1- minimum agreement, 2- maximum
agreement)
a. 1
b. 2
c. 3
d. 4
e. 5
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18. Answer the following question based on degree of your agreement towards the statement;
“Whenever I make a choice, I try to get information about how the other alternatives turned
out and feel bad if another alternative has done better than the alternative I have chosen.”
Rate the above question on the scale of 1-5 (1- minimum agreement, 2- maximum
agreement)
a. 1
b. 2
c. 3
d. 4
e. 5
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