Republic of the Philippines

Region V – Bicol
Division of Camarines Norte
Mabini Colleges Inc.
Daet

MIDTERM

CASE ANALYSIS:

BEHAVIORAL FINANCE

HONEYLYN VILLACRUEL
BSBA- Financial Management
2nd year – C

CESAR P. ABASOLO
Instructor
 Case Number 1: LOLA FLORA—The Emotional Investor

INTRODUCTION

Behavioral finance studies the impact of psychological phenomena on financial

behavior. In the center of the debate is the way people make decisions. In the course of
making decisions people generally make observations, process data and arrive at
judgments. In finance, these judgments and decisions pertain to the composition of
individual portfolio, the choices of the securities, the expectations, the investment style,
the horizon of investment, the turnover of the portfolio, the way investors react to news.

There are various ways to determine the behavioral finance biases that an
investor portrays. Examples of this method include using a rule of thumb, an intuitive
judgment, or common sense. These rules work well under most circumstances, but in
certain cases lead to systematic errors or cognitive biases. Cognitive biases is a pattern
of deviation from rational behavior in judgment that occurs in specific situations. In a
context where those specific situations occur, behavioral biases are therefore
predictable and that’s why, according to behavioral finance, human beings may be
considered as predictably irrational decision makers. Therefore, behavioral finance
suggests a new framework to think about investors’ behavior.

In this analysis, the investor – Lola Flora, a 70 year-old has difficulties about the
allocation of her assets due to her attitude and behavior when it comes to the
recommendations of the advisor. And also on how to respond on various changes in the
stock market.

PERSPECTIVE

In the perspective point of view of financial advisor of Lola Flora’s case, the
perception about this analysis is that the municipal and government bonds owned by
Lola Flora is not sufficient to support her financial expenses on everyday lives. The
process on how to prevent any losses from the investment that might happen is most
importantly consider by the financial advisor. In addition, financial advisor is responsible
to come up with suggestions and endorsements about the allocation of the assets of the
portfolio investment.

CENTRAL ISSUE

Problems are inevitable in our life, in our everyday living we met various
problems. As well as when it comes to the business aspects – specifically in this
analysis, problem about the portfolio investment of every investor. The main problem
here in Lola Flora’s case is the method of allocation of her generated asset from her
portfolio investment that serves as the only sufficient support for the rest of her life, on
how to response with the changes and inflations in the market with that poor and
inflexible thinking of her. In addition, the behavior of Lola Flora due to her behavioral
biases that affect her perception about her primary investment goal.

STATEMENT OF OBJECTIVES

 To identify numerous behavioral finance biases existed in this case.

 To determine how that biases greatly affect the allocation of asset.
 To help the investor to make decision for the portfolio investment.
 To generate a better mean-variance optimized portfolio recommendation for the
investment portfolio of the investor.

BEHAVIORAL FINANCE BIASES

Behavioral finance is a knowledge that cover psychology and sociology aspects

of human behavior. It considers as the most powerful force in the field of financial
problems.

In this case, these were the identified behavioral biases:

1. Anchoring

A bias that when new relevant information appears, adjustment of judgments is

very slow and rigid and belongs to the cognitive and information processing bias. In the
case of Lola Flora, she has never once altered her portfolio and applied to her
investment portfolio despite recommendations given by the financial advisor.
 2. Loss Aversion

It is not the reality of loss that matters, but the perception. Loss aversion refers to
stronger desire of the investors to avoid losses than obtain gains and causes investors
to focus on avoiding risk.

Because of Lola Flora’s primary investment goal to financially support the rest of
her life, here, she has this behavioral finance bias because the it obviously stated in the
case that she does not want to lose money due to the past experience of her relative in
the crash of 2011.

3. Cognitive Dissonance

Investors will ignore newly acquired information because it conflicts with previous
idea and perspective about the investment. And mostly, they avoid potentially relevant
information to avoid psychological conflicts.

Applying the concept of the bias of anchoring, Lola Flora is known as a stubborn
and inflexible thinker especially on the topic of financial markets. She never changed
her portfolio even though the advisor gave recommendations about that.

4. Overconfidence

The essence of this bias, means having inflated view of one’s own abilities.
Investors tend to view the world in positive terms.

5. Self-Attribution

This is the component and fueled by the overconfidence bias wherein individuals
faced with a new positive outcome following a decision, will view that outcome as a
reflection of their ability and skill. However, when faced with a negative outcome, this is
attributed to bad luck or misfortune.

6. Illusion of Control

Investors who suffer from illusion of control bias, think they can control
investment outcomes, even though they cannot.
 Biases of illusion of control, self-attribution and overconfidence were portrayed by
Lola Flora due to her act that she never altered or changed her portfolio and because of
her poor, stubborn, inflexible thinking about the financial markets. She strongly believes
in herself that she can make it on her own without considering recommendations of
financial advisors about the investment portfolio.

7. Optimism

Disregarding other factors and risks she still remains positive that investing in
municipal and government bonds would be better than re-allocating the investment
portfolio.

EFFECTS OF BIASES

1. Anchoring
 Investor will have focused too much importance on one aspect of portfolio
investment causing an error in accurately predicting the utility of a future
outcome.
 There will be a boundary and limitation between the negotiation and
communication of investor and other person.
2. Loss Aversion
 Investors become irrationally risk averse and overly fearful.
 Holdings losing positions too long and sell appreciated positions too
quickly.
 Application of the disposition effects that states that investors wanting to
both realize gains and avoid losses.
 Cases of win or lose, the outcome will have little material effect on life
circumstances.
3. Cognitive Dissonance, Overconfidence, Self-Attribution, Illusion of Control,
Optimism
 Investors avoid the feeling of regret when there was something bad
happens.
 Investors are not going to admit for the mistakes they made in the future.
  They tend to refuse any re-allocation of Refusal to reallocate to a better
investment.

CONCLUSION

Human being have tendency to credit their success to themselves, whereas

failures are attributed to external variables. Investors would do better in every aspect
not only in business world, but also in the real life world, if they keep in mind the
behavioral biases that affect intelligibility in thinking.

The investment portfolio is greatly affected not only now but to the future that will
come because of these various behavioral finance biases. In Lola Flora’s case, it was
identified that there were seven behavioral finance biases – the Anchoring, Loss
Aversion, Cognitive Dissonance, Overconfidence, Self-Attribution, Illusion of control and
the Optimism. And these biases were one of the hindrances to have a better portfolio
investment for the success of the future.

In respect to these biases, to come up with a better one, the financial advisor
must have knowledge about the investor’s investment portfolio. The re-allocation of the
investment portfolio will be a great strategy to meet the primary goal of Lola Flora’s
investment. The investor and the financial advisor must have communication between
themselves and this will be considered as one of the factors to have a better decision
that affect the investor’s living.

RECOMMENDATIONS

Asset allocation is one of the great recommendations about the case of Lola
Flora. It will greatly help her to reduce risk from those changes and inflation that the
country experiencing. As financial advisor, I highly recommend, first, to change her
investor’s personality for the succession of her goals, to have better response to those
recommendations by the advisor. To make an adjustment about the allocation regarding
her bonds, stocks, and cash. It is appropriate to re-allocate the percentage that will earn
total return over the period that the investor needed. Lola Flora also need to accept and
face the challenges and risk against the expected return to maintain her wealth.
 Mean-Variance Behaviorally Change Change in
Output Adjusted in Percent
Variances
Recommendation Allocation Percent (Weighted
s Recommendatio (Absolute Average)
n Value)
Equities 20 30 -10 50% 10%
Fixed 70 70 0 0% 0%
Incomes
Cash 10 0 10 100% 10%
TOTAL 100 100 Bias Adjustment 20%
Factor

For this asset allocation method, it is a commonly cited rule of thumb that has
helped simplify asset allocation. It states that individuals should hold a percentage of
stocks equal to 100 minus their age. So, for a 70-year old, 30% of the portfolio should
be equities. The residual value would comprise of high-grade bonds, government debt,
and other relatively safe assets.

ACTION PLAN

Recommendations Actions/Activities Person(s) Responsible

Alter the behavioral Great accountable attitude Lola Flora -- Investor

finance biases and the is to change the
investor’s personality. personality towards the
investment to be efficient
and effectively investor,
and avoid behavioral
finance biases, if
necessary.
Adjust the allocation of A better re-allocation of the Financial Advisor
assets. assets for the better
investment portfolio.
Change, accept and Accept to change the Lola Flora -- investor
applied the new re- investment portfolio to
allocated investment reduce risk against the
portfolio. diversification and inflation
to avoid losses and
deterioration of assets.

Case Number 2: Mr. President “A Well-Grounded and Conservative Investor”

INTRODUCTION

The concept of traditional economic theory governed the general thought process
that states that markets will be efficient and individual make rational decisions to
maximize profits. However, there are behavioral economic theory believes that, while
traditional economic theory may hold true in the long run, in the short run markets are
not efficient and people do not make rational decisions. People have their heart and
mind but people do not always make decisions only out of their mind. This is the time
when the behavioral biases come in to the way of thinking of each investor. Behavioral
finance biases do not justify the events and behaviors rationally but study the investor’s
behaviors in the view of feelings and will explain it.

A single, 50-year old man hard-working pharmaceutical executive that earns

million annually, who saved millions of peso and still lives excessively and overspends
in every occasion. In his past, Mr. President had a mild heart attack but now living a
healthy life and has a clean bill of health. To retire comfortably at aged 65 and to donate
P3 million pesos to his alma mater is his primary financial goal. For less than a year
working as his financial advisor, and developed good working relationship, knowing that
he listens intently and receptive to recommendations yet well-grounded person and self-
aware but still there’s some behavioral issues to deal with like behavioral biases that are
probably causing the distortion in Mr. President’s portfolio.

PERSPECTIVE

As Mr. President’s financial advisor thinks about the response of Mr. President
regarding the mean-variance optimized allocation. The financial advisor concerns the
severe downward fluctuation that may cut into Mr. President’s daily living expenses
including the possible health expenses. In respect with his personality, the advisor
believes that with a less aggressive portfolio, he can still meet his primary financial
objectives. In addition, the advisor strongly believes that the obtained behavioral biases
will cause alteration in Mr. President’s portfolio.

CENTRAL ISSUE
 Mr. President’s main issue, is that his specific behavioral biases that can
probably change and affect his portfolio of investment. In addition, the severe downward
market fluctuation that may affect his daily living and health expenses.

STATEMENT OF OBJECTIVES

 To determine the existed behavioral finance biases in investor’s case.

 To address the concerns about the portfolio and on investment’s market.
 To convince and prove to the investor the altered portfolio would be better than
the old investment portfolio.
 To render a new man-variance optimized allocation of investment.

BEHAVIORAL FINANCE BIASES

The investor’s behavioral finance biases greatly affect the investment portfolio.
Here’s the various finance biases of Mr. President:

1. MENTAL ACCOUNTING

It is a description of the ways we do the things of recording, summarizing,

analyzing, and reporting the results of transactions and other financial events. This bias
attempts to describe the process whereby individuals divide their current and future
assets into separate, non-transferable accounts. As man, our psychological self thinks
about money and risk through “mental accounts” – like Mr. President did, he separated
his wealth especially the cash wherein he saved approximate amount of P10.5 million.
into various buckets or pools which base on goals or time horizons (such as retirement).

2. OVERCONFIDENCE

One of the emotional biases that describes individual tends to have unnecessary
confidence in their decision making. In essence, this means having an overstated view
of one’s own abilities. We obviously noticed that Mr. President is a man characterized
as well-grounded person and self-aware and he thinks of himself that he is a very good
investor. This bias was also connected to the issue of control, with overconfident
investors believe that they were exercise more control over their investments than they
do.

3. CONSERVATISM

A cognitive dissonance that describes the idea of partially adjusting the view in
light of the new information. Investors focused or adhere to the initial judgment even
with new contradictory information. In Mr. President’s case, this bias was shown by his
features that he listens attentively, seems open to any recommendations, but the
advisor believes that he might not fully approve to the idea of the asset allocation.

4. REGRET AVERSION

When people fear that their decision will turn out to be wrong in perception, they
exhibit this bias. Regret –averse people may fear the consequences of both errors of
omission and commission. In regard to this bias, financial advisor worried that changes
of the portfolio may cause him to regret.

EFFECTS OF BIASES

1. Mental Accounting
 Natural tendency to create mental buckets also causes investors to focus
on the individual buckets or accounts rather than thinking broadly.
 Investors often view retirement funds as sacrosanct and treat them as
long-term investments.
 Accounts can also vary in risk tolerance, investing some risky in risky
assets for gain while treating others more conservatively.
 Investor shows less attention to the relationship between the investments
held in different mental accounts that traditional theory suggests.
2. Conservatism
 Make investors in a denial state that reduces the ability to learn from
unpleasant and experiences.
 People will pay attention to the information that supports their opinions,
and ignore the contrary evidence.
  Investor may be slow to adjust their view of the investment’s prospects
even after the company’s profitability deteriorates.
3. Overconfidence
 Investors hold concentrated stock positions.
 Against this advice, ‘Misguided conviction” can weigh with investors ‘sure’
of the good prospects of a given investment, and can cause them to
believe that diversification or modification is necessary.
 Investor overestimate their own abilities and overlook broader factors
influencing their investments.
4. Regret Aversion
 This brings inertia that can act as an obstacle to effective financial
planning, stopping the investor from saving and making necessary
changes to their portfolios.
 Lies at the heart of inertia, it gives uncertainty or confusion about how to
proceed and continue the operation of the investment. For example, an
investor is considering making a change to his portfolio, but he has
uncertainty about the qualities of taking action, the option that may
investor may decide on is to choose the most convenient path – wait and
see.
 It can cause tendency to procrastinate or delay dominates financial
decisions.

CONCLUSION

The identified behavioral finance biases that greatly affect the decision making
for Mr. President’s investment portfolio – the Mental Accounting, Conservatism,
Overconfidence and the Regret Aversion. These biases also have effect on the
response if the scenario of the severe downward market fluctuations or the ups and
downs happens on which this fluctuation doesn’t be seen as desirable but surely
inevitable.

Through this investigation, the financial advisor must consider some possible
way or response to help Mr. President decides on how to save or continuously financed
his daily living expenses including the health expenses. Financial advisor and Mr.
President must have mere agreement about the aggressiveness of the portfolio.

RECOMMENDATIONS

The investor must consider the consequences of being aggressive investor in the
occurrence of the market fluctuations aside for the asset allocation for a better
investment portfolio that will meet his primary financial goal. As a well-grounded person
and self-aware, the investor must be more receptive and open-minded to the
recommendations of his advisor. Mr. President shall also take the risk of his portfolio
and conquer the challenges about the aggressiveness of his investment portfolio.

In regard to his biases, he must accept and face challenges as well as the risks
for a better rate of return from his investment. Moreover, he must obtain adequate life
insurance who are willing to cover the gift to insured his donation in case of emergency.
He shall also have investment such as stock, bonds not only for the cash in order to
acquire higher return and ensure more safe keeping of his assets.

Mean-Variance Behaviorally Change Change in

Output Adjusted in Percent
Variances
Recommendation Allocation Percent (Weighted
s Recommendatio (Absolute Average)
n Value)
Equities 70 50 20 29% 20%
Fixed 25 50 -25 100% 25%
Incomes
Cash 5 0 5 100% 5%
TOTAL 100 100 Bias Adjustment 50%
Factor

For this asset allocation method, the bias adjustment factor is 50% because of
the adjustment for the allocation of assets. For a 50-year old man, 50% of the portfolio
should be equities, that indicates he shall have a balanced portfolio for the risk
tolerance of his investment.

ACTION PLAN

Recommendations Actions/Activities Person(s) Responsible

Adjust the allocation of A better and balanced re- Financial Advisor
assets. allocation of the assets for the
better investment portfolio and
for the tolerance of risk of the
investment.
More receptive to the The investor must be more Mr. President –
recommendations about the receptive and open-minded investor
investment portfolio. about the recommendations by
the advisor for a better
investment portfolio to meet his
primary financial goal.
Accept the challenges and The investor shall face the Mr. President –
face the risk about the challenges and risks investing in investor
investment in a market a market economy where the
economy. market fluctuations is inevitably
happening.
Obtain adequate life Investor must obtain a legal and Mr. President –
insurance of the donation or willing insurance company to investor and the Life
gift. insured his donations to the alma Insurance Company
mater as one of his financial for covering and
primary goal to make sure that insuring the donation.
this company will cover the
expenses in case of emergency
beyond the man’s control.
 Case Number 3: Pamilya Banal “The Conservative and Aggressive Family”

INTRODUCTION

Pamilya Banal is a financially well-informed couple aged 36 years-old with two

children. Suffered badly during the tech meltdown in 2000 and now is financially sound.
They have their savings for the retirement and for the college expenses of the children
but they believe that they total income is not expected to grow significantly. The
financial advisor working for five years, updates the financial plan and give
recommendation about the asset allocation using the mean-variance optimizer but
Pamilya Banal requested a more conservative asset allocation.

It obviously noticed that the behavior of the couple was patterned and based on
the recent activities or events because the family are trend followers. They also have
predictable idea about their investments. Obviously, they have their behavioral finance
biases that greatly affects the investment portfolio and their decision making.

PERSPECTIVE

As financial advisor working for five years to the family of Banal, thinks that
having different behavioral finance biases that were so obviously noticed in the case is
greatly attributes to the decision making of the couple. The advisor thinks that with their
predictable idea about the investment will bring them to a great risk and loss of their
investment portfolio.

CENTRAL ISSUE

The main problem in this analysis is the behavior of being full conservative in
decision making regarding the allocation of portfolios. The behavioral finance biases
that existed in the case that must be moderated and adapt by the financial advisor in
order to help and assist them to be more flexible in thinking about their portfolio for the
future preferences of Pamilya Banal that leads them also to get higher return from their
investment.
STATEMENT OF OBJECTIVES

 To identify the different behavioral finance biases of Pamilya Banal.

 To determine whether to moderate or to adapt to Pamilya Banal’s irrational
preferences.
 To generate a new mean-variance optimized portfolio investment
recommendation.
 To re-allocate the asset allocation to arrive at the better investment portfolio that
will help in decision making of the Pamilya Banal.

BEHAVIORAL FINANCE BIASES

Pamilya Banal have the following behavioral finance biases:

1. CONSERVATISM

It is the tendency for people to pay attention to information that supports their
opinions, and to ignore the contrary evidence. It describes the idea of the decision
maker clings to an initial judgement despite new contradictory information and investors
are unwilling to change their opinions in the light of new information.

Due to the request of conservative position of the mean-variance optimized

allocation, Pamilya Banal showed conservatism bias.

2. COGNITIVE DISSONANCE

Many investors will ignore newly acquired information because it conflicts with
their previous view or perspective when it comes to the investment portfolio. Pamilya
Banal are not receptive and not willing to alter their portfolio when the financial advisor
gave an advice about their portfolio.

3. REPRESENTATIVE

A cognitive and belief-perserverance bias where people make classifications

based upon their relevant past experiences.
 4. AVAILABILITY

A cognitive and information processing bias where investors use a shortcut,

based on how familiar the outcome appears in their life, and give emphasis on they will
follow what’s the fad as of now.

For the reason that they suffered during the tech meltdown in 2000, Pamilya
Banal perceive easily recalled possibilities as the best choices that showed in their
perspective idea and

5. MENTAL ACCOUNTING

This is the idea of separating wealth into various buckets or pools and often base
these pools on goals or time horizon. In here, Pamilya Banal have managed to save
P1,500,000 which serves as the financial support for the college of their children and
retirement funds. The accounts can also vary in risk tolerance, investing some in risky
assets for gain while treating others more conservatively.

6. ILLUSION OF CONTROL

Investor think that they control investment outcomes even in the reality they
cannot.

7. RECENCY

A cognitive bias and information processing bias, where investors

overemphasize more recent events than those in the near or distant past.

Obviously stated that Pamilya Banal are trend followers and vulnerable to short-
lived market fads, they tend to move in and out of classes in an effort to control their
financial destiny that are connected to their illusion of control.

8. HINDSIGHT

A cognitive and belief-perseverance bias where people remember their own

predictions of the future more accurately than they actually were. Pamilya Banal have
their predictable idea about the risk they might experience because of the past
experience during the tech meltdown in 2000.
EFFECTS OF BIASES

These are the possible effects of the identified behavioral finance biases:

1. Conservatism
 Investor will ignore the information that the advisor recommends because
they are only focused on the information that supports their opinions.
2. Cognitive Dissonance
 Like conservatism bias, investor will set aside the advisor’s
recommendation and refuse to adapt or alter the portfolio allocation.
3. Availability Bias and Representative Bias
 The investor may avoid investing more to different equity securities.
 The classifications can often produce incorrect understandings or
interpretations because of the past experiences.
4. Mental Accounting
 Investor pays less attention to the relationship between the investments
held in the different mental accounts than traditional theory suggests.
 It creates mental buckets that focus on the individual buckets rather than
thinking broadly, in terms of the entire wealth position.
5. Recency
 Investor will focus on the asset class in favor today and often focus on the
price and not on valuation and can falsely extrapolate future events.
6. Illusion of Control
 Investor have great confidence on himself about their control that they can
but they really cannot control the portfolio.
7. Hindsight
 The risk in this type of reconstruction of the past is that investors get a
false sense of security due to the fact that they think they have predictive
powers.
CONCLUSION

Pamilya Banal’s case obviously showed various behavioral finance biases that
greatly affect the portfolio allocation of asset and the decision making of the couple. And
these were the Conservatism; Cognitive Dissonance; Availability; Representative;
Mental Accountil; Recency; Illusion of Control; and the Hindsight. These must be
addressed by the financial advisor in order to have allocation of asset in the investment
portfolio. And in order to address the concern of the Pamilya Banal when it comes to the
short-term and on long-term investment. Importantly, the Pamilya Banal and the
financial advisor shall have deep communication to arrive on an agreement that will help
each other side.

RECOMMENDATIONS

Mean-Variance Behaviorally Change Change in

Output Adjusted in Percent
Variances
Recommendation Allocation Percent (Weighted
s Recommendatio (Absolute Average)
n Value)
Equities 50 58 -8 16% 8%
Fixed 45 36 9 20% 9%
Incomes
Cash 5 6 -1 20% 1%
TOTAL 100 100 Bias Adjustment 18%
Factor

This asset allocation was based form the requested conservative position of
portfolio that the Pamilya Banal wanted to implement. The Financial Advisor arrived at
the new mean-variance optimized allocation and the bias adjustment factor is 18%
because of the adjustment. For a 36 year-old couples, 58% of the portfolio should be
equities, that indicates they shall have a balanced portfolio for the risk tolerance of his
investment.

Moreover, the identified behavioral finance biases must be lessen or better, to

avoid these in order to come up with the great decision for the portfolio. The investors
must also come up with the idea through the help of advice of the advisor to invest more
in other equity securities other than cash in order to have a higher return for the
preparation of the future preferences. And the investors must be more interested and
open for all recommendations and other new information from third parties specifically
from the financial advisor. They must also consider the past experiences for today’s
operation of investment in order to face the risks and apply strategies to avoid loss or
any hindrances that happened in the history about their portfolio investment.

ACTION PLAN

Recommendations Actions/Activities Person(s) Responsible

Compute for the new mean- Adjusting and re-computing Financial Advisor
variance optimized asset the percentages to arrive at
allocation. new optimized asset
allocation for the portfolio
investment based from the
behavioral finance biases.
More receptive to the The investor must be more Pamilya Banal – investors
recommendations about the receptive about the
investment portfolio. recommendations or
suggestions for a better
investment portfolio to meet
their financial foundation.
Lessen or avoid behavioral The identified behavioral Pamilya Banal – investors
finance biases. finance biases must be
lessen or better, to avoid the
 behavioral biases in order to
come up with the great
decision for the portfolio.
Invest more in other equity The investors must also Pamilya Banal – investors
securities other than cash. invest more in other equity
securities other than cash in
order to have a higher return
for the preparation of the
future preferences.
Consider the past They must also consider the Pamilya Banal – investors
experiences for the present past experiences for today’s
and future preparation and operation of investment in
success. order to face the risks and
apply strategies to avoid loss
or any hindrances that
happened in the history
about their portfolio
investment.
References:

 The role of behavioral biases on investment decisions – Case Studies: Tehran

Stock. 2013., www.irjabs.com.
 SJRIS. Behavioral Finance “Mind Over Market” – A Case Study of Techno
Bubble. Aug-Sept., 2016., Vol. 3/17. www. sjris. Com
 Stupavsky, Michal., Behavioral Finance Foundations for Investors., Slovakia,
April 2018.
 Bryne Alistair. Behavioral Finance. 2013. Vanguard Asset Management

Webliography:

 www.bheaviouralfinance.net
 www.investopedia.com
 www.dailyfinance.com
 www.iwillteachyoutoberich.com
 Books.google.ph – Behavioral Finance and Wealth Management