Module 3

Interaction between Biases

• Biases can never be independent, rather they interact with each
other.
• Each decision is a result of multiple biases
• Some biases are
• complementary or two way in nature
• Never occur together
• Opposites to each other
EGS
• Complementary relationship between status quo and familiarity bias
• An investor who invests in a stock familiar to him may reluctant to
choose a stock he is less familiar with
• Independent Bias – Recency
• Opposite - Herd behaviour / Regret aversion
• Pessimism / over optimism
Outcome of biases
• Outcome can be intermediate or final
• Intermediate outcome: it involves certain illusions that may impact the speed
with which decisions are made.
• Overconfidence or over-optimisim could lead to quick and aggressive decision making
behaviour.
• Representative bias could create a situation, where investor feels that the decision made
by him is right
• Final outcome: decisions taken are irrational or suboptimal
• The prices at the market level may not reflect the actual value of the assets and hence fail to
predict appropriate returns.
• Certain investment decisions that involves huge sum of money may lead to escalation of
commitment, resulting in fear or loss of reputation.
• Get into the vicious circle of inappropriateness or bias
Dealing with biases
• Due to various biases, all investment decisions tend to ignore
available data and base them on previous experiences
• Actual risks are misjudged and importance of information reduces
• This may result in false sense of security, reduced vigilance and
resultant surprise losses.
• Investor may find difficulty in processing market signals and may not
differentiate between noise and price signals.
• Azzopardi (2012) presents three parameters to be evaluated and
optimized while taking investment decision.
• Opportunity cost of money or other resource invested
• Time regarding entry or exit
• High probability winning trade
Overcoming the Biases and debiases
• Internally generated biases can be easily controlled.
• But under all situations, they may not be able to control their internal
bias. Opoldki and potocki (2001) gave few suggestions
• Rizzi (2003) offers below options as remedies to deal with biases
• Limits to new products and markets
• Second opinion
• List as many possible scenarios
• Not to blindly follow experts
• Avoid herding
• Postmortem analysis
• Conduct independent investigation
• https://www.raymondjames.com/mind-matters
Debiasing
• It is a procedure to reduce or eliminate bias of a decision maker
• Bhandari and Hassanein (2010) – debiasing is learning from past,
watching the present and creating a future.
• Steps involved in debiasing:
• Identification of the existence and nature of potential bias
• Considering ways and impact to lower its impact
• Evaluation of the effectiveness of the selected technique
Behavioral aspects of investing
Psychographic model:
• It classifies individuals with respect to certain characteristics,
tendencies or behaviour
• Investors background and past experiences are important variables in
decision making
• If a psychographic profile of an investor is known, it may help to
understand his investment decision pattern
Important psychographic models
• Barnewall’s (1987) two way model
• A simple and non-invasive review of investors personal history and
career record can provide valuable insights about their investment
habit.
• https://www.investopedia.com/terms/a/activities-interests-and-opini
ons.asp
• https://instapage.com/blog/psychographic-segmentation
• https://www.investright.org/informed-investing/know-yourself/perso
nality-quiz/
• The model is often criticised as being over simplified
• It categories the investors on two opposite and extreme ends
• In reality, the behavioural patterns of investors are complex and
difficult to describe.
• Bailard, Biehl, and Kaiser five –way model
Model describes five investor personality
types
Behavioural portfolio theory
• Behavioral portfolio theory (BPT), put forth in 2000 by Shefrin and
Statman,provides an alternative to the assumption that the ultimate motivation
for investors is the maximization of the value of their portfolios.
• It suggests that investors have varied aims and create an investment portfolio that
meets a broad range of goals.
• It does not follow the same principles as the capital asset pricing model, modern
portfolio theory and the arbitrage pricing theory.
• A behavioral portfolio bears a strong resemblance to a pyramid with distinct layers.
• Each layer has well defined goals. The base layer is devised in a way that it is
meant to prevent financial disaster, whereas, the upper layer is devised to attempt
to maximize returns, an attempt to provide a shot at becoming rich.
The Case for ‘Behavioral’ Portfolio Theory
By Meir Statman

• A segment of “60 minutes,” the television program, featured Leona and

Harry Helmsley, owners of the Helmsley Palace Hotel and 200 other New
York buildings. Leona described the expressive and emotional benefits they
derive from their wealth as they stand on a hotel balcony overlooking New
York’s Central Park. Harry points at buildings and says: “I’m taking inventory. I
own this, I own this, and that one, and that one.”  
• Behavioral portfolio theory describes portfolios on behavioral-wants frontiers
and prescribes them to investors whose wants extend beyond the utilitarian
benefits of high expected returns and low risk, to expressive and emotional
benefits such as those of demonstrating sincere social responsibility, high
social-status, hope for riches, and protection from poverty.
• People are not likely to distinguish an 80% probability of reaching a
goal from a 90% probability, but they are likely to distinguish
something they need(food) from something they merely want (pizza),
and something they wish they had (regret) from something they
dream they will have (aspiration).
• The process of sequencing “goals to reach” and “circumstances to
avoid” transforms advisers from experts at investment management
or estate planning to competent and caring professionals, good at
eliciting clients’ wants and associated goals and helping clients satisfy
them.
• The portfolio pyramid
• A central feature in behavioral portfolio theory rests on the observation that
investors view their portfolios as sets of distinct mental account layers in a
portfolio pyramid. Each mental account corresponds to a particular want,
associated goal, and their utilitarian, expressive and emotional benefits.
• An optimal behavioral-wants portfolio is one that balances wants while
avoiding cognitive and emotional errors. Consider a 50-year-old investor
with a $1-million portfolio, described by Harry Markowitz, Meir Statman and
two of their colleagues. She divides her portfolio into three mental accounts
of wants and associated goals, specified as target wealth at target dates. She
places:
• $800,000 in a mental account dedicated to retirement spending, with
a $1,917,247 target wealth goal, implying a 6% annualized return
during the 15 years till the target date.
• $150,000 in a mental account dedicated to education expenses, with
an $188,957 target wealth goal, implying a 8% annualized return
during the 3 years till the target date.
• $50,000 in a mental account dedicated to bequest money, with an
$850,003 target wealth goal, implying a 12% annualized return during
the 25 years till the target date.
• Each mental account is optimized by the mean-variance procedure,
where risk is measured by the standard deviation of returns.
• The presentation of the portfolio as a whole, with the sum of the
three mental accounts has an advantage over a sole presentation of
the portfolio as a whole. The mental accounts presentation speaks the
language of normal investors. Investors want to reach their goals, not
only have portfolios on the mean-variance frontier.
• Wants-based mental accounts let investors articulate each want and
associated goal, the target wealth at the target date, and the attitude
toward risk, measured by standard deviation, in the mental account of
each want and associated goal.
Sound Investment Philosophy
• An investment philosophy is a set of beliefs and principles that guide
an investor's decision-making process. Some popular investment
philosophies include:
• Value investing which involves seeking stocks that an investor believes are
currently underpriced by the market and whose prices the investor expects
will eventually rise significantly.
• Fundamentals investing, which relies on identifying companies with strong
earnings prospects.
• Growth investing in which investors buy shares of companies whose products
or services hold the potential to generate strong earnings growth and higher
stock prices in the future.
• Socially-responsible investing, which focuses on investing in companies whose
practices align with an investor's values as they pertain to the company's
impact on society and the environment.
• Technical investing which relies on the examination of past market data to uncover
hallmark visual patterns in trading activity on which to base buy and sell decisions.
• Investment philosophies are one of the defining characteristics of
people or firms that manage money.
• Most investors who achieve long-term success develop and refine
their investment philosophies over time and do not frequently switch
between philosophies as market conditions change.