FINA2209

Financial Planning
Week 4: Client preferences and behavioural finance

Dr. Elizabeth Ooi

elizabeth.ooi@uwa.edu.au
Housekeeping

• Group assignment info now on LMS (Assessments

folder)
– SPARK is compulsory- "All students are expected
to fully participate in this task and required to
submit valid assessments. Students who do not
complete the task will automatically receive a
RPF factor of 0.5”
Today’s objectives

• Client preferences (for risk) See last week and more on

this next week
• Asset allocation
• Client preferences (other)
• Behavioural finance: What can affect investors’ decision
making and preferences?
From last week
 One of the most important components of the client analysis
is assessing the client’s risk profile.
 A recommended investment portfolio for a client should be
designed around their risk/return philosophy
 what amount of risk is a client prepared to accept in order
to generate a certain rate of return
 is the client - conservative, balanced, aggressive?

 Factors likely to influence the degree of risk a client is

prepared to accept:
 term of investment, likely need for the funds in future, previous
investment experience, investment knowledge, objectives,
relative importance of investment portfolio in terms of client’s
total wealth

 How do we determine what the client’s risk profile is?

Risk profiling- Method 1
Are you stock-like or bond-like?
• Thinking Holistically:
– The risk you expose your financial capital to should consider the risks
of your human capital
• Labour and wage income – as an investment
– Flexibility (Flexible vs Rigid)
• Extra hours possible?
• Overtime (weekly, seasonally)?
• Second job?
• Allow delayed retirement?
– Sensitivity to general market conditions (Stock vs Bond)
• How does employment correlate with the economy?
– Professional investment manager (Stock-like)
– Public Servant (Bond-like)
Risk profiling- Method 1
Are you stock-like or bond-like?
High Hairdresser Contract
Project Manager

Income Who has capacity for

Flexibility more financial risk?

Low Teacher Admin Staff at

Public Servant Investment Bank

Low High
Sensitivity to
Economy
Risk profiling- Method 2
Risk set-point (Bodie & Taqqu - Risk Less & Prosper)
• Financial theory is very much optimisation based
– What portfolio has highest return for the risk?
– What portfolio has lowest risk for the return?
Process
– Identify your goals/objectives
– Differentiate needs (place to live) vs wants (place in Monaco)
• Needs are not exposed to risky assets
• To meet Needs invest in Federal Govt Inflation Indexed
Bonds (or Term Deposits, Annuities)
– Where safety zone ends & risky zone begins: Risk Set-Point
Risk profiling- Method 3
Risk profile questionnaire
Pros and cons of risk profile
questionnaires

• While they are the accepted and most common way to

measure risk tolerance, questionnaires are likely to
have disadvantages
– Self-reporting on behaviour and self-evaluating on
financial knowledge/literacy
• Biases may exist- overconfidence, optimism,
anchoring etc
– Depth (anywhere from <10 to >45 questions)
– Understandability- language, technical terms
Asset allocation –
The investment asset classes

Defensive • Cash
• Fixed Interest/Bonds
– Corporate, Government
• Shares/Equity Characteristics
Growth – Domestic, International • Security/Risk
• Property • Liquidity
– Direct, Listed • Income/Growth
• Commodities Derivatives
Other • Currency Ethical, Socially Responsible
• Infrastructure Private Equity
Investor-type Categories and
Portfolios

These ranges can differ by product provider so this is just one example…
Asset Class Investor Type

Defensive Conservative Moderately Balanced Growth Assertive

Conservative
Cash and fixed 100% 3-33% 9-33% 2-28% 0-16% 0-5%
interest
Australian shares 13-35% 7-17% 25-48% 33-60% 35-65%

International 16-33% 4-16% 16-33% 24-42% 28-55%

shares
Property 6-14% 0-16% 2-15% 3-20% 0-20%
Investor-type Categories
and Portfolios
• This is another example (McKeown et al, 2012)
Investor classification Approximate asset mix
Very conservative Cash 60%
Fixed interest 30%
Growth investments 10%
Conservative Cash 20%
Fixed interest 40%
Growth investments 40%
Balanced Cash 10%
Fixed interest 30%
Growth investments 60%
Aggressive Cash 5%
Fixed interest 15%
Growth investments 80%
Very aggressive Cash 5%
Fixed interest 10%
Growth investments 85%
5 levels of asset allocation
Passive/Active: What do you add for a
client?
Passive • Index portfolio to a nominated benchmark, eg All Ordinaries.
– Goal: Invest in securities in this index so as to match the performance of the
benchmark
• Strategic asset allocation (SAA)
– Investment in asset classes over long term (“generally” >10 years).
– In effect take higher weighting in asset class we believe will outperform
• Tactical asset allocation (TAA)
– Re-weighting portfolio over shorter period, eg. month, away from SAA
– Believe performance in asset class different to that suggested by SAA
• Investing in particular sectors of that asset class.
– A proportion of portfolio invested in particular asset class, eg. equity. Within
equity identify resources & industrial sector as two broad sectors
– Take shorter term bets of particular sector within asset class. “Sector Rotation”
Active • Asset selection
– Having decided SAA, TAA and Sector Rotation now what particular company,
bond or equity are we going to buy. Which assets are more likely to
outperform?
Preferences other than risk
• In funds management, socially responsible investing (SRI) is the
practice of incorporating social goals into the investment decision-
making process.
• In traditional economic theory, the constraints of SRI investment
suggest that a fully diversified portfolio is not possible.
• There are many arguments (and supporting evidence) that suggest
these constraints could be good or bad for potential investment
return.
The question is:

Does SRI investing increase or decrease

investor’s risk exposure and is this beneficial
or detrimental to expected returns?
Vice funds
“the social responsibility of business is to increase its profit” (Friedman, 1970)

• Barrier fund (MUTF:VICEX), formerly known as the Vice Fund

(http://www.usamutuals.com/products)
• The Vice Fund invests in companies within industries that have significant
barriers to entry (tobacco, alcohol, gaming, and weapons/defence) :
– Natural barriers to new competition
– Steady demand regardless of economic condition
– Global Marketplace - not limited to the U.S. economy
– Potentially high profit margins
– Ability to generate excess cash flow and pay and increase dividends
• These industries tend to thrive regardless of the economy as a whole.
Barrier fund
(MUTF:VICEX)

"The average person that owns our fund doesn't feel good about
owning it, but they hold on for the diversification and the returns.”
Gerry Sullivan, Manager Barrier Fund
How to incorporate ESG concerns into investing:
The forum for sustainable and responsible investment
http://www.ussif.org/index.asp

Negative/ best of
Positive screens screens by
SICs, NAICs,
GICs
SRI screening
Negative screening, which excludes companies based on their
involvement in what are commonly known as SRI-prohibited industries. E.g.
alcohol, tobacco, gambling and defence stocks.

Positive screening involves seeking out companies that enhance SRI

practices, such as those with good labor relations or a good history of
community involvement.

Best-of screening is similar to negative screening; however, it does not take

such an extreme position when rejecting companies. For example, a negative
screen will completely exclude a company if any of their profits are derived
from a SRI-prohibited industry, whereas a best-of screen will still consider
companies that derive a small portion of their earnings from such industries.
Measuring SRI
performance
Some studies find slightly superior returns for SRI funds
• (Abramson and Chung 2000; Diltz 1995; Mallin et al.
• 1995; Sauer 1997),

Others find no statistical difference

• (Bauer et al. 2005; Guerard 1997; Kurtz 1997),

Still others find a slight underperformance of non-SRI funds

• (Goldreyer and Diltz 1999; Girard et al. 2007).
How can this be???
- How are screens defined?
- How is screening intensity defined/measured?
-What benchmark is performance measured against? How is it
calculated?
What can affect investors’ decision making and
preferences?

In an ideal world, humans are rational, can perform

calculations/ forecasts accurately, have self control and are not
ruled by their emotions. Thus their actions/ decisions allow
them to achieve the best possible outcome.

In reality, biases, heuristics and emotions get in the way of

optimal decision making.

Financial planners need to be aware of these biases and

their pitfalls to help clients make better investment
decisions
Kahneman (2011)
Thinking fast and thinking slow
• Kahneman argues that activities of the mind can
be approximated by two systems
– System 1 – “operates automatically and quickly, with
little or no effort and no sense of voluntary control” (p.
20)
– System 1 is operating when you do things
automatically  Innate skills

– System 2 – “allocates attention to effortful mental

activities that demand it, including complex
computations” (p.21)
– System 2 monitors thought & action proposed by
system 1
Kahneman (2011)

• When system 2 kicks in, you tend to get better decisions (by
burning more energy)
– If you repeat a complex task (system 2) often enough, system 1
acquires this response as a heuristic with a consequent
decrease in energy required to deal with the decision.
• A heuristic is a practical method not guaranteed to be optimal or
perfect, but sufficient/efficient for the immediate goal – a mental
shortcut
• Therefore, system 1 has systematic errors that can lead to biases
in decision making
– Examples in everyday life: rule of thumb, stereotyping, intuitive judgement

– Examples in financial decision making…(next slide)

Availability bias
(aka anchoring)

We remember and react more strongly to events that are recent, relevant and
dramatic.

Decisions are made on the basis of available/most recently observed

information

• What are some examples of people being affected by availability bias?

– Investors are more likely to fear a stock market crash if they experienced one in the
recent past
– choosing investments that are heavily advertised
– overreacting to good/bad news

• What are some outcomes of people being affected by availability bias?

– decisions are based on incomplete or incorrect data
– generalise from small samples- law of small numbers
– cling to initial judgement despite new (perhaps contradictory) information
Representativeness

Judgement based on stereotypes

– Will shares in a high-profile, reputable
company deliver strong returns in the
future?
• Not necessarily because past performance is
not a guarantee of future performance
• Not necessarily -maybe the company has
levelled out and achieved maximum growth. The
share price already reflects the quality of the
company and thus future return prospects may
be moderate.
Herd behaviour: Two heads are
(sometimes) better than one

Individuals can follow group behaviour- fall in

line- without their own critical thinking.
What are some examples of herding?
– frenzied buying (stock market bubbles) or selling
(stock market crashes)
Mental accounting

-People place different values on money, based

on subjective criteria

$100 $100
$100
from winning a from salary put
from a tax refund
bet into savings

Which do you think a person would be more

likely to spend?
- Assigning different utility affects consumption
decisions
Overconfidence
Subjective confidence in own
judgements outweighs
objective accuracy

Overconfident investors
- underestimate downside risk
- hold undiversified portfolios

Solution?
- Check information sources
- Conduct objective analysis
Behavioural finance
and financial literacy
According to Lusardi et al. (2017) and Jappelli
and Padula (2013), the decision to invest in
financial literacy is an endogenous human
capital choice. This choice has costs
including time, effort and money.

What else can affect your

financial literacy/ the way you
deal with your money?
Hofstede’s 6
dimensions of national culture
Indulgence
- relatively free gratification of basic and natural desires of enjoying life/ having
fun. NEGATIVE RELATIONSHIP

Long-term orientation
- self explanatory
- Because people care about the future, more likely to invest in their fin
literacy. POSITIVE RELATIONSHIP

Power distance
– How less powerful members of organisations/institutions (e.g. the family)
accept and expect that power is distributed unequally
- Happy to delegate financial decision making. NEGATIVE RELATIONSHIP
Hofstede’s
dimensions of national culture
Individualism
- Focus on the placement of the self
- Choose to invest in own financial future. POSITIVE RELATIONSHIP

Masculinity
- how much “masculine traits” are valued in society
- Focus on men as breadwinners/ decision makers, lower female participation.
NEGATIVE RELATIONSHIP
OR both men and women are more assertive/competitive. POSITIVE
RELATIONSHIP

Uncertainty avoidance
- level of comfort in ambiguity and unstructured situations.
- Establish rules (e.g. saving) to cope. POSITIVE RELATIONSHIP
OR Not comfortable with volatility so delegate to financial intermediary
NEGATIVE RELATIONSHIP
Always question everything…

• How did Hofstede come up with these

measures?
– What data was used to establish these measures?
Surveyed 117,000 IBM employees in 50 countries
in the 1960’s-1970’s
– What else binds /shapes countries? Economics e.g.
EU, ASEAN.
– How much homogeneity is there within countries?
– Can culture change over time? globalisation,
Deflation in japan, political instability in Argentina
Behavioural finance lessons
for financial planners
• Understand how people think- Help clients to
use a more rational System 2 thought process.
• In volatile times, be careful of the language
used with clients. Focus on the big picture story
(together with facts).
• Understanding biases can help FPs develop
personalised financial plans
• Avoid decision paralysis. Don’t overwhelm
clients with too many options/decisions. Present
smaller choice sets