MODULE-III

PORTFOLIO EVALUATION AND BEHAVIOURAL FINANCE

PORTFOLIO REVISION

In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which lads to the
construction of the optimal portfolio. Very little discussion is seen on portfolio revision which is as important as portfolio
analysis or selection.
The financial markets are continually changing. In this dynamic environment, a portfolio that was optimal when constructed may
not be so with the passage of time. It may have to be revised periodically so as to ensure that it remains optimal.
NEED FOR REVISION
The primary factor necessitating portfolio revision is changes in the financial markets since the creation of the portfolio.
The need for portfolio revision may arise because of some investor related factors also. These factors may be listed as:
• Availability of additional funds for investment.
• Change in risk tolerance
• Change in investment goals
• Need to liquidate a part of the portfolio to provide funds for some alternative use.

The portfolio needs to be revised to accommodate the changes in the investor’s position.
Thus the need for portfolio revision may arise from changes in the financial market or changes in the investor’s position, namely,
his financial status and preferences.
.MEANING OF PORTFOLIO REVISION
A portfolio is a mix of securities selected from a vast universe of securities. Two variables determine the composition of
a portfolio; the first is the securities included in the portfolio and the second is the proportion of total funds invested in each
security.
Portfolio revision involves changing the existing mix of securities. This may be effected either by changing the securities
currently included in the portfolio or by altering the proportion of funds invested in the securities. New securities may be added
to the
portfolio or some of the existing securities may be removed from the portfolio. Portfolio revision thus leads to the purchases and
sales of the securities. The objective of portfolio revision is the same as selection i.e. maximization of returns for a given level of
risk or minimizing the risk for a given level of return. The ultimate aim of portfolio revision is maximization of returns and
minimization of risk.
CONSTRAINTS IN PORTFOLIO REVISION
Portfolio revision is the process of adjusting the existing portfolio in accordance with the changes in the financial
markets and the investor’s position so as to ensure maximum return from the portfolio with the minimum of risk. Portfolio
revision necessitates purchase and sale of securities. The practice of portfolio adjustment involving purchase and sale of
securities gives rise to certain problems which act as constraints in portfolio revision. Some of these are discussed below:
• Transaction cost: Buying and selling of securities involve transaction costs such as commission and brokerage.
Frequent buying and selling of securities for portfolio revision may push up transaction costs thereby reducing the gains
from portfolio revision. Hence, the transaction costs involved in portfolio revision may act as a constraint to timely
revision of portfolios.
 • Taxes: Tax is payable on the capital gains arising from sale of securities. Usually, long-term capital gains are taxed at a
lower rate than short-term capital gains. To qualify as long-term capital gain, a security must be held by an investor for a
period of not less than 12 months before sale. Frequent sale of securities in the course of periodic portfolio revision or
adjustment will result in short-term capital gains, which would be taxed at a higher rate compared to long-term capital
gains. The higher tax of short-term capital gains may act as a constraint to frequent portfolio revisions.
• Statutory stipulations: The large portfolios in every country are managed by investment companies and mutual funds.
These institutional investors are normally governed by certain statutory stipulations regarding their investment activity.
These stipulations often act as constraints in timely portfolio revision.
• Intrinsic difficulty: Portfolio revision is a difficult and a time consuming exercise. The methodology to be followed for
portfolio revision is also not clearly established. Different approaches may be adopted for the purpose. The difficulty of
carrying out portfolio revision itself may act as a constraint to portfolio revision.

PORTFOLIO REVISION STRATEGIES

Two different strategies may be adopted for portfolio revision, namely, an active revision strategy and a passive revision
strategy. The choice of the strategy would depend on the investors objectives, skills, resources and time.
Active revision strategy involves frequent and sometimes substantial adjustments to the portfolio. Investors who take
active revision strategy believe that the securities markets are not continuously efficient. They believe that the securities can be
mispriced at times giving an opportunity for earning excess returns through trading in them. Moreover, they believe that different
investors have divergent expectations regarding the risk and return of the securities in the market. The practitioners of the active
revision strategy are confident of developing a better estimate of the true risk and return of the security than the rest of the
market. They hope to use their better estimated to generate excess returns. Thus the objective of active revision strategy is to beat
the market.
Portfolio revision strategy, in contrast, involves only minor and infrequent adjustments to the portfolio over time. The
practitioners of passive revision strategy believe in market efficiency and homogeneity of expectation among investors. They
find little incentive for actively trading and revising portfolios practically.
Under passive revision strategy, adjustment to the portfolio is carried out according to certain predetermined rules and
procedures designated as Formula Plans. These Formula Plans help the investor to adjust his portfolio according to changes in the
securities market.

FORMULA PLANS:
In the market the prices of securities fluctuate. Ideally, investors should buy when prices are low and sell when prices are high. If
portfolio revision is done according to this principle, investors would be able to benefit from the price fluctuations in the
securities market. But investors are hesitant to buy when prices are low either expecting the prices to fall further or fearing that
the prices would not move further up again. Similarly, when prices are high, investors hesitate to sell because they feel that the
prices will fall further and they may realize larger profits.
Thus, left to themselves, investors will not be acting in a way required to benefit from price fluctuations. Hence certain
mechanical revision techniques have been developed to enable the investor to take advantage of the price fluctuations in the
market. The technique is referred as Formula Plans.
Formula plans represent an attempt to exploit the price fluctuations in the market and make them a source of profit to the
investor. They make the decisions on the timing of buying and selling securities automatically and eliminate the emotions
surrounding the timing decisions. Formula plans consist of predetermined rules regarding when to buy or sell and how much to
buy and sell. These predetermined rules call for specific actions when there are changes in the securities market.
There are different formula plans for implementing passive portfolio revision. Some of them are enumerated below: -
Constant Rupee Value Plan:
This is one of the most commonly used formula plans. In this plan the investor constructs two portfolios, one aggressive
consisting of equity shares and the other one defensive consisting of bonds and debentures. The purpose of this plan is to keep
the value of the aggressive portfolio constant, i.e. at the original amount invested in the aggressive portfolio.
As share prices fluctuate, the value of the aggressive portfolio keeps changing. When share prices are increasing, the total value
of the aggressive portfolio increases. The investor has to sell some of his shares from his portfolio to bring down the total value
of the aggressive portfolio to the level of his original investment in it. The sale proceeds will be invested I the defensive portfolio
by buying bonds and debentures
On the contrary, when share prices are falling, the total value of the aggressive portfolio would also decline. To keep the total
value of the aggressive portfolio at its original level, the investor has to buy some shares from the market to be included in his
portfolio. For this purpose, a part of the defensive portfolio will be liquidated to raise the money needed to buy additional shares.
Under this plan, the investor is effectively transferring funds from the aggressive portfolio to the defensive portfolio and thereby
booking profit when share prices are increasing. Funds are transferred from the defensive portfolio to the aggressive portfolio
when share prices are low. Thus the plan helps the investor to buy shares when their prices are low and sell them when their
prices are high.
In order to implement this plan, the investor has to decide the action points, i.e., when he should make the transfer of funds to
keep the rupee value of the aggressive portfolio constant. These action points, or revision points, should be predetermined and
should be chosen carefully. The revision points have a significant effect on the returns of the investor. For instance, the revision
points may be predetermined as 10 per cent, 15 per cent, 20 per cent etc. above or below the original investment in the aggressive
portfolio. If the revision points are too close, the number of transactions would be more and the transaction costs would increase
reducing the benefits of revision. If the revision points are set too far apart, it may not be possible to profit from the price
fluctuations occurring between these revision points.

Example: We can understand the working of the “constant rupee value plan” by considering an example. Let us consider an
investor who has Rs. 1,00,000 for investment. He decides to invest Rs. 50,000 in an aggressive portfolio of equity shares and the
remaining Rs. 50,000 in a defensive portfolio of bonds and debentures. He purchases 1250 shares selling at Rs. 40 per share for
his aggressive portfolio. The revision points are fixed as 20 per cent above or below the original investment of Rs. 50,000.
After the construction of the portfolios, the share price will fluctuate. If the price of the share increases to Rs. 45, the value of the
aggressive portfolio increases to Rs. 56,250 (that is, 1250 x Rs. 45). Since the revision points are fixed at 20 per cent above or
below the original investment, the investor will act only when the value of the aggressive portfolio increases to Rs. 60,000 or
falls to Rs. 40,000. If the price of the share increases to Rs. 48 or above, the value of the aggressive portfolio will exceed Rs.
60,000. Let us suppose that the price of the share increases to Rs. 50, the value of the aggressive portfolio will be Rs. 62,500. The
investor will sell shares worth Rs. 12,500 (that is 250 shares at Rs. 50 per share) and transfer the amount to the defensive
portfolio by buying bonds for Rs. 12,500. The value of the aggressive and defensive portfolios would now be Rs. 50,000 and Rs.
62,500 respectively. The aggressive portfolio now has only 1000 shares valued at Rs. 50 per share.
Let us now suppose that the share price falls to Rs. 40 per share. The value of the aggressive portfolio would then be Rs. 40,000
(i.e., 1000 shares x Rs. 40) which is 20 per cent less than the original investment. The investor now has to buy shares worth Rs.
10,000 (that is, 250 shares at Rs. 40 per share) to bring the value of the aggressive portfolio to its original level of Rs. 50,000.
The money required for buying the shares will be raised by selling bonds from the defensive portfolio.
The two portfolios now will have values of Rs. 50,000 (aggressive) and Rs. 52,500 (i.e., Rs. 62,500 - Rs. 10,000) (defensive),
aggregating to Rs. 1,02,500. It may be recalled that the investor started with Rs. 1,00,000 as investment in the two portfolios.
Thus, when the `constant rupee value plan' is being implemented, funds will be transferred from one portfolio to the other,
whenever the value of the aggressive portfolio increases or declines to the predetermined levels.
Constant Ratio Plan
This is a variation of the constant rupee value plan. Here again the investor would construct two portfolios, one aggressive and
the other defensive with his investment funds. The ratio between the investments in the aggressive portfolio and the defensive
portfolio would be predetermined such as 1:1 or 1.5:1 etc. The purpose of this plan is to keep this ratio constant by readjusting
the two portfolios when share prices fluctuate from time to time. For this purpose, a revision point will also have to be
predetermined. The revision points may be fixed as ± 0.10 for example. This means that when the ratio between the values of the
aggressive portfolio and the defensive portfolio moves up by 0.10 points or moves down by 0.10 points, the portfolios would be
adjusted by transfer of funds from one to the other.
Let us assume that an investor starts with Rs. 20,000, investing Rs. 10,000 each in the aggressive portfolio and the defensive
portfolio. The initial ratio is then 1:1. He has predetermined the revision points as ± 0.20. As share price increases the value of
the aggressive portfolio would rise. When the value of the aggressive portfolio rises to Rs. 12,000, the ratio becomes 1.2:1 (i.e.,
Rs. 12,000: Rs. 10,000). Shares worth Rs. 1,000 will be sold and the amount transferred to the defensive portfolio by buying
bonds. Now the value of both the portfolios would be Rs. 11,000 and the ratio would become 1:1.

Now let us assume that the share prices are falling. The value of the aggressive portfolio would start declining. If, for instance,
the value declines to Rs. 8,500, the ratio becomes 0.77:1 (i.e., Rs. 8.500: Rs. 1,000). The ratio has declined by more than 0.20
points. The investor now has to make the value of both portfolios equal. He has to buy shares worth Rs. 1,250 by selling bonds
for an equivalent amount from his defensive portfolio. Now the value of the aggressive portfolio increases by Rs. 1.250 and that
of the defensive portfolio decreases by Rs. 1,250. The values of both portfolios become Rs. 9,750 and the ratio becomes 1:1.The
adjustment of portfolios is done periodically in this manner.
Dollar Cost Averaging
This is another method of passive portfolio revision. This is, however, different from the two Formula Plans discussed above. All
Formula Plans assume that stock prices fluctuate up and down in cycles. Dollar cost averaging utilizes this cyclic movement in
share prices to construct a portfolio at low cost.
The Plan stipulates that the investor invest a constant sum, such as Rs. 5,000, Rs. 10,000, etc, in a specified share or portfolio of
shares regularly at periodical intervals, such as a month, two months, a quarter, etc. regardless of the price of the shares at the
time of investment. This periodic investment is to be continued over a fairly long period to cover a complete cycle of share price
movements.
If the Plan is implemented over a complete cycle of stock prices, the investor will obtain his shares at a lower average cost per
share than the average price prevailing in the market over the period. This occurs because more shares would be purchased at
lower prices than at higher prices.
The Dollar Cost Averaging is really a technique of building up a portfolio over a period of time. The Plan does not envisage
withdrawal of funds from the portfolio in between. When a large portfolio has been built up over a complete cycle of share price
movements, the investor may switch over to one of the other formula plans for its subsequent revision. The “dollar cost
averaging” is specially suited to investors who have periodic sums to invest.
The various formula plans attempt to make portfolio revision a simple and almost mechanical exercise enabling the investor to
automatically buy shares when their prices are low and sell them when their prices are high. But formula plans have their
limitations. By their very nature they are inflexible. Further, these plans do not indicate which securities from the portfolio are to
be sold and which securities are to be bought to be included in the portfolio. Only active portfolio revision can provide answers
to these questions
PERFORMANCE EVALUATION OF PORTFOLIO

Portfolio evaluation is the last step in the process of portfolio management. Portfolio analysis, selection and revision
are undertaken with the objective of maximising returns and minimising risk. Portfolio evaluation is the stage where we
examine to what extent the objective has been achieved. Through portfolio evaluation the investor tries to find out how well
the portfolio has performed. The portfolio of securities held by an investor is the result of his investment decisions. Portfolio
evaluation is really a study of the impact of such decisions. Without portfolio evaluation, portfolio management would be
incomplete.

Two decades ago portfolio evaluation was not considered as an integral part of portfolio management. Portfolio evaluation has
evolved as an important aspect of portfolio management over the last two decades. Moreover, the evaluation process itself has
changed from crude return calculations to rather detailed explorations of risk and return and the sources of each.

MEANING OF PERFORMANCE EVALUATION OF PORTFOLIO

Portfolio evaluation refers to the evaluation of the performance of the portfolio. It is essentially the process of
comparing the return earned on a portfolio with the return earned on one or more other portfolios or on a benchmark portfolio.
Portfolio evaluation essentially comprises of two functions, performance measurement and performance evaluation.
Performance measurement is an accounting function which measures the return earned on a portfolio during the holding
period or investment period. Performance evaluation, on the other hand, addresses such issues as whether the performance was
superior or inferior, whether the performance was due to expertise or fortune etc.
While evaluating the performance of a portfolio, the return earned on the portfolio has to be evaluated in the context of the
risk associated with that portfolio. One approach would be to group portfolios into equivalent risk classes and then compare
returns of portfolios within each risk category. An alternative approach would be to specifically adjust the return for the
riskiness of the portfolio by developing risk adjusted return measures and use these for evaluating portfolios across differing
risk levels.
NEED FOR EVALUATION
The individuals may carry out their investment on their own. The funds available with individual investors
may not be large enough to create a well diversified portfolio of securities. Moreover, the t ime, skill and other
resources at the disposal of individual investors may not be sufficient to manage the portfolio professionally.
Institutional investors such as mutual funds and investment companies are better equipped to create and manage
well diversified portfolios in a professional manner. Hence, small investors may prefer to entrust their funds with
mutual funds or investment companies to avail the benefits of their professional services and thereby achieve
maximum return with minimum risk and effort.
Evaluation is an appraisal of performance. Whether the investment activity is carried out by individual investors
themselves or through mutual funds and investment companies, different situations arise where evaluation of
performance becomes imperative. These situations are discussed below.

Self Evaluation:
While individual investors undertake the investment activity on their own, the investment decisions are taken by them. They
construct and manage their own portfolio of securities. In such a situation, the investor would like to evaluate the performance
of his portfolio in order to identify the mistakes committed by him. This self evaluation will enable the investor to improve his
skills and achieve better performance in future.
Evaluation of Portfolio Managers:
A mutual fund or investment company usually creates different portfolios with different objectives aimed at different sets of
investors. Each such portfolio may be entrusted to different Professional Portfolio Managers who are responsible for the
investment decisions regarding the portfolio entrusted to each of them. In such a situation, the organisation would like to
evaluate the performance of each portfolio so as to compare the performance of the different portfolio managers.
Evaluation of Mutual Funds:
In India, at present, there are many mutual funds as also investment companies operating both in the public sector as well as
in the private sector. These compete with each other for mobilising the investment funds with individual investors and other
organisations by offering attractive returns, minimum risk, high safety and prompt liquidity. Investors and organisations
desirous of placing their funds with these mutual funds would like to know the comparative performance of each so as to
select the best mutual fund or investment company. For this, evaluation of the performance of mutual funds and their
portfolios becomes necessary.
Evaluation of Groups:
As academics or researchers, we may want to evaluate the performance of a whole group of investors and compare it
with another group of investors who use different techniques or who have different skills or access to different
information.
EVALUATION PERSPECTIVE
A portfolio comprises several individual securities. In the building up of the portfolio several transactions of purchase
and sale of securities take place. Thus several transactions in several securities are needed to create and revise a portfoli o of
securities. Hence the evaluation may be carried out from different perspectives or viewpoints such as a transactions view,
security view or portfolio view.
Transaction View:
An investor may attempt to evaluate every transaction of purchase and sale of securities. Whenever a security is bought or
sold, the transaction is evaluated as regards its correctness and profitability.
Security View:
Each security included in the portfolio has been purchased at a particular price. At the end of the holding period, the marke t
price of the security may be higher or lower than its cost price or purchase price. Further, during the holding period, interest or
dividend might have been received in respect of the security. Thus it may be possible to evaluate the profitability of holdin g
each security separately. This is evaluation from the security view point.
Portfolio View:
A portfolio is not a simple aggregation of a random group of securities. It is a combination of carefully selected securities,
combined in a specific way so as to reduce the risk of investment to the minimum. An investor may attempt to evaluate the
performance of the portfolio as a whole without examining the performance of individual securities within the portfolio. This
is evaluation from the portfolio view.
Though evaluation may be attempted at the transaction level, or the security level, such evaluations would be incomplete,
inadequate and often misleading. Investment is an activity involving risk. Proper Evaluation of the investment activity must
therefore consider return along with risk involved. But risk is best defined at the portfolio level and not at the security level or
transaction level. Hence the best perspective for evaluation is the portfolio view.
Risk adjusted return
The obvious method of adjusting risk is to look at the reward per unit of the risk. It is a known fact that investment in
shares is risky. Risk free rate of interest is the return that an investor can earn on a riskless security, i.e., without bea ring any
risk. The return earned over and above the risk free rate is the risk premium that is the reward for bearing risk. If this risk
premium is divided by a measure of risk, we get the risk premium per unit of risk. Thus the reward per unit of risk for
different portfolios may be calculated and the funds may be ranked in the descending order of the ratio. A higher ratio
indicates a better performance. The two methods to measure risk are: -
Sharpe Ratio:
It is the ratio of the reward or risk premium to the variability of return or risk as measured by the variance of the return.
Treynor Ratio:
It is the ratio of reward to the volatility of return as measured by the portfolio beta.
Portfolio Evaluation completes the cycle of activities comprising portfolio management. It provides a mechanism for
identifying weakness in the investment process and for improving the deficient areas. Thus portfolio evaluation would serve as
a feedback mechanism for improving the portfolio management process.

PSYCHOLOGICAL TRAITS AFFECTING INVESTING DECISION

Modern portfolio theory assumes that the investors are rational investors and invest only in efficient and optimal portfolios that
provide the maximum return for minimum risk. The truth (as posited by Behavioural Economists) is that the investors far from
rational and are subject to a myriad of psychological influences and behaviours that prevent the investors from not only making
optimal investment or business decisions, but can in some cases turn us into morons. The investors buy and hold too long or buy
and sell too quickly; they refuse to accept losses assuming that they will recover our money or they sell losing investments way
too soon; they are overconfident about their own abilities or place too much trust in “experts”; they maintain the status quo and
do nothing or they change things too frequently. The dichotomies of investing behaviour are numerous and fascinating and have
lead to creation of field of study referred to as Behavioural Economics. Some of these behaviours are discussed below:

Representative Bias:

Investors tend to make judgements based on stereotypes, which often leads them be too optimistic about winners and too
pessimistic about losers. The use of stereotypes is more pervasive than we think, as it helps us to make decisions in the face of
information overload. This, however, can lead to bad business decisions. It is simply not true that all purple people are excellent
accountants.
Overconfidence

Overconfidence, i.e. thinking that you are smarter than everybody else (even though you are) can be detrimental to your portfolio
and business. Hubris and arrogance have led to the downfall of many successful business owners and investors (although Donald
Trump apparently continues to thrive). Not all of us can be experts in everything.

Over Optimism/Irrational Exuberance:

Thinking that the stock market is going to continue to rise or that your business is going to thrive in the absence of profits and
positive cash flows can be foolhardy. The lessons of dot com bubble still loom large with many investors as they watched their
investment portfolios, and their businesses (pets.com), melt away.

Anchoring and Adjustment:

This refers to the behaviour where people tend to place too much stock in their first impressions and do not react appropriately to
new information. This has bitten many investors and business owners in the ass. I imagine Bernard Madoff made a great first
impression as do many interview candidates. I fell victim to this behaviour when I hired someone who came off as being
fantastic, and turned out to be, possibly, the worst employee ever. I should have taken action sooner, however it was hard to let
go of my first impression and admit that I was so wrong.

Aversion to Ambiguity

Investors like to invest in, and do business, with businesses that they know. One of the most common and most egregious
mistakes is to invest too heavily in your employer, as employees at GM discovered in 2008, when the stock was delisted. Poor
stock performance is often an indication of trouble within the organization. Worst case scenario you lose your retirement savings
and your job at the same time. Business people, similarly, tend to have a hard time letting go of suppliers, employees etc. that are
performing poorly as it can easier to deal with the “devil you know”

Loss Aversion

As we tend to experience losses more intensely than gains, we engage in behaviours to avoid feeling this pain. We might not
sell an investment, despite deterioration in fundamentals in the same way that we might not phase out a losing product line in the
hopes that there will be a turnaround. However, sometimes, it is time to cut your losses.

Self Control

People impose limits on themselves that make no sense. For example you might have a stop loss order on equities that fall more
than 5%. Similarly, you might not hire someone because they failed to answer one question to your satisfaction. In both cases,
the right decision requires a slightly more reasoned and holistic evaluation.

Regret Minimization:

The pain of loss combined with the pain of being responsible for the decision that caused the loss leads to regret and often results
in irrational behaviour. You may allocate your investments on some arbitrary measure that takes the decision making out of it, or
you may decide not to start your own business because you don’t want to be responsible for failure. Either way, the decision is
an emotional one.

Self Attribution Bias

This refers to taking credit for good decisions and blaming others for bad ones and in addition to being somewhat delusional, can
result in terrible investing, business and life decisions. You portfolio went up because you are so great, but it went down because
your portfolio manager sucks. Blaming your employees for your business failures, while taking credit for its success, is another
example of this.

EXPLAINING BIASES

Traditional portfolio choice models imply a simple investment strategy based on well-diversified, low expense mutual funds and
minimal portfolio rebalancing. Index and other low-fee, low-turnover equity funds are cheap, convenient vehicles for individual
investors to implement such a strategy. The purpose of the study "Behavioral Biases of Mutual Fund Investors" was to test
whether behavioral biases explain why the use of mutual funds varies substantially across individual investors and often departs
from the simple strategies suggested by classic theories.

• Investors with strong behavioral biases or lack of attention to firm-specific or macro-economic news are less likely to
hold mutual funds, or select mutual funds for the wrong reasons. When they do buy mutual funds, they trade them
frequently, tend to time their buys and sells badly, and prefer high expense funds and active funds instead of index funds.
• Biased investors are more likely to chase fund performance, casting doubt on the idea that trend-chasing reflects rational
fund selection decisions.
• These decisions are suboptimal because they're associated with lower overall returns.
• Interestingly, behavioral biases don't appear to affect the performance of index fund holdings.

Investors are of five broad categories, or stereotypes, they characterized as "gambler", "smart", "overconfident",
"narrow-framer", and "mature." Here are the breakdowns of these categories.

Gamblers: Gamblers represent individuals who are:

• Less likely to use mutual funds

• Tend to select high-expense funds
• Are more likely to trend-chase, and suffer significantly inferior mutual fund portfolio performance as a consequence

Gamblers employ mutual funds less than they probably should, but, when they do, they make poor use of them.

Smart: Smart describes investors with higher income, relatively higher educational level, and greater investment experience. It
also represents individuals who are more likely to use mutual funds and benefit from their choices by choosing funds with low
expense ratios or loads, and are less likely to trend-chase - and thus enjoy better performance.
Overconfident: Overconfident describes investors who are poor decision makers, avoid participation in mutual funds and chase
trends to an even greater degree than Gamblers. They also tend to select high expense, high load, and high turnover funds.

Narrow Framers: Narrow Framers' mutual fund participation is about as bad as Gamblers' participation, though not as bad as
those in the Overconfident category. Small holdings of mutual funds, selection of high expense funds, trend chasing and
consequent poor performance are also evident, though milder than for Gamblers and Overconfident investors.

Mature: Mature investors participate and hold mutual funds to a greater extent than our other stereotypes and avoid high-
expense funds and trend chasing to an even greater extent than those in the Smart category. However, there are other elements of
Mature investors decision making about mutual funds that yield significant negatives on other performance measures, negatively
impacting performance.

This study contributes to what was an already overwhelming body of evidence demonstrating that most investors make poorly
informed decisions impacted by both behavioral biases and ignorance. It suggest that "given the misuse of equity mutual funds, a
public campaign to increase awareness of basic investment principles and the benefits and pitfalls of equity mutual funds is likely
to help many types of individual investors make better decisions. Furthermore, the lack of attention to low cost or index funds
suggests more explicit disclosure of fund expenses and turnover, perhaps even as prominent as the health warnings now
displayed on packets of cigarettes. Finally, the reliance of mutual fund investors on broker-supplied information at the time a
fund is selected and on delegated investment decisions afterwards suggests that even more explicit disclosure of fund
characteristics be imposed on brokerage firms and fund managers."

FUSION INVESTING

Fusion investing and analysis combines fundamental, technical and behavioral investing with no regard to traditional asset
classes. Fusion draws on all the investing schools, taking the best tools and concepts from each. Fusion is a lattice work of ideas
drawn from investing, psychology, mathematics, accounting, economics, gardening and the very own knowledge set and mental
models.

Fusion Investing and Analysis combines fundamental and technical analysis with lashings of behavioral finance.

Fusion investing share key insights on how to fuse investors investing tools into a powerful toolset.

There are many paths to investing success. There are many tools to assist with the investors investing journey. Fusion Investing is
all about choosing which path and tools are best for investors. Many investment advisors and experts claim their path is the only
path to investment success or long term wealth accumulation. Their path may be right for them, but it is folly to believe it is the
only path. There is a best path for each person. Fusion investing combines elements from many investment schools; the
combination is varied depending on the practitioner.

Fusion investing combines growth and value. It also seek the best tools and methods from fields which analysts consider
diametrically opposed. It combine elements from fundamental and technical analysis. Another important tool in fusion analysis
is investor sentiment. Benjamin Graham, the father of security analysis, said “In the short run the market is a voting machine, and
in the long run it is a weighing machine”. Fusion investing is about profiting from understanding both the voting and the
weighing.

In summary fusion analysis and investing combines fundamental, technical and behavioural investing with no regard to
traditional asset classes or styles and profits from understanding both the voting and the weighing machine.
BUBBLES AND BEHAVIORAL ECONOMICS
Bubble

The term "bubble", in reference to financial crises, originated in the 1711–1720 British South Sea Bubble, and
originally referred to the companies themselves, and their inflated stock, rather than to the crisis itself. This was one of
the earliest modern financial crises.. The metaphor indicated that the prices of the stock were inflated and fragile –
expanded based on nothing but air, and vulnerable to a sudden burst, as in fact occurred. Some later commentators
have extended the metaphor to emphasize the suddenness, suggesting that economic bubbles end "All at once, and
nothing first, Just as bubbles do when they burst, though theories of financial crises such as debt-deflation and the
Financial Instability Hypothesis suggest instead that bubbles burst progressively, with the most vulnerable (most
highly-levered) assets failing first, and then the collapse spreading throughout the economy.

When the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive
from holding the asset. The Chicago Tribune of April 13th 1890, writing about the then mania in real-estate prices, described
"men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply
because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a
profit". Such behaviour is a feature of all bubbles.

Behavioural Economics
A branch of economics that concentrates on explaining the economic decisions people make in practice, especially when these
conflict with what conventional economic theory predicts they will do. Behaviourists try to augment or replace traditional ideas
of economic rationality with decision-making models borrowed from psychology. According to psychologists, people are
disproportionately influenced by a fear of feeling regret and will often forgo benefits even to avoid only a small risk of feeling
they have failed. They are also prone to cognitive dissonance, often holding on to a belief plainly at odds with new evidence,
usually because the belief has been held and cherished for a long time. Then there is anchoring: people are often overly
influenced by outside suggestion. People apparently also suffer from status quo bias: they are willing to take bigger gambles to
maintain the status quo than they would be to acquire it in the first place.

Traditional utility theory assumes that people make individual decisions in the context of the big picture. But psychologists have
found that they generally compartmentalise, often on superficial grounds. They then make choices about things in one particular
mental compartment without taking account of the implications for things in other compartments.

There is lots of evidence that people are persistently and irrationally overconfident. They are also vulnerable to hindsight bias:
once something happens they overestimate the extent to which they could have predicted it. Many of these traits are captured in
prospect theory, which is at the heart of much of behavioural economics.

BEHAVIORAL FINANCE AND EMH

Eugene Fama has set the benchmark for comparing the efficient market hypothesis (EMH) and behavioural finance
theories. He indicates that many alternatives to the EMH are unspecified. Quite rightly, he argues that alternative to
the efficient market hypothesis need to be well specified and testable. In particular, he suggest that much of the
evidence against markets being informationally efficient is, in fact, consistent with market efficiency – this is
especially so if anomalies are split evenly between under-reaction and over-reaction.
Under certain assumptions, the EMH maintains that asset prices reflect all the relevant information about the asset,
thus it is impossible for investors to get abnormal return and beat the market. The EMH implies that there is no
unexploited profitable opportunity in the finance market. Although the EMH provides a useful insight though which
we look at the financial market, the EMH fails to explain the more and more anomalies in the financial market. The
EMH provides little useful explanation about the recent financial crisis. The validity of EMH is questioned and the
confidence in the EMH is declines. Moreover, the EMH has even been criticized as the culprit of this financial crisis.
Given the criticism the EMH suffers, scholars have developed varieties of theories so as to explain the anomalies in
the financial market. Among these the most influential one is the behavioral finance. The behavioral finance studies
show the behavior of human beings affects asset prices and the financial market. Based on the assumption that
investors are sometimes irrational and the market is inefficient and that there are limits to arbitrage, the behavioral
finance overall gives better explanation concerning the anomalies in the financial market than the EMH. The
behavioral finance is a rapidly developing field in the financial economics.

MATHEMATICAL EXPLANATION OF BEHAVIORAL FINANCE

Mathematical probability has been used as a tool to address the need to model formally the fact that actors must often
act in the face of uncertainty – uncertainty about what the facts are and uncertainty about whether an action will bring
about an intended outcome. The traditional approach has been to treat uncertainty as an attribute of the knowledge,
and thus we have language such as probability that X is true and so forth.
Using homo communitstis, we can develop a different approach, which we term the behavioral approach. Knowing
and acting are distinct concepts, individuals are always acting; they can, tautologically, only act on what they take to
be the case. This is a relation between knowledge and action. For an actor, and therefore for those modeling actors, the
central question about any particular belief, regardless of the certainty of that belief, is the degree to which they are
prepared to act on it. This is the focus of economics and finance-prediction of what actors will do.
Thus there are two equally important distinctions:
1. What the actor takes to be the case; and
2. The degree to which the actor is prepared to act on what they take to be the case.
Preparedness to act on what they take to be the case is a fact about the actor, not about the knowledge. Traditionally,
all uncertainty has been considered a matter of knowledge uncertainty, with various mathematical models –
probability, kahneman and tversky’s w(p), fuzzy set theory and fuzzy logic and so on. The behavioral approach is to
keep the two distinctions separate, formally model preparedness to act and incorporate knowledge uncertainty insofar
at it is necessary or useful in calculating preparedness to act. What the actor take to be the case is modeled formally by
the parameter, we define the degree to which the actor is prepared to act on X as the behavioral certainty of X, denoted
β(x), with 0< β(x)≤1. In some cases, it may be that Bayesian probability or a modification of it such as w(p) accurately
models β, or is an input to its calculation, a question to be empirically determined. This allows us to generalize
prospect theory without using probability – a situation X with value v(x) and behavioral certainty β(x) has a net value
β(x) v(x). when β(x) = w(p), this reduces to w(p) v(x), the formulation in prospect theory.

TECHNICAL ANALYSIS AND BEHAVIOURAL FINANCE

Technical Analysis
Technical analysis is a financial term used to denote a security analysis discipline for forecasting the direction of prices
through the study of past market data, primarily price and volume. Behavioral finance and quantitative analysis incorporate
technical analysis, which being an aspect of active management stands in contradiction to much of modern portfolio theory.
The principle of technical analysis are derived from hundred of years of financial market data. Technicians using charts, study
technical indicators, moving averages, and look for forms such as lines of support, resistance, channels to forecast the
behavior of the securities.
Behavioral Finance
A theory stating that there are important psychological and behavioral variables involved in investing in the stock market that
provide opportunities for smart investors to profit. For example, when a certain stock or sector becomes "hot" and prices increase
substantially without a change in the company's fundamentals, behavioral finance theorists would attribute this to mass
psychology. They therefore might short the stock in the long term, believing that eventually the psychological bubble will burst
and they will profit.

The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors affect
prices and returns, creating market inefficiencies. It also investigates how other participants arbitrage such market inefficiencies.
Behavioral finance highlights inefficiencies such as under- or over-reactions to information as causes of market trends . Such
reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry and noise trading. Technical
analysts consider behavioral economics' academic cousin, behavioral finance, to be the theoretical basis for technical analysis.
Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in the bush"
paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to manifest itself in investor
behavior as a reluctance to sell shares or other equity, if doing so would result in a nominal loss. It may also help explain why
housing prices rarely/slowly decline to market clearing levels during periods of low demand.