2014 CFA Level 3 Secret Sauce.pdf

Apply this concepts to myself Psycology in the way how to trade

Behavioral finance assumes invesotr employ a combination of traditional finance and psycological biases when making investment decisions. Behavioral finance attempts to explain why they make the decisions they make . Two general categories: Micro behavioral finance: in concerned with describing the decisions - making processes of indivdual . 2. Macro behavioral finance: Why markets deviate from traditional finance. This method recognise no body is REM Two focuses: micro ( why individuals deviate from traditional finance) macro

More mechanical method to arrive to the result

Individual can make rank from the best to the worst

REM will make decisions conforming to the for aximos of utility : Between any two choices, the individual prefers one over the other or is indifferent between them

Traditional finance: prescribe how investors should make decisions. Assumes investor exhibit risk aversion and make unbiased , utility maximizing decisions that a rational economic man (REM) would make : -Always seek a personal utiliymaximizing decision , based on all available information - Except for personal utility derived from helping others , serving in the military , serving in a religous capacity. Why the try to behave in the way that they do . They are optimal selfish

If the investor prefer choice x to choice y and prefers choice y to choice z, the investor will prefer choice x to choize z You can add up utility or divide up. It doesnt change the ranking, no affect the outcome of the ecuation. It could combine utilities to obtain something else

If the investor prefers x to y , adding any proportion (p) of z, the investor will prefer (x + pz) to (y + pz) Three choices, L , M , N. and investor prefers L to M , and M to N. There must be a combination of L and N (portion of a and b) that makes the investor indifferent between (aL +bN) and M

Baye's Formula: To update to my forecast or my porbability. Condtional of probability : base on new information model Example : Stock price up and interest price down

P(A|B) : Probability of event A occuring given that event B has occured ; conditional probability of event A P(B|A): Probability of event B occuring given that event A has occured ; contional probability of event B P(B): unconditional probability of event B occuring P(A) : uncondtional probability of event A occuring

Utility theory : We have optimal frontier ( convace and maximizes the return for any risk taken) and 3 curves.Indiferent with the choices along the curve. They are convex because the ar risk - averse. B is dominated , because is under the frontier. The agents always choose the farther utility curve ( north west ) the highest attainable of utility.

Given two alternatives with the same expected return but different standar deviation Risk averse (rational) : Investor will always seek to maximize expected return given level of risk Risk neautral: investor would be indifferent between the two alternatives Risk-seeking : investor would actually prefer ( derive more utility from) the riskier alternative

Utility function:

marginal utility : increase utility with increase in wealth

Concave utility function Decreasing marginal utility

Linear utility function Constant marginal utility

Convex utility function:Increasing marginal utility

Rem : sell or buy stocks base on expectations

Prospect theory: "changes in wealth" Investor anlyze risk relative to gains and losses: -More concerned with the change in wealth than in the resulting level of wealth Place a greater value on a loss than on a gain of the same amout -Exhibit loss aversion ( risk relative to changes in wealth, more concerned about the loss) Become risk seeking in an attempt to avoid losess

Investors make decisions in 2 phases: the editing phase and the evaluation phase EDITING PHASE: invesotrs clarify their choices utilizing 6 steps : codification , combination , segregation, cancellation , simplification , and detection of dominance. 4. Cancellation: Identical outcomes between choices can be elimated. the way that I can understand. 5. Simplification : The investor will tend not to think in precise probabilities ( think around numbers) 6. Determine dominance: Dominated choises are eliminated CANCELLATION can lead to the isollation effect: -Investors focus on one factor or outcome while consciously eliminating or subconsciounsly ignoring effects 3.Segregatiob: The investor separates the certain and uncertain -Tendency to focus on high value, low 2. Combination: to gain a better understanding components of a gamble. Assuming payoffs of ( 50, 50%) and probabilities events of possible outcomes , the investor combines (100, 50%) a payoff of 50 is certain . -Ignore low value , high probabilities those with identical values events.

Behavioral finance: based on framing . They way of how people see information , alternative. How the frame in their mind Editinf : way how people see information , they try to clarify information, the way that 1.Codification: -Investors identi fy and "code" outcomes as gains or losses and assign a probability to each -To determine whether an outcome is a gain or a loss , the investor must select some reference point. Just only put a tag on it Put the reference How they frame outcomes, good or bad

EVALUATION PHASE: Investors place values on alternatives in terms of expected utility. Put value

SUBJECTIVE PROBABILITY WEIGHTING: Similar to isolation effect , individuals tend to under weight high probability events and over-weigh low probability events w(p1) w(p2) w(p3) subjective (investor specfic) weighting of the probability associated with outcome x,y, or z wp , w p , w p : investor's subjective probability that event x,y,z will occur We dont what those w are going to be , this behavioral

w(p1)v(x) probability of outcome x,z,y multiplied by its expected utility. Bounded rationality: Individuals act as rationality possible , but: -They dont have all available information -They lack the processing power ( cognitive ability) to interpet and place a value on information Rather than optimize , indviduals satisfice. - Gather an adequate amount of information and apply heuristics to analyse and shape the info into an accepatble decision

They are gonna try the best

EFFECCIENT MARKETS: "The price is right" If markets are efficient , prices instantaneously and accurately reflect all information. -All infroamtion includes past and present infromation , as well as unbiased expectations -Investors can base portfolio allocations on prices only

No free lunch: If markets are efficient , prices instanteously and accurately reflect all information -Information enters randomly , so prices change randomly -Managers cannot consistently earn excess return If you win today you are going to loose tomorrow

WEAK -FORM EFFICIENCY -Prices reflect all past price and volume information -Managers cannot consistently earn excess returns (alpha) using technical trading rules

Info that everubodys knows

SEMI-STRONG FORM: Implies weak-form efficieny Financial informations includes

insade information

Implies semi strong efficiency.

CALENDAR ANOMALIES: Investors generate excess returns based on time of the year or month. January effect -Turn of the month effect Need for liquidity offered as explanation -Large fund must maintain liquidity (cash) so hesitant to enter arbitrage positions Star good at the beginig of the month

I only consume the thing that I can consume later in the future FRAMING: refers to the way a question is asked or the way info is represented and can affect the way individuals perceive a choice and view its alternative Example: The individuals selection will be affected by wether the outcome of a gamble is stated in terms of the possible loss or in terms of the possible gain ( stating a 50% probability of losing instead of a 50% probability of winning) PROPENSITY TO OUTCOME is greatest with current income -Weath classified as current income is most likely to be consumed /spent .Excess goes into savings and becomes currently owned assets

MARKET ANOMALIES: Fundamental anomalies: -Investors generate excess returns based on fundamental characteristics of the firm, shuch as market capitalization or by value or growth classification. -Empirical testing in dificult -To test must use a model that begins by assuming market efficiency Anomaly : shoud be price away Anomaly: ability to get exceed return and the continous too High adjusted exceed of retun MARKET ANOMALIES: -Compare what the return is and TECHNICAL ANOMALIES: Investors generate exceeds returns using what the return should be technical trading rules - The actual higher that the -Moving averages - Resistance levels - Support levels should be : exceed return if it the Argued that the tests dont account for different tax rates and transactions opposite is negative exceed of costs return behavioral finance perspective: 4 behavioral finance models attempt to explain the behaviour of individuals and markets their implications for portofolio 1.The consumptions and savings model constructions: The model is based on the beahvioral life-cycle theory ,which mantains that : -Individuals are subject to framing , self-control bias and mental accounting. -They will not neccesaily achieve the optimal balance of short-term consumption and long-term investing

BIG DEAL: how actually they see the investemetn It can influece the decision

SELF CONTROL BIAS: refers to an indiviauls tendency to place a much greater value on current consumption than on future goals. Self control bias produces child , retirment , it has more risk or less risk subtoptimal lifetime consumption /savings money is money: fungible patterns Mental accoutning: refers to individuals' tendencies to mentally place goals into different "files" They assgin different portions of their THE CONSUMPTION AND SAVING MODEL: wealth to meet the different goals CLASSIFYNG WEALTH: HOW PERSEIVE CASH FLOW -This ignores the fact that wealth is -Behavioaral life-cycle also assumes individuals classify wealth fungible as current income currently owened assets , and present value - Mental accoutning can facilita selfof future income . control Ri: Rf + B( market risk premiun)+ sentiment premiun -Designate some wealth as untouchable

CLASSIFYING WEALTH: -The way wealth is framed can affect its clasification - For example: a one-time cash flow might be seen as current income , currently owned assets ,or future (retirment) income: -How it is framed determines the individuals propensity to consume it -Automatic 401 (k) deductions Sentimetn premiun = 0 close to the right value usually seen PV of future (retirment) income 1. Importtance of the goals -To assure meeting the most important goals, the investor focues on the first -Uses nearly riskless assets to meet the goals 2.Required return: -The risk of the assets in any layer depends on the return required to meet the goals in the layer

-If sentiment premiuns are consistent , they would be priced away -If unpredictable , however , mispricing of assets courld persist

BEHAVIORAL ASSET PRICING Adds a sentiment premiun to CAPM -The greater the dispersion of analysts forecasts , for example , the greater the sentiment premiun, the higher the discount rate , and the lower the perceived value of the asset.

4.Access to information: If the investor perceives that he has an info advantage , an individual layer could be concentrated in one or just a few securitties Ver confidence with one goal

3.The investors utility function: Investors face decreasing marginal utiliy so an individual asset produces less and less utility as more of the asset is ascquired -The number of different securties held in a layer will vary directly with the concavity of the investors utility function - the greater the concavity , the greater number of different securties BPT : shows how investors structure their portfolios in layers according to their goals. Concavity: dimisnigh marginal

-The composition( the number of assets inside ) of layer of the portfolio (pyramid) is determine by the interaction of 5 factos 1. The importance of the goals 2. Required return 3. The investor's utiliy function 4. Access to information 5. Loss aversion

5. LOSS AVERSION : two potential results. 1. Hold too much cash to avoid having to sell securities at a loss to provide liquidity 2.Hold losers too long to avoid having to publicly recognize the loss Important implication: Investors will seek a minimun postion ( a safety net) and only allocate to risky assets once it is achieved.

4.Risk premiun will vary depending on investors perception of and aversion to risk . Increased competititon among market participants can lead to a decreasing perception of and aversion to risk 5. Because investors satisfice , assets can be temporarily mispriced. Active managment can lead to excess return

ADAPTIVE MARKET HYPOTHESIS: -The adaptive markets hypothesis AMH assumes succesful market participants apply heuristics until they no longer work and then them accrodingly -Succes in the market is an evolutonary process -Those who do not or cannot adapt dont survive Survive : adapt to the situtation in the market AMH: Investors satisfice rather than maximize utiliy - Based on amunt of information they feel is sufficient , they make decisions to reach sub-goals -Steps that advance them toward their desired goals No all the cognitive abilities

REM: always optimize utility

COGNITIVE ERRORS AND EMOTIONAL BIASES -Cognitive errors: are the result of the inability to analyze all information or basing decisions on incomplete information -Due to a lack of capacityor information individuals are unable to process information into rational decisions -Classified as either belief perseverance errors and processing errors -Cognitive errors are more easily corrected than emotinal biases the problem to analize when I have no info Mechanical problem

COGNITIVE ERRORS: 1.Cognitive errors: Belief perseverance -Cognitive errors stemming from believe perseverance arise out individuals's attempts to avoid congnitive dissonance -These biases can be divided into conservatism , confirmation ,representativeness, illuision of control , and hindsight.

Emotional BIASES: are due to psycological predispositions Affect how individuals see information and make decisions -The way individuals frame the information and the decision rather than the mechanical or physical process used to analyze and interpet it -Emotional bias is a spontaneous reaction. Predisposition that they have , without thinking

Cognitive dissonance: when I get info and i THINK IS NOT TRUE AT ALL

COGNITIVE ERRORS: CONSERVATISM BIAS: -Individuals unconsciously place more emphasis on the information they used to form their original forecast than on new information -They are difficult to pull away from an original forcast as they subconsciously place less value on new information -Not the result of emotional predisposition

CONFIRMATION BIAS: -Individuals tend to notice only information that agrees with their perceptions or beliefs -They look for confirming evidence while discounting or even ignoring evidence that contradicts their beliefs or their perceptions I only see the information that I agree Anybody is looking for the aproval what they are doing

CONSERVATISM BIAS:IMPACT -Slow to react to new information or avoid analysing new information -Stay with previous forecasts -Tendency to hold winners or losers too long How to recgonise? -Place too much weight on the base rates (prior probabilities) and too little on the new infromation -If the cognitive cost of new information is high, tend to ooverweight base rates and under-react to the new information -If low congnitive cost, tend to overweight and overrreact to new information.

CONSERVATISM BIAS: MITIGATION -Professionals should evaluate new information alone -Dont look at it in relation to prior information -If needed, individual investors should seek professional help REPRESENTATIVENESS BIAS:MITIGATION WITH A PERIODIC TABLE: -Shows relative annual performance of asset classes over time -Before drawing a false conclusion from new information, check relative performance of asset classes -May indicate (provide a heads-up) that a closer look is necessary.

CONFIRMATION BIAS:IMPACT -Focus on postive information and ignore or dismiss anything negative or conflicting -May reject evidence that sceening criteria used to analyze investments are incorrect or lacking -Too much confidence in the ivestment; overweight it in the portfolio -For employees , leads to overweighting employer's stock

Sample size neglect: -Individuals derive more information than is reasonable from the sample -For example. classifying a recent upward market movement as the beginning of an upward trend -Place too much weight on the new information than can be justified by the sample size. New information like if they are conclusition -TOO much weight to this sample sizze that it happens now CONTROL BIAS ( ILLUSION CONTROL): Indivduals feel they have more control over outcomes than they actually have -Their subjectives probabilities of success are too high - high probabilities to succes -SUBJECTIVE , I dont use statistics tools

REPRESENTATIVENESS BIAS: IMPACT. "sample size" -Place too much emphasis on newinformation -Likely to change stategies based on a small sampleof information -Place information into categories and utilizean if--then heuristic MITIGATION: -Consciously take steps to avoid base rate neglect and sample size neglect -Consider the true probability that information fits the indicated category -Determine a reasonable weight to place on the info, the extent to which it shoul affect expectetations ---REPRESENATIVENESS BIAS: -Individuals classify information into subjective categories using heuritics. -They place new information into the most appropiate category based on personal experiences -Think of representativiness as an if-then or stereotype heuristic -Due to base rate and sample size neglect REPRESENTATIVENESS BIAS: Base rate neglect -The investor neglects to consider the probability that information fits the category into which it has been placed -In bayesian statistics, the investor puts too little weight on the base rate ( the probability of A given B) HINDSIGHT BIAS: -Individuals tend to make their forecasts fit the outcomes -They remember only the parts of their forecasts that fit the outcome -Tends to make them overconfident in their future forecast Make me feel overcofidence in my ability to make forecast

INFORMATION PROCESSING Anchoring and adjustment -Individuals seem anchored to a value , such as an expected price or other forecast -Unlike the conservatism bias that has similar effects but is biased on how investors relate new information to old information , anchoring is based on a specific number -It is more specific than confirmation

FRAMING: -Individuals view information differnetly depending on the way it is received -For example , they will answer qustion diffently depending on the way it is asked

AVAILABILITY: -Individuals estimate future probabilities by how easily they recall a past event -An easily recalled event is more quickly associated with (fit to) new information -The problem is worsened by the fact that individuals' memories can be incomplete or biased Putting information in categories Cateogries comes from experience ILLUSION OF CONTROL BIAS:IMPACT Excessie trading with accompanying costs Concentrated portfolios Lack of diversification ILLUSION OF CONTROL BIAS:MITIGATION Understand the true complexity of investing Seek the opinions of others Keep through records of trades including motivations and outcomes. Compare strategies to outcomes

Confirmation bias:Mitigation -Actively seek out information that seems to contradict your opinions and anlyze it carefully -Make a conscious effort to seek out confirming andcontradicting information -Use more than one method of analysis

HINDSIGHT BIAS:impact -Overestimates the accuracy (precision) of forecasts -Relates positives performance to strategy whether or not the relationship exists. -Feeling of accomplishment leads to taking too much risk

MENTAL ACCOUNTING: -Individuals place each goal and the wealth that will be used to meet each goal into a separate mental account. -They dont consider the risk of each set of assets or the correlations among the sets of assets. -Divide goals in portofolio the problem is find what is the rue allotcation for the portoflio MENTAL ACCOUNTING BIAS:IMPACT -Assgin specific assets to specific goals -More or less ignore correlations of assets -Consider income and capital gains seperately, spend rather than reinvest current income -Could lead to a decrease in a real portofolio value over time -Take too mcuh risk in seach of high current income, as with low-rated, high risk bonds. MITIGATION:Look at all investments as if they are part of the same portfolio.-Analyze their correlations-Leads to clearer perception of the true porfolio allocation. FRAMING BIAS:IMPACT -Concentrated equity positions etc NARROW FRAME OF HINDSIHGT (Retroespectiva) bias:MITIGATION REFERENCE :focus on one -Similar to mitigating the illusion of control piece of information and lose -Keep detailed records of all forecasts , including the data sight of how the information analyzed and the reasoning behind the forecast. fits into the whole -Exhibit loss aversion if ANCHORING AND ADJUSTMENTS BIAS:IMPACT outcome framed in terms of a -Remain focused on and stay close to their original possbile loss forecasts or intepretations -Exhibit risk aversion if -Although similar , conservatism bias is a belief framed in terms of a possible perseverance bias and anchoring and adjustment gains. is processing bias MITIGATION.Focus on ANCHORING AND ADJUSTMENTS BIAS:MITIGATION Give new information thorough (minusioso) consideration to expected returns relative to risk, rather than on gains or determine its correct impact, if any , on the original forecast losses.Including assets or or opinion. portfolios with existing gains or losses.

AVAILABILITY BIAS:Causes RETRIEVABILITY:The more easily and individual retrieves a memory , the more likeyle that he will use it to classify new information CATEGORIZATION:Individuals are more likely to categorize information using familiar classifications. NARROW RANGE OF EXPERIENCE: Reduced number of categories in which to frame new information. RESONANCE: Investor assumes that whatever reasonables with him must also reasonable with others. LOSS AVERSION:IMPACT -Focus and gains and losses-Hold losers too long hoping to recoup (recuperar) -Sell winner too soon , capture the gain before it gets away..-Tends to increase porfolio turnover (volumen de negocios) , limit the growth of the porfolio and increase risk -Myopic loss aversion leads to avoiding assets that have experienced recent volatiliy

LOSS AVERSION: They show -Individuals focus on potential gains and losses relative to risk rather than returns relative to risk -They place more"value" on losses -When cosidering a risky investment, investors exhibit loss averision rather than risk aversion -People llok possible gains and losses , they look at current investment -They put more value to the losses than to the value with the same magnitud -Game of utility is less than losses of utility -Loose of 100 o gain of 100 : it is most importnat 100 loose

OVERCOFIDENCE -Also referred to as illusion of kowledge -People feel they know more than they do -They feel have more or better information or they are better at interpreting information LOOK DOWN PREDICTION OVERCONFIDENCE: leads to underestimating risk and setting confidence intervals too narrow "overestate the probability of succes" CERTAINTY OVERCONFIDENCE relates to over-stated probabilities of success -The combination of the 2 can lead to narrow confidence intervals with positively skewed probability disributions

SELF-CONTROL BIAS: -Lack of discipline -Fail to balance the need for immediate(short-term) satisfaction with long-term goals -Savings-consumption patterns tend to be sub-optimal

SELF ATRIBUTION:bias contributes to overconfidence -Self attirbution is the combination of self-enhacing bias and self -protecting bias -Self-enhancing bias: take all the credit for success -Self-protecting bias:place the blame failures on someone or something else

STATUS QUO BIAS: "do nothing" Individuals have a tendency to stay in their current allocation -Might miss some valueenhacingchanges -Asset allocation (risk) becomes tilted toward riskier, faster growing assets

ENDOWMENT BIAS: .Individuals value assets differently based on whether they hold the assets or not -They place greater value on an asset they own than on the same asset if they dont own it -An individual is likely to ask a higher price to sell an asset he holds than he would be willing to pay for the same asset if not already held REGRET AVERSION BIAS: Regret can arise from taking or not taking action -ERROR OF COMISSION:investor feels regret from taking an action -ERROR OF OMISSION: investor feels regret for not taking action.

BEHAVIORAL BIASES: IMPACTS AND MITIGATION For the exam: -Be able to identify a behavioral bias from its impact on the investor's actions or statements -Be sure you can classify the bias as cognitive or emotional -Be ready to offer suggestions on how to mitigate the impact of the bias INVESTMENT POLICY AND ASSET ALLOCATION: Goals-based investing : -Incorporates loss aversion and mental accounting-Investor builds a portfolio in layers , one laye at a time-Each layer contains assets used to meet individuals goals or subset of goals -First layer is comprised of assets designated to meet the investos's most important goals

AVAILIBITY AVAILIBILITY BIAS:IMPACT -Select products, including investments, BIAS:MITIGATION -Utilize a long-term stategic based on adverstising because those approach memories are more easily retrieved -Develop and IPS and (recuperado) and categorized. construct a sutibale portfolio -Due to a narrow range of experience , (adecuado portfolio) through they might stay in very few asset diligent research. classes , leading to concentrated -Dont rely (confiar) solely on portfolios. information that is most -Using resonance (resonancia), they readily available. may over-invest in industries that resonable with their way of thhinkg LOSS AVERSIONS BIAS:IMPACT. -MYOPIC LOSS AVERSION:combines the effects of time horizon and framing. -Investors tend to focus on the shur run ,so likely to estimate risk using recent past.. -Tend to segment investments and look at their trisk charestics separately. -Standalone (idependiente) perspective rather than combined in a portfolio. LOSS AVERSION BIAS:MITIGATION. -Overcome the mental anguish of recognizing losses. -Perform a thorough fundamental analysis. -Base investment decisions on expectations rather than past performance.

SELF CONTROL BIAS: IMPACT -Tendency to over - consume -Try to make up the resulting shortfallby taking too much risk -May invest for the futue but lean toward highincome investments that produce spenddable income-The result is restricted portfolio growth. SELF CONTROL BIAS:MITIGATION -Investors should have complete , clearly defined investment goals and strategies -Budgets help deter the propensity to over-consume

COGNITIVE BIASES: 1.Conservatism 2.Confirmation 3.Representativeness 4.Illusion of control 5.Hindsight 6.Anchoring and adjustment 7.Mental accounting 8.Framing 9.Availibity GOALS-BASED INVESTING: -Once the foundation layer is constructed, the OVERCONFIDENCE BIAS:IMPACT -Tend to hold under-diversified portfolios investor moves to the next layer -Underestimate the downside while over -Each successive layer estimating the upside. consists of incrwasingly -Trade excessively, leading to high costs risky assets used to meet and underperfomance less import goals MITIGATION:-Keep detailed records of trades , incluiding the motivation for each -Provides the ability to seek risk more clearly trade.-Compare strategy to performance -Resulting portfoliois not -Both successes and losses. efficient but will tend to be failry well divesified.

STATUS QUO BIAS:IMPACT -Portfolio allocation drifts over time toward higher perfoming assets. -By not looking , could have missed potentially profitable assets STATUS QUO BIAS:MITIGATION -Education about risk and return and proper asset allocation is important -This is one of the more difficult biases to mitigate.

EDOWMENT BIAS:IMPACT -->Replace familiar assets -Asset has greater value owned than un-owned gradually to avoid signficant -Hold assets regardless of whetther they provide discomfort. the appropiate risk-return profile -Have become familiar and comfortable with the assets or inherited assets -Steongest with inherited assets MITIGATION: -Must determine whether the asset allocation is appropiate -Research the risk-return performance of the familiar assets as well as unfamiliar assets the invesots may no hold

BEHAVIOARALLY MODIFIED ASSET ALLOCATION: The strategy portfolio (behaviorally modified portfolio)is constructed according to the investors behavioral risk and return prefernces and wealth -The portfoliois probably not efficient , but the investor is comfortable with it -When the investor is comfortable with the portfolio he will tend to have more confidence in it and stay with longer -Generally the weathier the client, the more the behavioral biases can be accommodated -Wealthy investor is able to weather the negative effects of behavioral biases without significantly jeopardzing to meet long-term goals -The client with less wealth has a greater exposure to longevity risk -Must avoid the negative effects of behavioral biases 2.Classifies investor as either active or pasive ACTIVE INVESTOR:risk their own capital to gain wealth and usually take an active role in investing their money -Muchless risk averse than passive investors and are willing to give up security for control over their own wealth creation. -this kind of guy try to gamble their money , who is willing to risk their own money 3.Passive INVESTOR: have not had to risk their own capital to gain wealth -They might have gained wealth through long, steady employement and disciplined saving or through inheritance -As a reuslt of accumulating wealth passively , they tend to be more risk averse and have a greater need for security than active investors-THEY TRY TO PROTECT THEIR WEALTH

REGRET AVERSION BIAS: IMPACT. -Tendency to stay in low-risk investment-Result is limited upside potential and the accompanying probaility of not meeting long-term goals-May stay in familiar investments -May seek confirmation and "follow the herd" MITIGATION: -Education is the primary mitigation tool-Apply the modern portfolio theory concepts of risk and return rather than focus on gains and losses.

BEHAVIORALLY MODIFIED ASSET ALLOCATION COGNITIVE ERRROS should be mitigated: Result of faulty reasoning due to lack of informationor ability to evaluate information, so failry easily mitigated with education.EMOTIANAL BIASES:shouldbe accomadated:Often the result of a lifetime of experiences and are less easily mitigated. -Whether to mitigate or accomadate behavioral biases depends on client's wealth -Wealth should be determined by considering total wealth relative to lifestyle. -The lower the client's standard of living risk, the greater the client's effective wealth and the greater the ability to accomodate behavioral biases. -How closely the behavioarally modified portoflio resembles a risk and return effcient (rational) portofoliois a function of a degreeto which behavioral biases are mitigated or accommodated,which in turn is a function of client welath -Think in terms of "effective wealth" -Combinationof wealth, desired lyfestyle, and standar of lliving risk. 1BEAVIORAL FINANCE MODELS: We look at behavioral finance models that attempt to explain ivestor behavior. 1.The barnewall two-way model 2-The Bailard , Biehl, and kaiser five-way model 3.The pompien model

12.PASSIVE PRESERVER: ( they dont want to rsik own capital , and preserver capital , less financial sophitiscated, dififficult to qadvis-Low risk tolerence , focus on preservation of wealth -Emotional: worry aboutSHORT-TERM PERFORMANCE -Not willing to risk his own capital -Usually not financially sophisticated -Possibly difficutl to advise because driven by emotion

3.BAILARD , BIEHL , AND KAISER FIVE MODEL Classifies investors along 2 dimensions, confidence and method of action 1.CONFIDENCE(how confidence to mak deicsions): refers to the level of confidence exhbitited when the individuals make decision RANGES TO CONFIDENT AND ANXIOUS 2.METHOD OF ACTION:measures the individuals approach to decision making RANGES FROM CAREFUL AND IMPETUOUS

5.1.The adventurer (confidence to make decisions and impeteous to make deicsins fast)Dangerous individual, fast deicsions and confidence about that NORTH EAST -Confident and impeteous -Might hold highly concentrated portfolio -Willing to take chances -Likes to make own decisions -Unwilling to take advice -Advisors find them difficult to work with 6.2CELEBRITY: ( they dont feel confidence, easy to advice seek advice, easy to convince) -Anxious and impteous -Might have investment opinions but recognizes limitations -Seeks and takes advice about investing

8.4.The guardian "emotional type of people" south west corner., good thing about this , they will seek advice, to make careful deicision problem. -Anxious and careful -Concerned with the future and protecting assets -May seek the advice of someone they perceive as more knowledagable thn themselves

7.3.The individualist Methodical to make all the things , they want a lot of info , easy to work -Confident and careful -Likes to make own decisiosn after careful analysis -Good to work with because they listen and process information rationally

10.POMPIAN MODEL:Eliminate biases testing the client, behavioral alpha aproach, tow down approach they classify into cateogories, accoriding to the kind of behaviour I know his biases Pompian suggests thast the advisers go through a 4-step process to determine the investor's behavioral investor types (BITs) 1.Interview the client to determine if she is active or passive as an ndication of her risk tolerance ( put in general cateogy) 2.Plot the investor on a risk tolerance risk 3.Test for behavioral biases. 4.Classify the investor into one of 4 BITs 18.DEALING WITH BITS INDEPENDENT INDIVDUALIST -Considerable faith in their own intelligence and abilities -Will follow advice only if presented in a logical, thoughtful manner -Mostly cognitive errors, so eduaction is as important as with firendly followers -To keep them thinking strategically , meet regurlarly and provide educational concepts 19.DEALING WITH BITs ACTIVE ACCUMULATOR -Tend to be emotional and want to take control, can be over-confident -Tendency to over-spend, trade too much, lack self-control -Advisor must take control ; convince the client that they ( advirosrs) have the requisite experience and knowledge 20.ADVISOR - CLIENT INTERACTTIONS The succes of the typical client/ afdviser relationship can be measured in four areas: 1.Does the adviser understand the client's long-term financial goals? -Behavioral finance helps the adviser understand the reasosns fot the client's goals -The client/adviser relationship is enhanced because the client feels the adviser truly understands him and his needs

13.Friendly follower "the nice guy , more tolereance than 12, they will listen advice, the follow me ": -Passive investor ;Low to moderate risk tolerance-Mostly cognitive errors-Tends to overestimate own risk tolerance; tendency to follow trends-Wants to be in the most popular investments -Must be encouraged to utilize proper investment analysis and prsue diversification. 14.INDEPEDENT INDIVIDUALIST -Active investor;willing to risk his own capital-Moderate to high risk tolerance and sufffers from cognitive biases -Strong-willed; likets invest; dows own research; tend to be a contrarian -Tends to be difficult to advise, but will listen to sound advice. 15.ACTIVE ACCUMULATOR: -Active investor; high risk tolerance;emotional investorPossible entrepreneurial background-Likes to get deeply involved in investing -Strong4.BB&K uses confidence and method willed, confident, likes to of action to categorize investors into control her investing -Usually considered the most 5 behavioral types difficutll clients to advise 1.The adventure 2.The celibirty 3.The individualist 4.The guardian 5.The straight arrow

22.3.Does the adviser act as the client expects? -This area can be signnicantly enhanced by incorporating behavioral finance -Helps adviser understand the client , including her motivations -Knows what actions to perform, what information to provide, and the frequncy of contact required to keep the client happy

21.2.Does the adviser maintain a consistent approach with the client? -Behavioral finance adds sturcture and professionalism to the relationship -Helps the adviser understand the client before giving investment advice

9.5The STRAIGHT ARROW. "rational economic men" , "more risk to more returm" -Average investor -Neither overly confident nor anxious -Neither overly careful not impetuous -Willing to take increased risk for increased expected return. 11.POMPIAN MODEL: Four behavioral investor types (BITs) 1.Passive preserver 2.Friendly follower 3.Indepednent individualist 4.Active accumulator. 2,3 have cognitive errors Cognitive (I dont hav the ability to do something, focus more and facts and figures) differnet emotianal error 1,4 (emotialn error ) 17.DEALING WITH BITS FRIENDLY FOLLOWER: -Thinkers , so they have a tendency to follow advice that makes sense without analysing it - Should be encouraged to think decisions through instead of just following -Supporting data and analysis- Make them look at their own behavioral tendencies that lead to increased risk.

23.4.Do both the client and advisor benefit from the relationship? -The primary benefit of incorporating behavioral finance into the client/advisor relationshipis a closer bond between the bond -This produces happy clients and enhances the advisers' practice.

16.PASSIVE PRESERVER: -They like to see how investmenets fit into their long-term plans -Focus attention on long-term goals -Do not focus on risk , return , and other cognitive measures -Must be convinced of advisor's intentions but can become good very long-term clients

24.RISK TOLERANCE QUESTIONNAIRES: -As one of the first steps in the client/adviser relationship , the client should fill out a risk tolerance questionnaire -Indivuduals can give different answers to the same set of questions depending on their frame of mind or current circumstances -Most questionaires are not sturcutred to measure behavioral biases -Limits the traditional questionnaire 25 RISK TOLERANCE QUSTIONNAIRE -Client's response are affected by the wording of questions (framinin) -Same questions can produce differnet results if the sturcture of the questions is changed -Client answers reflect all their behavioral biases simultaneously -Admistering only during during the initial meeting is insufficient -Should be analyzed annually along with IPS

26.PORTFOLIO CONSTRUCTION: -Behavioral traits are evident in defined contribution pension plan DC porfolios: -Status quo bias; investors make no changes to their initial asset allocation -Has led to target date funds constructed with a target retirement date in mind -Allocation adjusted as the target date approaches -Does not consider the individuals needs 27.PORTOFOLIO CONSTRUCTION -DC PLANS -1/N ( naive) diversification -Only aware of diversification , not the mechanics behind it -Allocate an equal portion to each fund the plan offers INVESTING IN COMPANY STOCK:At least five reasons plan participants tend to over - invest in their company's stock

28.REASONS FOR INVESTING IN COMPANY STOCK 1-Familiarity :leads to overconfidence 2-Naively extrapolate past performance into future performance:Liek representantiveness 3-Framing: Particurlarly evident when employer contributions are in company stock 29. 4-Loyalty: Attempt to help management by holding stock- Makes takeovers more difficult 5.Financial investments: May be rational to hold excess company stock if offered at discount price-May be tax incentives ( low tax basis)

30.RETAIL CLIENTS: BEHAVIORAL BIASES: EXCESSIVE TRADING:Possibly caused by overconfidence DISPOSITION EFFECT:Tendency to seel winner too soon and hold losers too long ( fear or regret?) HOME BIAS: Tendency to stay in familiar stocks and other investments-Easily remmebered /recalled

31.BEHAVIORAL PORTFOLIOS: Individuals tend to exhibit mental accoutning -Specific assets to meet each goal -Construct porfolios in layers ( pyramid) -Most important golas met (immunized) first -First layer of the pyramid -Each succesive layer contains goals..

of decreaing importance and assets of higher risk -Ignores correlations among assets