Behavioral Finance 2022 Level III High Yield Notes

R02 Behavioral Finance and Investment Processes

Uses and limitations of classifying investors into personality types
Investors can be classified by their psychographic profile i.e. values, personality, attitudes
and interests.
The Ballad, Biehl, and Kaiser (BB&K) model classifies investors into five types based on
two axes of “investor psychology” – confident versus anxious and careful versus impetuous.

According to the Barnewall two-way model, there are two types of investors: active and
passive.
Active investors show the following traits:
 Earned wealth by risking own money (e.g. entrepreneur)
 Maintain control over investment decisions
 Have faith in own abilities
 Prefer risky asset allocation
 Aim for maximization of wealth by foregoing current lifestyle
 Take initiative
 Not reluctant to borrow money
Passive investors show opposite traits.
The behavioral investor types (BIT) classification, uses a top-down approach to bias
identification:
1. Interview the client to identify active or passive traits and risk tolerance.
2. Plot investor on active/passive scale and risk tolerance scale.
 Active investors: medium to high risk
 Passive investors: low risk
Note: Unlike the Barnewell model, which is binary (active/passive), this model has
two types of passive investors and two types of active investors.

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Behavioral Finance 2022 Level III High Yield Notes

If an investor is classified as an active investor in Step 1 but he exhibits low risk

tolerance in Step 2, then step 2 dominates, and we assume that he/she is a passive
investor.
3. Test for behavioral biases to identify behavioral biases in a client.
4. Classify investor into a behavioral investment type (BIT) to identify biases.
The following flow-chart demonstrates the process of classifying investors into a
BIT.

Limitations of classifying investors into personality types

An individual may:
 exhibit both cognitive and emotional biases at the same time.
 reflect the characteristics of multiple investor types.
 undergo behavioral changes over time.
 need unique treatment.
 act irrationally and in an unpredictable manner.
Biases associated with each behavioral investor type (BIT)

Basic type Passive Passive Active Active

Risk
Low Low to medium Medium to high High
tolerance

Investment
Conservative Moderate Growth Aggressive
style

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Behavioral Finance 2022 Level III High Yield Notes

Primary
Emotional Cognitive Cognitive Emotional
bias

BIT Passive Friendly Follower Independent Active

Preserver Individualist Accumulator
 follow others
 dislike losses  invest in popular  overestimate ability to
 entrepreneurial
 dislike change investments predict
 maintain views on  exhibit over-
 uneasy during  believe that their
market confidence in
times of stress forecasts about
their ability to
 probably future events  under-react to new
predict or
became wealthy were more information
succeed
passively accurate than  do not get corroboration
they actually were  do not save for
(through from other sources
future
inheritance)  respond  place higher weight to
 actively
 under-react to differently based information which is
how questions are involved in
new information readily available
decision-
framed  make decisions based
making 
 overestimate risk on personal
trade
tolerance classification
excessively

Emotional  loss aversion

biases  status-quo  overconfidence & self-  overconfidence
 regret aversion
 endowment attribution  self-control
 regret aversion

Cognitive  mental  availability  conservatism  illusion of

biases accounting  hindsight  confirmation control
 anchoring and  framing  availability
adjustment  representativeness

Investment  difficult to  may listen to  may listen to advice  most difficult to

advice advise advice  advisors should provide advise
 explain effects of  advisors should quantitative measures  explain effects
investment provide of investment
decisions on quantitative decisions on
various measures various
investment investment
goals goals

How behavioral factors affect adviser-client relationships

Understanding a client’s behavioral tendencies allow advisors to:
 better formulate financial goals.
 better understand the client before delivering any investment advice.
 formulate an appropriate asset allocation for the client.
 develop a stronger bond by satisfying clients.

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Behavioral Finance 2022 Level III High Yield Notes

Impact of behavioral factors on portfolio construction

Behavioral Factors/Biases Impact on Portfolio Construction

Status quo bias
Regret aversion and framing
biases
Overconfidence,
representativeness &
availability, status-quo, framing,
endowment biases
Regret aversion,
overconfidence, and disposition
effect (loss aversion) biases
Availability, illusion of control,
endowment, familiarity, and
status quo biases
Sticking with default portfolio allocation despite
changes in risk tolerance level or other circumstances.
Naïve diversification or 1/n strategy: Allocating an
equal amount of money to available investment
options regardless of the different risk profiles of
these options.
Investing in the familiar: A classic example is being
overweight in own-company stock.
Excessive trading which results in high transaction
costs and poor portfolio performance.
Investors invest a relatively high portion of their funds
in domestic stocks (Home bias)

Impact of behavioral factors on analysts

Behavioral Biases Remedial Actions

Factors
Overconfidence Overconfidence (often encouraged by Prompt and accurate
in forecasting complex models), representativeness, feedback, structure that
skills availability, hindsight rewards accuracy, learn to
use Bayes’ formula correctly.
Influence of Framing, anchoring, and adjustment Disciplined and systematic
company’s (analysis influenced by initial default approach
management position or anchor), availability
on analysis (greater importance to more easily
available information)

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Behavioral Finance 2022 Level III High Yield Notes

Analyst biases Access to excessive unstructured Focus on objective data,

in conducting information can lead to an illusion of systematic and structured
research knowledge bias ( a subset of approach, follow Standard V,
overconfidence bias) seek contrary facts and
Excessive information also feeds opinions
representativeness bias (classify new
information based on past
experiences)
Confirmation bias

How behavioral factors affect committee decision making

Social proof bias: Individuals are susceptible to social proof bias, due to which committee
members refrain from voicing their own opinions and adopt the group consensus.
Implications:
 Group members become overconfident among themselves, leading to excessive risk
exposure.
 Group decisions are more vulnerable to confirmation bias.
 Group member avoids divergent opinions to avoid unpleasant tensions within a
group.
Remedial Actions
 Individual views should be collected before the meeting.
 Committee composition should have diversity in culture, knowledge, skills,
experience, and thought processes.
 Chair of the committee should be impartial.
 Committee members should respect the opinions of each other.
 At least one member of a group should play the role of “devil’s advocate.”
How behavioral factors influence market behavior

Observed Market Behavioral Explanation

Behavior
Momentum or trending Herding behavior
effect Availability bias: more recent events easily recalled and given
relatively high weight (recency effect)
Hindsight bias leads to regret which results in a trend-
chasing effect
Bubbles Overconfidence bias (illusion of knowledge and self-
attribution) leads to allow underestimation of risk and over-
trading

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Behavioral Finance 2022 Level III High Yield Notes

Crashes Disposition effect in the context of loss aversion bias:

tendency to sell winners quickly and hold on to losers too
long
Value stocks outperform Halo effect: tendency of people to generalize positive
growth stocks in the long- views/beliefs about one characteristic of a product/person to
run another characteristic. The halo effect is similar to
representativeness bias which refers to classifying new
information based on past experiences

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