A Module in

BEHAVIORAL
FINANCE

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 PREFACE

I have been fortunate enough to form and build healthy relationships with many
different types of people over the years of teaching several key business disciplines. When I
say "different," it means temperament, occupation, financial conditions, social class, gender,
and other characteristics. I have found out that human psychology is complicated, and
people create their attitudes and habits in various ways; attitudes and habits regarding
anything from eating to working styles, interpersonal relationships, and yes, money and
investment are all part of the human mind's intricate web. Understanding behaviors may
influence a person's decision-making processes, which is incredibly beneficial when working
with something crucial like money matters.

These choices are made based on two psychological concepts: emotions and
cognitions. Emotions are concerned with how people feel, whereas cognitions are concerned
with how people reason. This contrast may not appear to be particularly useful at first
glance, but in the long run, it is. It establishes a framework for analyzing how people think
and act in regard to money. This emotionally cognitive concept will be covered later in the
module.
ELIZABETH C. DAÑAS, MBA
 TABLE OF CONTENTS

PAGE
CHAPTER 1: INTRODUCTION TO BEHAVIORAL FINANCE
Lesson 1: Introduction to Behavioral Finance …………………….……………. 1
Activity1 ……………………………………………………………..……………… 5
Lesson 2: Stock Market Anomalies………………………………………………. 5
Activity 2……………………………………………………………..……………… 9
CHAPTER 2: BEHAVIORALBIASES
Lesson 1: Systematic Biases ...…………………………………..……………… 10
Activity 1……………………………………………………………..……………… 17
Lesson 2: Investors Behavioral Biases …………………………………………. 17
Activity 2……………………………………………………………..……………… 21
Lesson 3: Investors Psychological Biases ……………………………………… 21
Activity 3……………………………………………………………..……………… 24
CHAPTER 3: INVESTOR BEHAVIOR
Lesson 1: Behaviors by Professional Investors and Analyst …………………. 25
Activity 1……………………………………………………………..……………… 46
Lesson 2: Behavioral Theories in the Stock Market …………………………… 46
Activity 2……………………………………………………………..……………… 50
CHAPTER 4: THE AGGREGATE PERSPECTIVE
Lesson 1: Capital Market Anomalies…………………………………………….. 51
Activity 1……………………………………………………………..……………… 57
Lesson 2: Behavioral Theories in Corporate Finances ……………………… 57
Activity 2 …………………………………………………………..……………… 63
CHAPTER 5: BEHAVIORALLY PLAN AND ACT
Lesson 1: Capital Markets and Asset Classes …………………………………. 64
Activity 1 …………………………………………………………..……………… 85
Lesson 2: WhatIs AssetAllocation?……………………………………………. 85
Activity 2 …………………………………………………………..……………… 99
Lesson 3: InvestmentAdviceforEachBehavioralInvestorType……………... 99
Activity 3 …………………………………………………………..……………… 110
References……………………………………………………………..………….. 111
Course Guide……………………………………………………………..………. 112
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EASTERN SAMAR STATE UNIVERSITY

 UNIT 1: BEHAVIORAL FINANCE

Behavioral finance is a fairly young but rapidly growing area that combines
behavioral and cognitive psychological theory with traditional economics and finance to
provide explanations for people's economic actions. The inadequacy of classical anticipated
utility maximization of rational investors within the efficient markets framework to explain
many empirical findings has fueled the expansion of behavioral finance research. Behavioral
finance tries to explain these contradictions using explanations based on individual and
group human behavior.
The first chapter is an introduction to behavioral finance and stock market oddities.
Target Learning Outcomes
LO1 – Describe the differences between a behavioral finance perspectives and a
traditional
perspective.

Lesson 1: Introduction to Behavioral Finance

Learning Outcomes: In contrast to theories of investor

behavior, behavioral finance tries to
At the end of the lesson, you are understand and explain actual investor
expected to: and market behaviors. Understanding
• identify the two primary how individuals make decisions, both
disciplines of behavioral finance; individually and collectively, is at the
• define the terms "traditional heart of behavioral finance. By
finance" and "behavioral finance”; understanding how investors and
and markets behave, it may be reasonable to
• examine behavioral finance's role change or adapt their behavior to
in working with private clients. improve economic outcomes.
Understanding and incorporating
behavioral finance can assist advisers
and their clients achieve better outcomes
in many circumstances.

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Lesson Proper

Standard Finance versus Behavioral Finance

According to Meir Statman, standard financeprovides discussions on financial
concerns that are often confounded in real life by inaccurate and stiff circumstances. The
traditional financial method is based on a set of assumptions that exaggerate reality.
Behavioral finance seeks to understand and learn from human psychological
processes at work in financial markets and among investors. Basic precepts and
assumptions govern behavioral finance, just as they do regular finance. Standard finance,
on the other hand, bases its assumptions on idealized financial conduct, whereas
behavioral finance bases its assumptions on actual financial behavior.
Behavioral Finance: Micro versus Macro
Behavioral finance is the application of psychology to finance gaining traction
following the burst of the tech-stock bubble and being thrust to the frontline of the minds of
investors' and advisors following the financial market catastrophe.
1. Behavioral Finance Micro (BFMI) investigates the individual investor's behaviors or
biases that differentiate them from envisioned conventional economic theory of
rational actors.
2. Behavioral Finance Macro (BFMA) discovers and describes abnormalities in the
efficient market theory that may be explained by behavioral models.

Efficient Markets versus Irrational Markets

In 1970s, the conventional finance theory of market efficiency began to be embraced
by majority of academics and a significant number of professionals as the model of market
behavior. The Efficient Market Hypothesis, which originated with Fama's PhD dissertation,
has grown during the past decade. Fama convincingly established that investments will be
adequately valued and represent all relevant information in a securities market populated by
many well-informed investors.
The efficient market hypothesis can take three different forms:
1. The "Weak" type asserts that the entirely previous market prices and data are
fully represented in securities prices, and there is little or no relevance in
technical analysis.
2. The "Semistrong" form claims all information that is publicly available is fully
represented in stocks prices, implying that fundamental study is useless.
3. The "Strong" form claims that all information is completely reflected in stock
prices, implying that insider information has no significance.

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 If a market is efficient, no amount of data or sophisticated analysis can be anticipated
to lead to outperformance against a chosen benchmark. A market that is efficient can be
defined as one in which a large number of rational investors engage in concert to maximize
profits in the direction of individual assets. One of the most important assumptions is that all
participants have access to relevant information. This competition among market participants
results in a market where, at any given time, the total effects of all information, including
information about events that have already occurred and events that the market expects to
occur in the future, are reflected in the prices of individual investments. To summarize, in an
efficient market, the price of a security will always be equal to its intrinsic value.
There are three main types of market anomalies
1. Fundamental Anomalies
Fundamental anomalies are anomalies that appear when a stock's
performance is examined in light of a fundamental appraisal of the stock's value.
Many individuals are unaware that value investing, one of the most popular and
successful investment strategies, is founded on fundamental flaws in the efficient
market theory. Investors regularly overestimate the prospects of growth
companies while underestimating the worth of out-of-favor enterprises, according
to a significant body of evidence.
2. Technical Anomalies
Another hot topic in the investment sector is whether or not historical security
prices can be used to forecast future security prices. The term "technical
analysis" refers to a variety of methodologies that use historical data to estimate
future stock prices. Technical analysis can occasionally uncover contradictions
with the efficient market hypothesis; these are known as technical anomalies.
3. Calendar Anomalies
The January Effect is one example of a calendar quirk. Stocks in general, and
tiny stocks in particular, have historically provided extraordinarily high returns in
January. Stocks are rising after year-end tax selling, according to the January
Effect. Individual equities that have fallen in value near the end of the year are
more likely to be sold for tax losses. Some academics have begun to see a
December Effect, which derives from the fact that many mutual funds are
required to report their holdings, as well as investors buying ahead of prospective
January hikes.

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Rational Economic Man versus Behaviorally Biased Man
Homo economicus is a simplified model of human economic behavior derived from
neoclassical economics. It assumes that humans make economic decisions based on
principles of perfect self-interest, perfect reason, and perfect information. Like the efficient
market hypothesis, Homo economicus is a notion held by economists with varying degrees
of rigor. Some people have adopted it in a semi-strong form; this version does not regard
sound economic behavior to be entirely dominant, but it still assumes a comparatively large
frequency of rational economic features. Other economists advocate for a weaker version of
Homo economicus, one with the requisite features but lacking in strength.
Economists like to use the concept of rational economic man for two primary
reasons:
1. Homo economicus simplifies economic analysis; nonetheless, one can wonder
how beneficial such a simplistic model can be.
2. Homo economicus enables economists to quantify their discoveries, resulting in
more elegant and digestible work.
If humans are totally rational, with perfect information and perfect self-interest, their
actions may be quantifiable. The foundations for these three fundamental assumptions—
perfect rationality, perfect self-interest, and perfect information—are challenged in the
majority of Homo economicus attacks.

1. Perfect Rationality. Humans have the ability to reason and make positive
decisions when they are sensible. However, reason isn't the only factor that
influences human conduct. Many psychologists feel that the human intellect is
actually subservient to human emotion, therefore it may not even be the
fundamental motivation. As a result, they argue that human action is driven more
by subjective impulses like fear, love, hate, pleasure, and pain than by rationality.
Humans only utilize their minds to attain or avoid these emotional outcomes.
2. Perfect Self-Interest. People are not perfectly self-interested, according to
numerous research. Philanthropy would not exist if they were. Religions that
emphasize selflessness, sacrifice, and goodwill to strangers would be unlikely to
survive in the same way that they have for generations. Volunteering, assisting
the needy, and serving in the military would all be impossible if people had
perfect self-interest. Self-destructive behavior, such as suicide, drunkenness, and
substance misuse, would also be ruled out.
3. Perfect Information. Some people may have perfect or near-perfect knowledge
of a subject; a doctor or dentist, for example, should be well-versed in his or her
profession. It is, however, impossible for everyone to have perfect knowledge in

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 every subject. There is virtually an unlimited amount to know and study in the
world of investing, and even the most successful investors do not master all
areas.

Activity 1
Answer the following questions.

1. What are the similarities and differences of traditional finance and behavioral
finance?
2. Distinguish with examples behavioral finance micro from behavioral finance
micro.
3. Why is behavioral finance important when working with private clients?

Lesson 2: Stock Market Anomalies

Learning Outcomes: Anomalies are a result of market failures.

Some anomalies appear only once and
At the end of the lesson, you are then vanish, whereas others appear
expected to: again and again. You shouldn't expect
• recognize the many types of every Monday to be a disaster and every
stock market anomalies; and January to be a success because past
• determine the stock market's performance is no guarantee of future
impact on stock market results, but there will be days that "prove"
anomalies. these anomalies true.

Lesson Proper

An anomaly is a surprising or uncommon occurrence in the world outside of

investing. When a security or set of securities behaves in a way that defies the concept of
efficient markets, in which security prices are said to reflect all available information at any
one time, anomalies in financial markets occur.

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 We'll take a look at some common reoccurring abnormalities and see if attempting to
exploit them is beneficial.
1. Size Effect
According to market efficiency theory, the size effect is a market anomaly in asset
price. According to current research, market anomalies occur either as a result of market
inefficiencies or because the underlying pricing model is faulty. Empirical tests are
commonly used to uncover anomalies in the financial markets. Typically, these tests are
focused on a single null hypothesis H0=markets are efficient and follow a predefined
equilibrium model (usually CAPM). It's possible that the empirical study rejects H0 due to
market inefficiencies or because the model is incorrect.
According to the CAPM, the size effect is classified as a market oddity. Researchers
have discovered other elements, known as CAPM anomalies that explain asset returns
since the CAPM was first established. The size effect is one of these notable anomalies
uncovered by empirical CAPM testing; it describes a negative link between size and
returns, meaning, it is discovered that returns of large enterprises are much lesser than
small firms.
2. Value Effect
One of the most well-known fundamental anomalies is the value effect. Due to
investor excitement in a company's potential, companies with below-average balance
sheets tend to beat growing companies on the market.
If a stock's market value surpasses its book value per share, it is usually considered
overpriced, whereas a stock with a higher book value than its market value is frequently
considered undervalued. Rather of causing the market to adjust, the value impact drives
traders to go against conventional sense and buy shares that are technically overvalued.
Although investing in low-book-value stocks has a greater risk of going insolvent, this
is countered by the possibility for bigger gains.
3. Momentum Effect
The momentum effect is based on previous fundamental indicators, which suggests
that stock markets winners are more likely to outperform recent stock market losers – or
that shares with a strong upward trend are more likely to continue climbing in the short
and medium term.
Traders can profit from price movements by going long on winners and shorting
losers due to the momentum anomaly. The momentum effect is often explained by the
fact that markets do not price in new information quickly, but rather over time. If a
corporation announces positive news, but buyers are slow to react and flood the market,

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 the price increase will be more gradual. This gives the impression that the winners are
gaining consistently.
Momentum is the tendency for assets that have performed well (or poorly) recently to
continue to perform well (or poorly) in the future, at least for a short time.
4. Post-Earnings-Announcement Drift
The post-earnings-announcement drift is a trend in which stock returns continue to
move in the direction of surprise results. The market adjusts to new information over
time, resulting in an anomaly after a company announcement.
In theory, if markets were perfectly efficient, business earnings releases would result
in immediate price changes because the report would be immediately factored into the
market price. In practice, however, markets might take up to 60 days to react, with a
positive earnings report causing an upward drift and a negative earnings report causing
a downward drift. The most commonly accepted explanation for the delay is that markets
under-react to earnings announcements, which means it takes time for the information to
be incorporated into the stock price.

Source: Google images

5. Long-Term Reversal Effect

According to Blackburn and Cakici (2017), the long-term reversal effect is the
tendency of securities with high returns over the past three to five years to underperform
relative to securities with low returns through the same period. It has been demonstrated
not only in individual stocksbut also in national equity indices, futures, currencies, and
commodities.

Other market anomalies are:

Calendar Effects – are anomalies associated with a specific period of time.
• Weekend Effect: The weekend effect reflects the propensity of stock prices to fall on
Mondays, implying that Monday closing prices are lower than Friday closing prices.

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 • Turn-of-the-Month Effect: The turn-of-the-month effect describes how stock prices
tend to climb on the last trading day of the month and the first three trading days of
the next month.
• Turn-of-the-Year Effect: In the last week of December and the first two weeks of
January, the turn-of-the-year impact defines a trend of greater trading activity and
higher stock prices.
• January Effect: During the first two to three weeks of January, small-company stocks
outperformed the market and other asset groups.

Announcements and Anomalies

Anomalies aren't always tied to the day of the week, month, or year. Some are
associated with the disclosure of information on stock splits, earnings, and mergers and
acquisitions.
• Stock Split Effect: Stock splits increase the number of outstanding shares while
decreasing the value of each outstanding share, resulting in a net effect of zero on
the market capitalization of the company.
• Short-Term Price Drift: When stock price swings due to an announcement last for a
long time following the announcement, this is known as short-term price drift.
Because information may not be instantly reflected in the stock's price, short-term
price drift develops.
• Merger Arbitrage:Merger arbitrage takes advantage of potential mispricing once a
merger or acquisition is announced. The purchase proposal made may not
accurately reflect the target company's true value. Arbitrageurs try to take advantage
of the fact that bidders normally offer higher prices for target companies.

Superstitious Indicators
Apart from anomalies, there are several nonmarket signs that some individuals
believe can reliably predict market direction. A small selection of superstitious market
indicators follows:
• The Super Bowl Indicator: The market will end lower for the year if a club from the old
American Football League wins the game. The market will conclude the year higher if
an old National Football League team wins. However, there is one drawback to the
indicator, I It makes no provision for a triumph by an expansion team.
• The Hemline Indicator: The market rises and falls with the length of skirts. This is
also called as the "bare knees, bull market" theory.
• The Aspirin Indicator: Aspirin production and stock prices are inversely connected.
This measure implies that as the market rises, fewer people require aspirin to treat

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headaches caused by the market. Lower aspirin sales should suggest that the
market is improving.

Activity 2
Answer the following questions.

1. Elucidate with examples the types of stock market anomalies.

2. How does stock market anomalies affect the stock market?
Does this create a negative or positive effect? Support your
answer.
3. How can behavioralists ever achieve simplicity in their field
when human behavior is inherentlycomplex?

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 UNIT 2: BEHAVIORAL BIASES

Behavioral biases have the potential to influence financial market participants'

actions and decisions. Financial market participants may be able to reduce or adjust to
behavioral biases and so enhance economic results by understanding them. These biases
can be divided into two types: cognitive errors and emotional biases. Whether the impact of
prejudice is moderated or adapted to depends on the type of bias. Behavioral biases usually
arise spontaneously as a result of an individual's own feelings at the time of a decision. They
could also be based on personal experiences that influence decision-making.
The systemic prejudices and invectives discussed in this chapter are systematic
biases and investors behavioral biases.

Target Learning Outcomes

LO2 – Discuss the cognitive biases and errors of judgment that affect financial decisions.

Lesson 1: Systematic Biases

Learning Outcomes: Investors' psychology is commonly

engrained with systematic biases, which
At the end of the lesson, you are are more difficult to overcome than
expected to: cognitive biases. Systematic biases
• examine commonly recognized aren't always the result of mistakes. An
systematic biases and their investor's systematic bias may, in some
significance in financial decision situations, assist them in making a more
making; protective and appropriate decision for
• identify and assess a person's themselves.
systematic biases; and
• examine how systematic biases
impact investment policy and
asset allocation decisions.

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Lesson Proper

Here are some of the systematic biases:

1. Availability Bias
Availability bias is an information processing bias in which people estimate the
probability of a result using a heuristic (also known as a rule of thumb or a mental
shortcut) depending on how easily the outcome comes to mind. Easy-to-recall outcomes
are often thought to be more likely than those that are more difficult to recall or
comprehend. People frequently make unconscious decisions about the likelihood of an
event based on how quickly they can recollect a memory of the event.
The core problem is that many people's memories are skewed. Recent occurrences,
for example, are far more easily remembered and accessible. The ease with which
FMPs can recollect information may influence their investment decisions. FMPs may do
the following as a result of availability bias: Instead of conducting a detailed investigation
of the possibilities, choose an investment, investment advisor, or mutual fund based on
advertisements.
2. Representativeness Bias
People prefer to classify new information based on previous experiences and
classifications, which is known as representativeness bias. They feel their classifications
are correct and give them excessive significance. This bias arises from people's
tendency to categorize objects and ideas into individualized categories in order to create
meaning from their experiences. When confronted with new information, they use those
categories, even if the new information does not necessarily fit. To find out which
category should serve as a frame of reference for understanding the new data, they
employ a best-fit approximation.
Determinants of Representativeness
a. Similarity
People frequently consider the degree of similarity between a novel
stimulus/event and a standard/process when determining its representativeness. Due
to the representativeness bias, for example, people have long assumed that stress
causes ulcers while, in fact, germs are to blame. Even simpler beliefs, such as the
notion that consuming fatty meals makes one obese, can be understood as using the
representativeness heuristic.
b. Randomness
Randomness perceptions are influenced by irregularity and local
representativeness. Things that do not appear to have any logical sequence are
thought to be random and so more likely to happen. For example, because it is too

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 well organized, THTHTH as a sequence of coin tosses would not be deemed
indicative of randomly generated coin tosses.
3. Anchoring and Conservatism Bias
Anchoring
Anchoring is an information processing bias in which people's estimation of
probability is influenced by the use of psychological heuristics. When faced with the task
of estimating a value of uncertain size, most people start by visualizing an initial default
number—an "anchor"—which they subsequently move up or down based on new
information and analysis. Because people are better at evaluating relative comparisons
than absolute figures, they anchor and adjust.
The initial price provided for a used car, for example, creates an arbitrary focus point
for all subsequent conversations, whether set before or at the outset of negotiations.
Lower-than-the-anchor prices suggested in talks may appear acceptable, even cheap to
the buyer, even though they are still significantly higher than the car's true market value.
Influencing factors of Anchoring
a. Mood–plenty of studies have connected sad or depressed moods to a more
thorough and accurate analysis of problems. As a result, previous studies suggested
that persons in depressive moods would employ anchoring less frequently than those
in better moods. Recent research, on the other hand, has found that sad people are
more prone to employ anchoring than cheerful or neutral persons.
b. Experience–experts (those having a lot of knowledge, experience, or expertise in a
particular sector) were found to be more resistant to the anchoring effect in early
studies. Several studies since then have shown that, while experience can
sometimes minimize the effect, even specialists are vulnerable to anchoring.
c. Personality –anchoring is more likely to affect people who are pleasant and
conscientious, whereas those who are extraverted are less likely to be affected.
d. Cognitive ability –Anchoring was found to be reduced among those with stronger
cognitive ability in a recent study on willingness to pay for consumer products, while it
did not completely disappear.
Conservatism Bias
Conservatism bias is a belief perseverance bias in which people fail to incorporate
new knowledge into their previous ideas or judgments. Academic research have shown
that conservatism causes people to overestimate their initial assumptions about
outcomes and underreact to new information; in other words, people rarely adjust their
ideas and actions to the amount that the new knowledge rationally justifies them. FMPs
may underreact to or fail to act on new information as a result of conservatism bias,
maintaining beliefs that are similar to those based on past estimations and information.

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4. Overconfidence Bias
Overconfidence is a psychological bias in which people place undue trust in their own
intuitive reasoning, judgments, and/or cognitive abilities. Overestimating knowledge
levels, abilities, and information access could be the cause of this overconfidence.
People, for example, are generally bad at predicting probabilities. Nevertheless, they
believe they are good at it because they believe they are brighter and more
knowledgeable than they are.
Overconfidence can be defined in three ways: (1) overestimation of one's
performance results; (2) over placement of one's performance with regard to others; and
(3) over precision in expressing unreasonable belief in the validity of one's opinions.

Overconfidence Distinctions
a. Overestimation
The propensity to overstate one's standing on a dimension of judgment or
performance is one expression of the overconfidence effect. This subcategory of
overconfidence is concerned with one's belief in one's own competence,
performance, level of control, or likelihood of success. When estimating difficult jobs
or items, when failure is likely, or when the person making the estimate is not
particularly skilled, this phenomena is more likely to occur. Overestimation has been
observed in domains other than ones involving one's own performance. This involves
the planning fallacy and the illusion of control.
Illusion of control – The term "illusion of control" refers to people's tendency to act
as though they have some control when they actually don't.
Planning fallacy – The planning fallacy refers to people's tendency to overestimate
their work rate or underestimate how long it would take them to complete tasks.
Contrary evidence – Wishful-thinking effects, in which people exaggerate the
likelihood of an event due to its appeal, are uncommon.
b. Over precision
Overconfidence in one's knowledge of the truth is known as over precision.
Many of the research that support over precision come from surveys in which
participants are asked how confident they are that specific things are right.
Confidence intervals – The best evidence for over precision comes from research
in which participants are asked to identify a 90 percent confidence range around
estimations of specific quantities to demonstrate how accurate their knowledge is.
People's 90 percent confidence intervals would include the correct answer 90% of
the time if they were precisely calibrated. People have drawn their confidence

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 intervals too narrowly, implying that they believe their knowledge is more accurate
than it is.
c. Over placement
Over placement is a comparison of your performance to that of another
person. People who think that they are more capable than everyone elseis under this
category of overconfidence. It's when you put yourself or rate yourself higher than
others (superior to others).
5. Rational decision-making under risk
Expected Utility Theory
The expected utility hypothesis – claims that the perceived value attached to a
participant's bet is the empirical probability of that individual's behaviour of the gamble's
outcomes that might vary from the cash value of those events.
The best way to understand expected usefulness is to look at an example. Assume
I'm going for a lengthy stroll and must determine whether or not to bring my umbrella. On
a sunny day, I'd rather not carry the umbrella, but I'd rather confront rain with it than
without it. I have two options: I can either take my umbrella or leave it at home. Which of
the following acts shall I perform?
This informal problem statement can be reformulated in terms of three types of
entities in a little more formal manner.
• outcomes—non-instrumental preferences' objects In this case, there are three
possible outcomes: I am dry and free, I am dry and burdened by an oversize
umbrella, or I am wet..
• states—things outside the decision-maker's control and have an impact on the
decision's result. There are two states in the example: either it is raining or it is not.
• acts—Instrumental preferences of the decision-objects, maker's and in certain ways,
things she can do. There are two options in this scenario: I can either bring the
umbrella or leave it at home..
The expected utility hypothesis allows us to rank actions based on how choice worthy
they are: the higher the expected utility, the better the act is to choose. (In the event
when several acts are tied, it is advisable to choose the one with the highest expected
utility—or one of them.)
As a result, the umbrella example may be represented in the matrix below, where
each column represents a state of the world, each row represents an act, and each entry
represents the result of the act when performed in the state of the world.

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 states

it rains it does not rain

take umbrella encumbered, dry encumbered, dry

acts
leave umbrella wet free, dry

Now that I've established the foundation, I can more precisely quantify expected
utility. The expected usefulness of an act AA (e.g., taking my umbrella) is determined by
two characteristics of the problem:
• The utility, which is a real number that represents the value of each outcome.
• The chance of each outcome if AA is present.
6. Mental Accounting
Individuals and households employ a series of cognitive procedures called mental
accounting to organize, evaluate, and keep track of their financial actions. Mental
accounting bias is when people treat one sum of money differently than another of equal
value depending on whose mental account it is assigned to.
Mental accounts are based on arbitrary categorization such as the money's source
(e.g., salary, bonus, inheritance, gambling) or the money's intended use (e.g., leisure,
necessities). The principle of fungibility of money underpins the theory. To state money is
fungible is to argue that all money is the same, regardless of its origins or intended use.
Individuals should perceive money as entirely fungible when allocating among different
accounts, whether it's a budget account (daily living expenditures), a discretionary
spending account, or a wealth account, to avoid the mental accounting bias (savings and
investments).
Practical Implications of Mental Accounting
1. Credit cards and cash payments
Another example of mental accounting is people's preference for utilizing
credit cards rather than cash to pay for products. When paying for tickets to a
sporting event with a credit card, people are more likely to spend more than if they
paid with cash. Transaction decoupling, or the separation between when a good is
obtained and when it is really paid for, is also related to this phenomena. Swiping a
credit card postpones payment to a later date (when we pay our monthly bill) and
adds it to an already enormous balance (our bill to that point). As a result of the
delay, we remember the payment less clearly and vividly.

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 2. Marketing
Mental accounting is particularly beneficial for marketers because it allows
them to forecast how customers will react to various ways of presenting losses and
gains. When gains are segregated and losses are integrated, people respond more
positively to incentives and costs. Marketers segregate net losses (the silver lining
concept) and integrate net gains.
When calculating how much to charge clients for a new smartphone and how
much to pay them for their trade-in, cellular phone firms can employ mental
accounting principles. When the phone's cost is high and the value of the phone to
be traded in is low, it's better to charge customers a slightly higher price for the
phone and give them that money back as a higher trade-in value. Because
consumers are loss averse, it is better to charge them less for the new phone and
offer them less for the trade-in when the cost of the phone and the value of the trade-
in are more comparable.
3. Public policy
When designing public systems, trying to understand and identify market
failures, redistributing wealth or resources in a fair manner, reducing the salience of
sunk costs, limiting or eliminating the free-rider problem, or even just delivering
bundles of multiple goods or services to taxpayers, policymakers and public
economists would do well to consider mental accounting. The way people (and so
taxpayers and voters) view actions and outcomes is inherently influenced by their
mental accounting process. Policymakers should be able to conceive and construct
public policy that results in better outcomes if they examine the implications of how
people mentally book-keep their decisions.
7. Familiarity
Many people we meet in everyday life will only buy a specific brand of clothing, go to
the same store every time, and take the same route to get there. In everyday life, these
are some examples of familiarity bias.
Individuals' propensity to remain confined to what they are familiar with is known as
familiarity bias. They prefer to stay in their comfort zone and avoid going down a path
that has never been traveled before. Humans are more likely to believe in an option that
they recognize and understand. Unfamiliarity makes people feel uneasy and uncertain.
The familiarity bias is also very widespread in the investment world. Investors are
more likely to purchase a stock that they are familiar with. This could include purchasing
shares in their own country, their own company, or companies whose products they are
familiar with.

17
 When given the choice to pick between Apple stock and Synaptics stock, for
example, investors are more inclined to choose Apple. Because they are more familiar
with the brand and utilize its products more frequently, this is the case. The familiarity
bias discourages investors from evaluating the true potential of lesser-known companies
and stocks, which may prove to be more profitable than the well-known options.

Activity 1
Answer the following questions.

1. What are the commonly recognized systematic biases? What are its
implications in financial decision making?
2. Evaluate your individual’s systematic biases. How does the systematic
biases affect investment policy and asset allocation decisions?

Lesson 2: Investors Behavioral Biases

Learning Outcomes: Behavioral finance is becoming

increasingly significant in discussions
At the end of the lesson, you are about corporate finance, investments, the
expected to: stock market, and financial market
• investigate the behavioral and efficiency.
institutional underlying prospect
theory in behavioral finance.;
• compare and
contrastprospecttheoryandEUthe
ory; and
• discuss the implications of
prospect theory for public policy.

18
Lesson Proper

Prospect Theory
Individuals' nonconventional behavior may be smart and so rational in light of the
constraints they face, according to prospect theory. Imperfect and unequal information, as
well as the rules of the game in financial markets, may be linked to rational
nonconventional conduct. Such irrational behavior could be justified in terms of economic
efficiency. To such an extent, this shows that the problem can be solved by modifying the
restrictions that decision-makers confront, rather than by changing individual behavior.
Prospect theory is a subset of behavioral finance that emphasizes the importance of
decision behavior that differs from the norm. Prospect theory, in particular, is based on
stylized facts that are derived through economic and psychology-type research..
The average person: (1) weights losses more heavily than gains; (2) evaluates
losses and gains relative to a subjectively determined benchmark; (3) is interested in
changes at the margin rather than level affects; and (4) is influenced by prospect framing,
even if the frames do not appear to have a substantive or real effect on the pro's expected
value. These discoveries are extremely relevant in a world of uncertainty. Such acts,
according to many modern behavioral economists, indicate irrationality and/or behavioral
biases.

The Nature of Prospect Theory

The most appropriate predictive and descriptive theory of decision behavior under
risk and uncertainty is proposed as an alternative to EU theory, with substantial
consequences for choice under uncertainty. In contrast to EU theory, Kahneman and
Tversky argue that their theory is not normative and does not prescribe behavior at any
level. For rational decision behavior, EUT remains the standard. Thus, prospect theory
does not replace SEU theory as a normative theory.

Prospect Theory and the Choice Behavior

Although prospect theory captures the importance of psychological variables in
choicebehavior,aswellasthedominanceofshort-termconcernsinchoicebehavior, Kahneman
and Tversky (1979) typically assign the prescriptive face of choice theorytoEUtheory.They
argue that one major difference between the two theories—both as a description and
predictor of choice behavior—is that in EU theory, choices are supposed to be reference-
independent, whereas in prospect theory, choices are assumed to be reference-
dependent. In prospect theory, utility is defined by people's attitudes (related to preference
functions) toward profits and losses, which are established based on the reference point.

19
Changes in a person’s income compared to some point of comparison, in other words,
have an influence on efficiency.

Implications of Prospect Theory for Choice Behavior

Individuals may reject possibilities of net positive material worth because of the
emotional suffering associated with a potential loss, according to prospect theory. As a
result, people don't just try to increase their riches.
According to Kahneman and Tversky, closely related to prospect theory's reality-
based assumption that wealth maximization is not the type of behavior that people prefer in
an uncertain world in which a certain outcome (a specific state of wealth) is preferred over a
gamble (an uncertain outcome) with an equal or greater monetary expected value..
Prospect theory's prospective ability to explain specific characteristics of financial
markets or market behavior more clearly than conventional wisdom is based mostly on
three distinctive features of prospect theory:

1. Prospect theory assumes that decision-making is based on a subjectively decided

reference point that is unrelated to the decision maker's financial situation.
2. Subjective reference points give a prospect a frame, which influences their
decision-making.
3. There is a kink in the value function of prospect theory at the reference point,
assuming that individuals' weight reductions are greater than their gains.
Prospect theory can better characterize and anticipate average choice behavior in
financial markets, which is a crucial contribution in this case. Although some behavioral
economists believe that myopic loss aversion is illogical, this viewpoint may be erroneous.
Individuals who expect to have to sell a portion of their financial assets on short notice
should evaluate the returns on an annual basis. That is, they assign a positive probability
that they believe is large, despite the fact that it is objectively low.
Emotional Biases
Emotional cognitive bias and decision-making bias that is influenced by emotional
events.

For example, a person may be prone to:

• attributing negative evaluations to neutral events or things;

• believing something that has a good emotional effect, such as a pleasant mood,
despite evidence to the contrary;
• being hesitant to accept unpleasant realities that cause mental agony.

20
 Here are some of emotional biases:
1. Loss-AversionBias
Loss aversion is defined as a strong preference for avoiding losses above achieving
benefits, according to prospect theory. According to several research, losses are
substantially more impactful psychologically than rewards. According to several of these
research, avoiding losses is two times as motivating as achieving profits. Rational FMPs
should take on greater risk in order to increase gains rather than to reduce losses.
People with loss aversion will hold on to their losers even if they have little or no hope of
recovering their losses. When people consider a prospective gain, loss-aversion bias
leads to risk avoidance.

2. Self-Control Bias
Self-control bias occurs when people lack self-control and hence fail to act in pursuit
of their long-term, overall goals. Short-term enjoyment and the fulfillment of some long-
term goals are inherently at odds. People are infamous for demonstrating a lack of self-
control in the domain of money, but it is not the only one. As an example, consider how
people feel about losing weight. A doctor tells a person who is 100 pounds overweight
that losing weight is critical for long-term health. Despite this understanding, the
individual may be unable to reduce their food intake. Eating for short-term pleasure is
incompatible with the long-term goal of good health.

3. Status Quo Bias

The status quo prejudice is an emotional bias that causes people to do nothing (keep
the status quo) rather than change. People are more emotionally at ease maintaining
things the same than they are with change, therefore they are less likely to seek out
situations where change is helpful. The status quo is maintained because no evident
problem necessitates a decision. Furthermore, when faced with a circumstance where
one option is the default, people are more likely to stick with that option rather than
opting out and making a different decision. As a result, the method of presenting options
might have an impact on judgments.

4. Endowment Bias
People value an asset more when they have rights to it than when they don't. This is
known as endowment bias. Endowment bias contradicts conventional economic theory,
which states that the price a person is prepared to buy for a thing should be the same
price at which that person is willing to sell that same good. However, psychologists have
discovered that when people are asked, they prefer to cite minimal selling prices for a

21
 product they possess but surpass maximum buying costs for the same product.
Ownership effectively “endows” the asset with more value.

5. Regret-Aversion Bias
Regret-aversion bias is an emotional bias in which people avoid making decisions
that will lead to action because they are afraid of making a bad judgment. Simply said,
people attempt to avoid the regret that comes with making poor judgments. This
propensity is especially prominent when it comes to making investing decisions. FMPs
with regret aversion may cling to situations for too long. They are hesitant to sell because
they are concerned that the position's value will rise, and they will later regret selling it.

Activity 2
Answer the following questions.
1. When can systematic biases lead to errors in judgment and
foolish decisions? Explain with specific examples.
2. Give an example of a time when you used systematic biases in
your life.
3. Differentiate prospecttheoryandEUtheory. What do you think is
its implication in an investor’s decision making process?
4. What are the effects of prospect theory in public policy?

Lesson 3: Investors Psychological Biases

Learning Outcomes: Psychological bias is the

tendency to make irrational decisions or
At the end of the lesson, you are actions. You might, for example, use
expected to: data selectively subconsciously or feel
• discuss the different pressured to make a judgment by
psychological biases; and influential co-workers.
• explain on how to avoid
psychological biases.

22
Lesson Proper

Psychological bias is the opposite of common sense and clear, measured judgment.
It can lead to missed opportunities and poor decision making.

Here are some of Psychological Biases:

1. Diversification Bias
People seek variety because they are risk averse and uncertain about their
preferences. Choosing variety reduces the likelihood of repeatedly consuming something
undesirable. Because the predicted value of such low-risk assortments can be greater
than that of riskier bundles containing only one type of item, diversification is an
unbiased decision rule (even if it is the one they expect to like best).
For example, I might put classical, rock, and pop music on my MP3 player before
going on vacation, but during the trip itself, I might largely listen to my favorite rock
music. When people choose between things that can be categorized as virtues (e.g.
high-brow movies or healthy deserts) and vices (e.g. low-brow movies or hedonic
deserts) at the same time, their diversification approach usually implies a higher
selection of virtues.

2. Excessive Trading
According to the notion of excessive trading, high overconfidence behavior causes
investors to engage in aggressive and excessive trading techniques. It will, in the end,
result in poor investment results. Investors will raise their trading volume if they
overestimate the accuracy of the information. According to Gervais and Odean (2001),
when trade volume and volatility rise, investors will gain less and potentially lose money.
Overconfidence in financial markets can have negative consequences, but it can also
bring profits that are higher than those achieved by prudent investors.According to
Glaser and Weber (2003), investors that have a high level of overconfidence are more
likely to trade in huge volumes. The greater their urge to trade, the more aggressive their
transactions will become, as seen by higher trading frequency and volume.

3. Disposition Effect
The disposition effect, which is defined as a tendency to realize gains while deferring
losses, raises capital gains taxes and decreases profits even before taxes. This effect
underpins market trade volume patterns, leading to the positive link between housing
market liquidity and price levels, for example. The disposition effect contributes to price
momentum in stock market under-reactions.

23
 Focusing on realized returns rather than overall portfolio returns might lead to a
distorted picture of investment success. The disposition effect may explain why investors
are too enthusiastic about their future performance (Barber and Odean, 2001), but
appear to be unaware of their real previous performance (Glaser and Weber, 2007).

What Causes the DispositionEffect?

1. Prospect theory is the first element. After experiencing wins, an investor with
prospect theory preferences would become more risk-averse, and after
experiencing losses, more risk-seeking. This means that if the investment's value
falls, holding on to it becomes more appealing than selling since the investor is
willing to take on greater risk.

2. Mental accounting is the second component. It describes people's proclivity to

categorize various financial sources and uses into several psychological accounts
in their heads. People may, for example, perceive money received as a salary
differently than money saved for a purchase. This is frequently innocuous. People,
on the other hand, may lose sight of what is best for their overall financial well-
being if they examine these mental accounts separately.

3. Regret aversion is the third component. Closing a stock position at a loss and so
admitting a mistake might lead to regret about the initial stock purchase choice.

4. Self-control is the fourth element. Self-control explains why the end-of-year

disposition impact is weaker. When presented with clear self-control mechanisms,
such as the end of the tax year, investors may find it easier to get rid of losing
investments.

4. Framing
The term "framing bias" refers to an information processing bias in which a person
responds to a question differently depending on how it is phrased (framed). The frame
that a decision maker adopts is influenced by the problem formulation as well as the
decision maker's conventions, habits, and personal qualities. The way things are
presented or framed can influence FMPs' willingness to accept risk. When investing
concerns are framed positively or negatively, a frequent framing problem develops.
Assume Mr. Ing has an option between Portfolio A and Portfolio B, both of which have
the same predicted risk and return. Mr. Ing is told that Portfolio A has a 70% chance of
meeting his financial objectives, whereas Portfolio B has a 30% risk of failing to meet

24
his objectives. Because of the favorable way the question was presented, Mr. Ing is
likely to choose Portfolio A.

Activity 3
Answer the following questions.
1. What are the different psychological biases? How do you
avoid this psychological biases?
2. If you weren’t able to avoid psychological biases, what will
be the effect in one’s investment decisions?

25
 UNIT 3: INVESTOR BEHAVIOR

In a misperceived or misunderstood situation, reasonable thinking can lead to

irrational conclusions. Furthermore, biases can lead to people overemphasizing or
underemphasizing information, as well as a strong connection to a concept or an inability to
notice an opportunity. The context in which you perceive a decision, as well as the mental
frame you assign to it (i.e., the type of decision you deem it to be), can stifle your otherwise
objective perspective.

In this chapter, we'll look at how professional investors and analysts behave, as well
as stock market theories.

Target Learning Outcomes

LO3 – Evaluate behavioral influences involving individual’s investment decisions.

Lesson 1: Behaviors by Professional Investors and

Analyst

Learning Outcomes:
There are several key reasonable
motivations for individual investors to
At the end of the lesson, you are
trade, according to classic financial
expected to:
economics research. Grossman and
• identify the different types of Stiglitz, for example, suggest that
investors; investors will trade when the marginal
• discuss the implication of gain of doing so is greater than or equal
investors to mutual fund to the costs of doing so. They argue
performance; and that information, particularly private
• describe the tournament effect. information, should be a primary
motivator for investors to engage in
trading.

There are, of course, a variety of other

reasons to trade in a more realistic and
active market. Individuals may, for

25
 example, need to trade in order to
rebalance their portfolios after some
stock prices significantly rise or
decrease, causing portfolio weights to
shift. They can keep their preferred asset
allocation structure by trading in those
stocks. Individuals may also need to
liquidate a portion of their equity
investment to raise cash for personal
consumption.

Lesson Proper

The following are the types of investors:

A. THEPRESERVER
Name of Behavioral Investor Type: Preserver

Basic Orientation: Loss averse and deliberate in decision making

Dominant Bias Types: Emotional, relating to fear of losses and inability to make
decisions/take action

Impactful Biases: Loss Aversion and Status Quo Investing Style: Wealth preservation first,
growth second

Level of Risk Tolerance: Generally lower than average

A Preserver Behavioral Investor Type is an investor that prioritizes financial comfort

and money preservation over taking risks in order to develop wealth. These types of
investors are stewards of their money and take losses severely. Preservers are generally
cautious in their selections and have trouble acting on their investments because they are
afraid of making the wrong choice. Instead, they might opt to avoid danger and maintain the
status quo. Preservers are frequently preoccupied with short-term performance (in both up
and down markets, but primarily down markets) and losses, as well as the prospect of losing
what they have already gained.This practice is in line with how Preservers have tackled their
job and personal lives—carefully and deliberately.

It is common to come across senior investors who behave in the manner described
above. This is entirely normal. As we get older, cash flow certainty becomes more important.
As a result, it's typical to see Preservers use their riches to benefit their family and coming

26
generations, particularly through sponsoring life-enhancing events like education and
property ownership. Because the emphasis is on financial stability, Preserver biases are
more likely to be controlled by emotion—how they feel—rather than cognitive factors they
think.Obsession with maintaining assets and (occasionally) extremely conservative habits,
such as loss aversion, status quo, and endowment biases, can hinder the Preservers' ability
to achieve their financial goals.

Upside/Downside Analysis

On the upside, Preserver BITs gain access to certain advantages. Preservers adopt
a cautious approach to investing since they are focused on conserving cash and avoiding
losses. This can be advantageous in terms of reducing portfolio volatility, which can result in
higher long-term compounding returns. Furthermore, Preservers who exercise savings
habits through mental accounting (e.g., saving for retirement, college financing, and paying
bills) can build long-term wealth if they invest in a balanced fashion across these many
mental accounts.Preservers are also less likely to participate in trading, which has been
demonstrated to be harmful to wealth building. Having the ability to maintain to a long-term
strategy is an advantage of taking a more thoughtful approach to investing.

The biggest disadvantage of the Preserver BIT is an overabundance of attention on

minimizing. During economic breakdowns such as those in 2000–2001 and 2008–2009,
some Preservers have been observed to worry and sell out after suffering losses, only to see
markets rise in the next 12 to 24 months. It's also worth noting that Preservers may sell
profitable investments too soon in order to protect earnings, which might stifle long-term
financial success. Furthermore, if too much cash is held across numerous mental accounts,
such as those mentioned in the previous "upside" section, excessive mental accounting
might lead to inefficient portfolio development.Another disadvantage of the Preserver BIT is
that it tends to take a risk-averse attitude to investment planning in general. For example, if
Preserver BITs put too much of their money in cash and bonds, they may not be able to
meet their financial objectives if they require a portfolio return of 5% to 10% or more. Bonds
and cash will not get you there. Furthermore, Preserver BITs' biases are primarily emotional,
making it difficult to change or regulate them, particularly during market upheavals. Investors
should consider making riskier investments rather than selling risky ones during these
periods.This may seem contradictory, particularly when markets are plummeting, but it is
virtually always the proper decision to enter hazardous asset markets when there is "blood in
the streets."

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Bias Analysis

Loss-Aversion Bias Bias Type: Emotional

Preservers are more sensitive to the agony of losses than to the joy of wins,
especially when compared to other behavioral investor types. There are two main scenarios
in which loss aversion can be observed, and it is critical to comprehend how loss aversion
might be applied in both situations. Individual hazardous assets, such as a single stock, are
appealing to certain investors.They buy XYZ firm stock after receiving a recommendation
from a friend. Due to a difficulty with their product line, XYZ declines 20% shortly after the
investment has been made. Because the risks connected with XYZ's line of products are too
big to be disregarded, some reasonable investors will have no trouble accepting a loss and
exiting XYZ. Preservers and other investors who are afraid of losing money will hold on to
XYZ because losing money is too unpleasant. These clients may hold on to losing assets for
much too long, even if there is little hope of a recovery. This is a wealth-destroying behavior.

The asset allocation context is another place where loss aversion can be exhibited.
Many savvy investors avoid investing in individual stocks in favor of a diverse portfolio of
asset classes that includes equities, fixed income, and possibly some alternatives.

Status Quo Bias Bias Type: Emotional

Preservers who are loss averse, as we've just learned, have a hard time acting on
portfolio changes (status quo bias). Now we'll look at two examples of status quo prejudice.

Scenario #1:Let's say Jim, a 50-year-old Preserver investor, wakes up one day in
September 2008, after missing the last bull market, and realizes he needs to start saving
and investing. He makes a financial plan (either with his financial advisor or on his own) and
discovers that if he wants to achieve his long-term financial goals, he needs to invest in
stocks (in this case, the S&P 500). He currently has 40% cash, 40% bonds, and 20%
equities in his portfolio. According to his strategy, he needs to sell some of his bonds and
invest part of his hard-earned money in the equity markets.He has a hard time pressing the
trigger, and as luck would have it, he doesn't act. Late 2008 and early 2009 saw the stock
market plummet. He can't actually believe how fortunate he was to be spared the horror. He
is aware, though, that he must begin investing. But when is it appropriate to do so? We
already knew the proper time was March 2009, when there was blood in the streets and
dread reigned supreme. Preserver investors, on the other hand, are likely to be the most
scared of all when fear is pervasive. So, unless advised, convinced, or otherwise told to do
so by an outside counsel, a Preserver investor like Jim is unlikely to invest during a period
when markets are plummeting rapidly. He does not invest in March 2009.

28
 Let's pretend it's October 2009, a year after the economic crisis began. Since the
lowest in March 2009, the stock market has returned by 35%. Is now a good time to buy?
Jim simply missed out on the quick profits from the bounce, and he may now be joining at a
time when markets are likely to plummet again. There is no measures done. It's now March
of 2010. The stock market is up another 25%. Jim narrowly avoided a 60 percent rally. There
can't be a better time than now. You get my drift. If Jim is worried of losing money, there is
always a period when he should not invest in stocks.

Scenario #2: Assume Jack, a Preserver investor, has an investment/asset allocation plan
going into the 2008-2009 financial crisis, as well as a fully invested portfolio of 40% equities,
40% bonds, and 20% cash. In the fourth quarter of 2008, the stock market plummeted. An
investor may have been able to rebalance his or her portfolio depending on when a review of
his or her portfolio allocation occurred. If the Preserver had been able to rebalance in
December 2008, he might not have done so because he was afraid of buying into a falling
market. Let's go ahead to the end of the first quarter of 2009.Most investors, like Jack, are
relieved that they did not have to rebalance their portfolios in 2008. However, between the
conclusion of the last quarter of 2008 (December 2008) and the later part of the first quarter
of 2009, there was undoubtedly some form of portfolio review (March 2009). The investor's
portfolio must be rebalanced according to the asset allocation plan. Simply said, when
stocks fall and fixed income rises, it's time to rebalance back to your target allocation.
Rebalancing in March 2009 was challenging for any investor, let alone Jack, who is a
preserver.In March 2009, many Preserver investors were “frozen in the headlights.” The
stock market was in free fall. Fear reached its peak. As a result of the status quo bias, no
action was made. We may go back to the last scenario to see what transpired to Jack in
March 2009 after he failed to rebalance.

Finally, whether we have a client who has to invest a large sum of money in equities
or an individual who only needs to rebalance his portfolio, Preservers can make the process
difficult. If you're an investor or an advisor, you should have a better notion of how to
manage this circumstance now that you've identified the issue.

A simple diagnostic for status quo bias can also be useful: ask your clients whether
they are more comfortable not taking action during times of change or whether they can
embrace change in their investments or in their lives in general. They are more likely to be
affected by status quo prejudice if they want to keep things the same and constantly wait
and see.

29
Endowment Bias Bias Type: Emotional

Many Preservers, particularly those who inherit riches, place a higher value on an
investment they already hold (such as real estate or an inherited stock position) than they
would if they didn't own it but had the opportunity to acquire it. To put it another way, some
investors hang onto investments solely because they already possess them.

A easy test for endowment bias is to ask your clients if they keep things or assets because
they already possess them (via inheritance, for example), but would not be interested in
purchasing them themselves. If this is the case, they are likely to suffer from endowment
bias.

Anchoring Bias Bias Type: Cognitive

When faced with questions like "Should I buy or sell this investment?" investors in
general, and Preservers in particular, are frequently affected by purchase points or arbitrary
price levels, and they prefer to cling to these numbers. Assume the stock is down 25% from
its five-month peak ($75/share against $100/share). A Preserver client will frequently refuse
to sell until the price of the stock returns to the $100/share level it reached five months
earlier.

A simple test for anchoring bias is to ask your clients if they've ever had trouble
getting "anchored" to an investment's pricing, as in the case mentioned above. If that's the
case, they're likely to be affected by anchoring bias.

Mental Accounting Bias: Cognitive

Most investors regard different amounts of money differently depending on how they
are cognitively classified. Preservers, for example, frequently divide their possessions into
safe "buckets." When all of these assets are perceived as safe havens, the overall portfolio
returns are typically unsatisfactory.

A simple test for mental accounting bias is as follows: Inquire whether your
consumers tend to organize their money by use or categories, such as money for vacations,
college funds, and bills. If that's the case, they're probably vulnerable to mental accounting.

Advice for Preservers

Following this lesson, you may infer that preservers are hard to advise because they
are motivated primarily by the need to prevent losses, which is an emotional reaction to
changes in the value of their portfolios. Long-term investments in equities, which are
certainly the most unpredictable investment, have been rewarded handsomely, according to

30
statistics. As a result, it is an investor's ability to regulate their behavior in terms of not selling
at the wrong time and rebalancing at the correct time that determines whether or not they
achieve their financial objectives. Preservers require sound financial guidance. Advisors
should spend time interpreting the behavioral indications that Preserver clients
present.Preservers require big-picture advice, and behavioral coaching rather than strict
financial or investing knowledge is frequently required. Advisors, for example, would
definitely be more effective in advising Preserver clients if they didn't concentrate on issues
like standard deviations and Sharpe ratios, especially during times of market turmoil,
otherwise they'd lose the client's focus. Preservers must comprehend how the portfolio they
choose to build will respond to emotional factors such as family members' or future
generations' demands.They will be ready to take action after they feel comfortable
discussing these critical emotional issues with their counselors and a bond of trust has been
built. Preservers are likely to become an advisor's best customer after a timeframe because
they regard the advisor's competence, competence, and impartiality in assisting them in
making the greatest financial decisions.

B. THE FOLLOWER

Name of Behavioral Investor Type: Follower

Basic Orientation: Lack of interest in money and investment in general, as well as a desire
for guidance while making financial decisions.

Dominant Bias Type: Cognitive, relating to following behavior. Impactful Biases: Recency
and Framing

Investing Style: Passive

Level of Risk Tolerance: Generally lower than normal, although frequently mistakenly
believes his risk tolerance level is higher than it is.

A passive investor with little interest in and/or qualities for money or investing is
referred to as a Follower Behavioral Investor Type. Furthermore, follower investors are
unlikely to have their own investment ideas. Rather, individuals may make their financial
selections based on the advice of their friends and colleagues, or on whatever current
investing trend is popular. Frequently, they make decisions without concern for the long
term. When an investing option works out, individuals can delude themselves into thinking
they are smart or gifted in the investment world, which can lead to inappropriate risk-taking
behavior.They may respond differently when given with the same equity investment more
than once since they don't have their own notions about investing; that is, the way something
is provided (framed) can cause them to feel and behave differently. They may also be

31
resentful of missing out on the latest investment craze and end up acquiring at the worst
possible time, when stocks are at their maximum.

Dealing with Followers has a number of issues, one of which is educating them how
to avoid overestimating their tolerance for risk. They may be so enticed by an investment
that they take it without thinking about the hazards. Advisors must be careful not to
recommend too many exciting investment opportunities; followers will be tempted to try them
all. Some people dislike, or even fear, the chore of investing, and as a result, many put off
making investment choices without seeking professional assistance, resulting in huge cash
balances.When given professional advice, followers often follow it and attempt to educate
themselves financially. However, because they don't appreciate or have an aptitude for the
financial process, counseling them can be tough at times.

Upside/Downside Analysis

Let's take a look at the bright side. Follower BITs are entitled to specific advantages.
Because Followers aren't overly concerned with money, they usually live lives that are less
stressful than those who are constantly thinking about money. Also, because investing isn't
always on their minds, Followers are less likely to trade their accounts too much, which is a
big plus because trading has been shown to be a wealth-depleting activity. Low portfolio
turnover can help reduce portfolio risk, which can contribute to superior long-term
compounding returns.

Followers may also learn that they aren't very good with money and decide to employ
an investing advisor to assist them. Advisors can assist in instilling discipline in the investing
process, which is especially important for Follower investors.

The disadvantage of the Follower BIT, supposing they do not hire an advisor, is a
lack of discipline during the investment process. Unadvised Followers, for example, tend to
put a lot of focus on investing in the most current investment trends—those that already
have done successfully lately.This might result in people investing in asset classes at the
wrong time, when prices are at their highest, causing them to lose money. When
investments rise in value, followers may delude themselves into feeling they are skilled
investors when, in fact, it was a rising tide that raised all boats. This can lead to increased
risk-taking behavior, and taking on too much risk at the wrong time might result in lasting
capital losses.

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Bias Analysis

Recency Bias Bias Type: Cognitive

Followers are disengaged from the investing process, opting to take a simpler way to
invest by either following the crowd (investing in whatever the majority is doing) or following
the advice of friends and coworkers. Recency bias arises when investors are looking at an
investment's most recent performance and make an investment decision based on that
performance. This is a pretty common Follower BIT behavior. The following is an example of
recency bias that a Follower investor could display.

Recency bias is a cognitive bias that occurs when recent occurrences or perceptions
are given excessive weight compared to those that transpired in the recent or distant past.
Assume that a passenger on a passenger liner voyage observes an equal number of green
and blue boats from the viewing platform during the cruise. If there are more green boats
than blue boats at the end of the trip, however, recency bias will lead the guest to believe
that there were more green boats than blue boats during the trip.

The following is a simple recency bias test: Give your clients a scenario in which they must
assess the track history of a successful investment. Inquire about their interest in the
investment. They may be prone to recency bias if they are interested.

Framing Bias Bias Type: Cognitive

The term "framing bias" refers to how decision makers may respond to a topic
differently depending on how it is phrased (framed). A decision frame is a decision maker's
subjective perception of the actions, outcomes, and contingencies associated with a certain
option. The frame that a decision maker adopts is influenced by the problem formulation as
well as the decision maker's conventions, habits, and personal qualities. It's common to be
able to frame a decision dilemma in multiple ways. A framing effect is a shift in preference
between options as a result of changing frames, which could be done by changing the
problem formulation.For instance, a problem could be described as a gain (a treatment will
save 35% of those with an illness) or as a loss (a disease will kill 35% of those who take it)
(65 percent of those people with a particular disease will die without the medicine). They in
the first situation adopt a gain frame, which leads to risk aversion, whereas in the second
case, people embrace a loss frame, which leads to risk-seeking behavior.

A simple test for framing bias is as follows: Show your clients the prior example.
Inquire if they would respond differently to the questions. They may be prone to framing bias
if they do.

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Hindsight Bias Bias Type: Cognitive

Followers frequently lack autonomous investment views and are prone to hindsight
bias, which happens when an investor views investment outcomes as predictable. The
reaction of investors to the financial crisis of 2008 is an example of hindsight bias. Many
people first saw the housing market's behavior from 2003 to 2007 as normal (not indicative
of a bubble), only to subsequently declare, "Wasn't it obvious?" when the market crashed in
2008. When it comes to investing decisions, hindsight bias offers investors a false sense of
security, encouraging them to assume extra risk without realizing it.

The following is a basic test for hindsight bias: Provide a scenario in which your
clients failed to come to a decision or followed the advice of others because they didn't want
to regret their choices afterwards.

Cognitive Dissonance Bias Bias Type: Cognitive

Attitudes, emotions, beliefs, and values are all examples of cognitions in psychology.
People try to lessen their discomfort by disregarding the reality and/or explaining their
judgments when several cognitions intersect—for example, a person believing in something
only to discover it is not true. Investors with this bias may continue to invest in an asset or
fund they currently hold after it has declined (averaged down), while knowing that they
should be analyzing the new investment objectively. This approach is often referred to as
"throwing good money after bad."

The following is a simple test for cognitive dissonance bias: Request that your clients
describe a situation in which they suffered losses on a stock portfolio. After that, inquire as to
why the loss occurred. They may be suffering from cognitive dissonance bias if they insist it
was "not my fault" and blame other things such as poor management.

Regret Aversion Bias: Emotional

Follower investors typically delay taking definitive moves because they are afraid that
whichever path they choose will turn out to be less than ideal in the long run. Because of
previous losses, regret aversion can force these investors to be too cautious in their
investing decisions.

A simple test for regret aversion bias is as follows: Inquire if your clients have ever
made an investment they regret, and if that regret has influenced a current or future
investing decision. If this is the case, individuals are prone to experience regret aversion
bias.

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Advice for Followers

First and foremost, advisors to followers must know that followers frequently
overestimate their tolerance for risk. Part of the reason for risky trend-following behavior is
that followers dislike the effort of investing and the discomfort that can come with deciding to
enter an asset class when it is out of favor. When an investment concept pays off,
individuals may convince themselves that they "knew it all along," which boosts future risk-
taking behavior. Advisors must be cautious when dealing with followers, as they are more
prone to say yes to investment ideas that make logical to them, regardless of whether the
advice is in their best long-term interests.Followers must be led by Advisors to examine
behavioral characteristics that may cause them to overstate their tolerance for risk. Because
follower biases are mostly intellectual, the best line of action is usually to educate people
about the benefits of portfolio diversity and to stick to a long-term plan. Follower clients
should be challenged to be reflective and give data-backed justification for suggestions,
according to advisors. It's a good idea to provide education in simple, straightforward ways
so that they can "understand it." This gradual, informative approach will develop customer
loyalty and commitment to long-term investment strategies if advisors take the time.

C. The Independent

Name of Behavioral Investor Type: Independent

Basic Orientation: Engaged in the investment process and opinionated on investment

decisions.

Dominant Bias Type: Cognitive, relating to some pitfalls associated with doing one's own
research.

Impactful Biases: Confirmation and Availability Investing Style: Active

Level of Risk Tolerance: Generally above average but not as high as aggressive investors.

Investors who are Independent Behavioral Investor Types have unique investment
ideas and enjoy participating in the investment process. They are not indifferent in investing
and are fairly engaged in the financial markets, unlike Followers, and they may have unusual
investment opinions. Independents, on the other hand, may be hesitant to follow a long-term
investment strategy because of their "contrarian" outlook. Having said that, many
Independents can and do stick to an investment strategy in order to achieve their financial
objectives.Independents are analytical, able to think critically who rely on reason and their
gut feeling to make many of their decisions. They are willing to take a risk and take

35
immediate action when necessary. Independents, as opposed to followers and dreamers,
are thinkers and doers who can complete projects when they put their minds to it.

However, some Independents are susceptible to prejudices that can jeopardize their
capacity to achieve their objectives. Independents, for example, may move too hastily
without first understanding as much as possible about their investments. They might, for
example, confuse reading an item in a business news publication with conducting unique
research. They may leave some critical stones unturned in their half-ready, full-on pursuit of
profits, which could tangle them up towards the end.

Upside/Downside Analysis

Independent BITs benefit from a number of advantages. Independents are intelligent,

powerful thinkers who aren't hesitant to put their financial theory into practice by
incorporating them into their portfolios. Independents can take chances and act decisively,
which is necessary for successful investing. They must not only have innovative ideas, but
also be able to put them into action when called upon to do so. Because there are many
investors who are herd followers and are often unhappy as a result, independents can be
successful as contrarian investors.Because they are logical, they may be able to assist
themselves by locating the cheapest service providers. They are more likely to be innovators
and achievers than followers and visionaries.

The disadvantages of the BIT are primarily prejudices that can jeopardize their
capacity to achieve their financial objectives. As we'll see in the next part, independents
have a tendency to move too soon without first learning as much as they can about their
holdings. They might also look for evidence that supports their assumptions rather than
evidence that disproves them.They may also hold unreasonably to their own notions rather
than being receptive to fresh ideas that may prove them wrong. Their analytical nature might
often work against them. Some Independents, for example, may place too much emphasis
on taxes and not enough on adopting an effective investment strategy. This is referred to as
letting the “tax tail wag the investment dog” in the business.

Bias Analysis

Confirmation Bias Bias Type: Cognitive

People want to be able to back up their decisions. It's in our nature. And, because it
makes us feel better to believe we've made the proper decision, we begin to perceive and
overlook items that support our decisions and ideas. Confirmation bias is defined as this. It
persuades us that what we want to believe is accurate by emphasizing the factors that help
our preferred outcome. This tendency can be dangerous to one's wealth because we can be

36
caught off guard by information we didn't anticipate. The investor is harmed by confirmation
bias, which makes an investment decision appear better than it is.

Confirmation bias has a basic diagnostic: Make a scenario for your clients in which
they make an investment that doesn't work out. Inquire whether they prefer to seek evidence
that proves they were correct in making the investment or information that proves they were
wrong. They may be prone to confirmation bias if they are drawn to facts that will prove them
correct.

Availability Bias Bias Type: Cognitive

The availability bias is another factor that influences Independents' investment

decisions. Availability is a cognitive bias that leads investors to feel that the facts that are
most relevant to their own lives are the ones that are most important to the success of an
investment. As a result, the reliability of information is determined in part by how “available” it
is to them. When one suffers from the availability bias, options that are easy to recall and
known to us appear to be more likely to be true than those that are less familiar. It's
challenging to fully comprehend all of the information that bombards us every day.As a
result, we digest and swallow bits of information that are easy to detect and ingest, while
ignoring the rest.

When investing, this basically translates into making decisions based on previous
experiences and easily seen consequences rather than absorbing more difficult-to-
understand data, such as figures. Rather than examining objectively at the cold, hard facts,
some people give information a subjective spin. Investing with brokers or mutual funds that
advertise the most is a classic example. These businesses make information publicly
available, and individuals pay for it; however, are they the best? If you do your homework,
you might find out that this isn't the case.

Bias Analysis

Self-Attribution Bias Bias Type: Cognitive

Whenever a choice we make turns out well, we tend to credit our own abilities and
forethought for our achievement. We tend to blame poor luck and other situations that are
beyond our control when things don't go as planned. Do you feel that a high test score is a
direct outcome of your hard effort and intrinsic intelligence, and that a low score is a product
of the exam's grading system? If you have a tendency to assume that your triumphs are
solely due to your talents and abilities, and that your failures are never due to your own
flaws, you are likely suffering from self-attribution bias.

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 When an Independent BIT's financial decisions pay off, the investors like to pat
themselves on the back for their foresight. When things don't go as planned, though, the
Independent BIT finds solace in concluding that someone or something else is to blame.
Neither of these statements is totally accurate. When things go well and persons with a self-
attribution bias evaluate their portfolios, they often have more faith in their stock-picking
talents than is merited, and as a result, they may take on more risk than they should. Have
you heard the statement "a little knowledge can be dangerous"? It can be excruciatingly
difficult when it comes to investing.

Successful returns on investments are often due to a variety of variables, the most
notable of which is a bull market; stock value declines, on the other hand, can be equally
random and complex (sometimes owing to fraud or mismanagement, sometimes due to
luck). People with a self-attribution bias are captivated by the pride that arises when deals do
very well, and because they do not step back to figure out what went wrong when trades
don't go well, they tend to trade too frequently, resulting in a portfolio that comes up short.

Conservatism Bias Bias Type: Cognitive

Independent BIT investors with a conservatism leaning are more likely to stick to
what they currently believe to be true than than learning new knowledge. This is
demonstrated in the following example. Assume James, an investor, learns some terrible
news about a business's earnings, which contradicts another earnings projection from the
previous month, which he used to invest in the company. James underreacts to new
information due to his conservatism bias, sticking to his prior estimate rather than acting on
the fresh information.As a result of his refusal to understand that he could lose money, he
ends up holding on to a stock that he will lose money on. People with conservatism bias, like
James, can make poor investing selections because of their preconceived notions.

Representative Bias Bias Type: Cognitive

The representational bias is the last bias that may be attributed to the Independents.
The representational prejudice, like the availability bias, is based on our need to have the
information we need to process fit into a clean framework. The representative bias, on the
other hand, takes this tendency a step further, in that when persons with a representative
bias come across aspects that don't fit into their categories, they try to find the "best fit"
solution.

On the one hand, representational bias aids our ability to swiftly acquire and
assimilate new information; on the other hand, it works against us by allowing us to perceive
only those possibilities that fit within the framework of what we want to observe. Consider a

38
gambler who is on a winning streak. There is no such thing as a winning streak statistically,
but try telling that to a gambler when the chances are in his favor. The gambler observes
winning hand after winning hand and puts it into a structure that he can comprehend: the
winning streak. But, in the end, it's all down to luck.

Representative bias can be divided into two types: base-rate omission and sample
size omission. An investor may use base rate neglect to try to predict the success of an
investment by setting it in a familiar context. He or she might, for example, classify Company
F as a value stock because it resembles the well-performing Company A. It's a shortcut to
putting together components that appear to be "likes," and it's similar to stereotyping. You
may know a lot of physicians who enjoy tennis, but is it really fair to state that Steve enjoys
tennis simply because he is a doctor?

When you group similar-looking investments together in investing, you miss out on
the elements that distinguish them, which can have a big impact on the investment's
performance. Let's say George wants to diversify his portfolio with a decent long-term
investment. He learns about PillGene (PG), a trendy new pharmaceutical startup, via his
friend Harry. According to Harry, the CEO is a "movers and shaker" who has assisted PG in
successfully marketing a generic medication that has received "buy" recommendations from
many Wall Street businesses. George is satisfied and places an order for 100 shares of PG,
believing that this hot IPO is a smart long-term investment despite the lack of knowledge and
hype.

If George had done his homework, he would know that only a small proportion of
IPOs turn out to be solid long-term investments—that they often make money in the first few
days after the offering and then tend to trail their IPO values over time. He would have
known this if he had done his homework and would have been less eager to jump.

On the other side, sample size neglect occurs when an investor makes a broad
decision based on a set of criteria presented to him. Do you recall the classical music fan?
The "rule of small numbers" leads some investors to believe that small sample sizes are
typical of populations (or "actual" data).

Let us return to George. Jim, one of his friends, is ecstatic about a new stockbroker
who has given him three outstanding stock ideas in the previous month or two, all of which
are up over 10%. George determines he needs to speak with Jim's representative. He's got
to be a genius with three solid picks over 10% in a month. George, on the other hand, does
not have the full picture. If George had gathered all of the details, he would have discovered
that the broker Jim is depending on covers a popular industry at the time, and that every

39
stock he covers has recently had success. And Jim failed to explain that this same broker
had issued a streak of three losing recommendations the previous year.

The lesson here is that when investors don't have a complete picture, they're more
likely to make incorrect assumptions based on a few bits of available data and assign
universal generalities to this limited sample of data. This can include making investments
that are going south without realizing it, which is more prevalent than you might think. If you
don't want this to happen to you, always look at all of the data before making a decision.

Advice for Independents

Due to their independent thinking, independents can be tough customers to advise,

but they are usually grounded enough to listen to excellent advice when it is provided in a
way that respects their independence. Independents, as we've seen, are steadfast in their
belief in themselves and their actions, yet they can be blinded to opposing viewpoints.
Independents, like Followers, require education to change their behavior; their biases are
primarily cognitive. Regular informative conversations during customer interactions is an
excellent strategy.This way, the adviser can educate the client on a regular basis and adopt
principles that he or she believes are acceptable for the customer, rather than pointing out
unusual or recent failures. Because independent biases are mostly cognitive, the best line of
action is usually to educate yourself on the benefits of portfolio diversification and stick to a
long-term strategy. Advisors should challenge their Independent clients to think about how
they make investing decisions and back up their recommendations with facts. It is effective
to provide education in a clear and straightforward manner. This continuous, educative
approach could offer great results if advisers put in the effort.

D. The Accumulator

Name of Behavioral Investor Type: Accumulator

Basic Orientation: Interested and engaged in wealth accumulation and confident in investing
ability.

Dominant Bias Types: Emotional, relating to overconfidence and desire for influence over
investment process.

Impactful Biases: Overconfidence and illusion of control. Investing Style: Actively engaged in
decision making.

Level of Risk Tolerance: High to very high.

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 Investors who are engaged in accumulating money and are confident in their ability
to do so fall into the Accumulator behavioral investor category. These BITs have often been
successful in some form of company and have enough faith in themselves to become
successful investors. As a result, they may prefer to change their portfolio allocations and
holdings in response to market conditions rather than stick to a planned plan. Furthermore,
they seek to influence or even control the decision-making process, which might potentially
weaken the position of an advisor.Accumulators are, at their core, risk takers who are
convinced that whichever path they chose is the right one. They, unlike Preservers, are in it
to win—and win big. They, unlike Followers, rely on themselves and wish to be in charge of
the ship. And, unlike Independents, they like to get into the weeds rather than charting a
course with only half the knowledge they want.

However, some investors are prone to prejudices that can limit their investment
success. Accumulators, for example, may be overconfident in their abilities. Why shouldn't
they be successful investors if they're successful in business or other endeavors?
Overconfidence can also cause them to believe that they can influence the outcome of the
investment process.They may overlook the fact that investing results are frequently
unpredictable and fraught with unknown hazards. Due to the "wealth effect" of having
amassed riches, accumulators might sometimes allow their spending to spiral out of control.
This can lead to lifestyles that are more expensive than prudent. Accumulators may also
make investments depending on how the opportunities they come across align with their
personal ideals or affiliations.

Accumulators have a high risk tolerance, but when things go wrong (they lose
money), they can be very uncomfortable. This unease may stem not only from monetary
loss, but also from a lack of confidence and the knowledge that they have little influence over
the results of their investments. Because these clients are striving to make their own
judgments rather than relying on their advisors' guidance and counsel, certain Accumulators
might be difficult for advisors to form meaningful relationships with. These clients are more
strong-willed and confident than Individualists because they are entrepreneurs and
frequently the first generation to acquire money.Accumulators who are not advised often
trade too much, which can have a negative impact on investment performance. They are
also rapid decision-makers, but they may pursue higher-risk investments than their peers.
They like the thrill of making a good investment if they are successful. Because they do not
believe in basic investment principles like diversification and asset allocation, some
Accumulators might be difficult to counsel. They prefer to be active in the investment
decision-making process and are often hands-on.

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Upside/Downside Analysis

Accumulator BITs benefit from a number of advantages. Accumulators have faith in

their abilities, and as a result, they act on their investment ideas. As I previously stated,
successful investment necessitates the fortitude to not only believe in investing ideas but
also have the confidence to put them into action. In other words, Accumulators are confident
in their ability to act decisively. They also understand what it takes to succeed, which
includes hard work and determination. As a result, they devote time to learning about
investment opportunities and scrutinizing the intricacies of the investments they
make.Finally, they recognize that building wealth requires taking risks; not all investors see
the importance of taking risks. This isn't to argue that Accumulators are ecstatic when things
don't work out, but they are aware that not every move will be successful.

The drawback of the Accumulator BIT is primarily due to biases related to being
overconfident that things will go their way and assuming that they can exert some kind of
influence over investment results regardless of what happens. In practice, overconfidence
frequently causes to bad investment performance, either because BITs believe they can
consistently outsmart the markets or because they trade excessively.Conversely, thinking
that investment results can be managed is a misconception; there is so much uncertainty
surrounding practically all investment vehicles that investors who feel they can control
outcomes are refusing to accept reality. Accumulators, as we'll see in the next section, may
have problems regulating their spending, investing based on what they associate with in
other aspects of their lives, and being overly optimistic in their investment activities.

Bias Analysis

Overconfidence Bias Bias Type: Emotional

Overconfidence is defined as an unfounded belief in one's own abilities and thoughts.

Overconfidence is manifested in investors' overestimation of their judgment's quality. Many
aggressive investors believe they have an above-average ability to pick investments;
nonetheless, they, like other investor types, become upset and frightened during times of
market stress and make less-than-optimal judgments. For example, in March 2009, there
were a number of overconfident, aggressive investors who couldn't take the volatility of the
2008–2009 period and sold at the wrong time, since the low point was erased in a relatively
short amount of time.Those who were encouraged to keep to their plans, no matter how
difficult they were, and who had the insight and tenacity to ride out the volatility had their
portfolios recover handsomely. In retrospect, of course, this was an excellent buying
opportunity. Advisors must be cognizant of circumstances in which clients make portfolio
changes at the incorrect moment, only to see the exact opposite of what they expected.

42
 People who have achieved success in business and other endeavors have a strong
belief in themselves, which is how they got there in the first place. However, in the realm of
investing, overconfidence can be harmful. For lengthy periods of time, markets can and do
remain irrational. Just because a security's price should be higher or lower doesn't indicate it
will in the near future. The scenario of a former CEO or family heritage stockholder of a
publicly traded business such as Bank of America, Enron, or Lehman Brothers is a typical
illustration of investor overconfidence.Because they claim insider information or personal
commitment to the company, these investors frequently refuse to diversify their assets. They
are unable to view these stalwart stocks as high-risk investments. However, scores of once-
iconic business names in the United States have fallen or vanished, including those
mentioned above.

Illusion of Control Bias Bias Type: Cognitive

When people believe they can control or at least affect investment results when they
can't, this is known as the illusion of control bias. Investors that suffer from illusion of control
bias believe that constantly adjusting an investment portfolio is the best approach to manage
it. Trading-oriented investors, for example, who are willing to take on a high amount of risk,
believe they have more influence over the result of their investments than they actually do
because they are the ones who pull the trigger on each choice. Investors may trade more
than is prudent due to the illusion of control bias.Traders, particularly online traders, believe
they have more control over the outcomes of their investments than they actually do,
according to research. Excessive trading leads to worse returns in the long run. Illusions of
control can lead to investors concentrating their bets on just a few companies, resulting in
underdiversified portfolios. Some investors like to hold concentrated stock portfolios because
they are drawn to companies over whose fate they have some control. However, that control
is illusory, and the investors' portfolios suffer as a result of the lack of diversity.

The illusion of control bias leads to investor overconfidence in general. Successful

investing is frequently a probabilistic activity, which investors must recognize. Taking a step
back and seeing how intricate US and global capitalism are is a good starting step. Even the
most astute investors have no influence over the majority of the investments they make. Do
you truly have control over the fate of a stock or the outcome of a purchase just because you
made a deliberate decision to buy it? Some correlations appear to be arbitrary rather than
causal when viewed rationally.Allowing yourself to make financial decisions based on what
you can intellectually perceive as arbitrary grounds is not a good idea.

Another suggestion is to seek out opposing opinions. Take a time as you evaluate a
new investment to analyze any factors that might work against you. Ask yourself, "Why am I

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investing this money?" What are the potential drawbacks? When will I be able to sell? What
could possibly go wrong? These crucial questions might assist you in screening the logic
behind a decision before putting it into action.Finally, keeping records is a smart idea.
Maintaining records of your transactions, including reminders stating out the rationales that
underpin each trade, is one of the best methods to keep illusions of control at away once
you've decided to proceed with an investment. Make a list of some of the most crucial
characteristics of each investment you make, emphasizing those that you have assessed to
be favorable to the investment's success.

Affinity Bias Bias Type: Emotional

Affinity bias is the tendency for people to make unreasonably expensive purchase or
investment decisions based on how they perceive a product or service will reflect their ideas
or values. This concept emphasizes a product's expressive benefits rather than what the
product or service actually achieves for someone (the utilitarian benefits).When purchasing
wine, this is a common illustration of this behavior in the consumer product realm. A
consumer may spend hundreds of dollars in a restaurant or wine shop to impress their
visitors with a fine bottle of well-known wine, while a bottle that costs much less could be
equally delicious but not express the same status.

Self-Control Bias Bias Type: Emotional

The desire to consume today rather than save for tomorrow is known as self-control
bias. The main issue for advisors with this inclination is a customer that has a high risk
tolerance and spends a lot of money. Let's say you have an aggressive client who prefers
risky investments and has strong immediate spending requirements, and the financial
markets experience extreme instability. To cover current expenses, this client may be
obliged to sell solid long-term investments that have been discounted owing to current
market conditions.

Outcome Bias: Emotional

Individuals' inclination to decide to do something—such as invest in a mutual fund—

based on the outcome of previous events (such as five-year returns) rather than the process
by which the outcome was achieved is known as outcome bias (the investment process
used by the mutual fund manager over the past five years). Instead of comprehending how
such high returns were created or why the returns earned by other managers might not have
been as good over the past five years, an investor might believe, "This manager had a
phenomenal five years, so I'm going to invest with her."

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Advice for Accumulators

Clients who are accumulators, especially those who have suffered losses, are
typically the most difficult to advise. Accumulators prefer to avoid advice that might keep
their risk tolerance in check since they like to control or at least get deeply involved in the
specifics of investing decision making. They are emotionally invested and hopeful about the
performance of their investments, even if their confidence is illogical. Excess spending by
some Accumulators must be controlled because it can stifle the performance of a long-term
portfolio if left unchecked. Other Accumulator investors make assets that reflect their
worldview, but which may not be the best long-term investments.

Taking a leadership position in the problem is a reasonable technique for advisors

when working with these customers. If the advisor allows the Accumulator client set the
parameters of the advisory engagement, they will constantly be at the mercy of the client's
(often emotional) decision-making, which will almost always result in a dissatisfied client and
an unhappy adviser. Advisors to Accumulators must show how their financial actions affect
family members, lifestyle, and family legacy.If these advisers can show their Accumulator
clients that they can assist them make solid long-term decisions, they will most likely see
their Accumulator clients fall into line and become easier to advise.

Tournament Theory
Tournament theory is a personnel economics theory that describes scenarios in
which salary differentials are based on relative differences between persons rather than
marginal production.
Consider the tournament in its most basic form: a two-player tournament with a prize
for the winner and a smaller consolation prize for the loser. The gap between the losing and
winning prizes raises the incentive to win, and thus the worker's investment increases as the
disparity between the winning and losing prizes increases. It is in the firm's best interests to
widen the award distribution. However, there is a disadvantage for the businesses. Workers'
costs climb as they invest more. Competing companies may offer a tournament with a lower
spread in order to attract more employees because they would have to invest less.As a
result, corporations establish an appropriate price spread that is large enough to encourage
investment but low enough to keep the investment affordable for workers. The prize may be
in the shape of extra money or a promotion, which would entitle you to more money as well
as entry into a higher level of tournament with potentially larger stakes.
Benefits of Tournament
a. Motivates employees;
b. Provides stability in volatile market conditions (reduces shocks);

45
c. Selects employees (observe);
d. Reduces pay variability (commit & credible);
e. Encourages long-term behavior to stay with the company.

Marginal productivity is how traditional economic theory explains income inequality.

Because building contractors would benefit if any other wage rate existed, we expect Bill,
who can lay 50 bricks per hour, to earn twice as much as Joe, who can only put 25 bricks
per hour. Everyone will want to hire the more productive mason if he is paid less than twice
as much as the less productive mason. No one will want to hire the less productive mason.
People will be as inclined to hire either if his pay is exactly twice as much, corresponding to
the difference in output.

Activity 1
Answer the following questions.

Evaluate the behavior of investors toward the biases discussed in

the previous lessons.

1. The Preserver
2. The Follower
3. The Independent
4. The Accumulator

46
Lesson 2: Behavioral Theories in the Stock Market

Learning Outcomes: Stock market behavior is significant for a

variety of reasons and for many market
At the end of the lesson, you are stakeholders. Many studies have
expected to: attempted to explain this phenomenon,
• describe the equity premium and even more have attempted to utilize
puzzle; these theories to forecast future changes
• discuss the volatility puzzle; and in stock values. The increased
• explain the bubbles theory. interconnectedness of national currency,
commodity, and stock markets with
global markets, as well as the presence
of common actors, has given stock price
behavior a new property: rapid
transmissibility across markets. The goal
of this lesson is to go through some of
the ideas that explain stock market
behavior.

Lesson Proper

A. Equity Premium Puzzle

The equity premium puzzle (EPP) is a term that refers to equities' historically
exceptional outperformance versus Treasury Bills. It refers to an important class of
economic models' inability to explain the average premium of returns on a well-
diversified equities portfolio over Treasury Bills that has been seen for more than a
century.
In basic terms, investor returns on equities have been so much better on average
than returns on Treasury Bonds that it's difficult to explain why investors buy bonds, even
when risk aversion is taken into account.
The intuitive notion that stocks are riskier than bonds is insufficient to explain why the
equity risk premium (ERP) is so large that it implies an implausibly high level of investor
risk aversion, which is fundamentally incompatible with other branches of economics,
particularly macroeconomics and financial econometrics.
Implications

47
 The equity premium's size has consequences for resource allocation, social
welfare, and economic policy. The existence of a substantial equity premium has the
following implications, according to Grant and Quiggin (2005):
• The cost of recession-related macroeconomic variability is high.
• The stock market loses the majority of its value when corporate profits are
threatened.
• Executives in corporations are under unavoidable pressure to make rash
decisions.
• Policies such as deflation, which is an expensive reform that offers long-term
advantages at the expense of short-term pain, are less appealing if the rewards
are uncertain.
• In order to mobilize extra risk-bearing capacity, social insurance systems may
profit from investing their resources in hazardous portfolios.
• There is a compelling case for public investment in long-term projects and
businesses, as well as policies to lower the cost of risky capital.

B. Volatility Puzzle
The current discounted value of future returns, according to efficient market theory,
can be used to forecast asset values. However, due to excessive volatility, stock price
forecasts based on this concept are less dependable than the prices themselves. Some
efficient market theorists believe that prices are efficient at the individual stock level but
not at the aggregate market level, while others admit that the overall stock market's level
of volatility cannot be explained by any version of the efficient market model.”
The apparent increase in volatility over short periods of time – the flash collapse
being an extreme example – makes regulators more vigilant, particularly in terms of
ensuring circuit breakers are properly placed to avoid excessively big and rapid market
movements. In the face of excessive volatility, these required brakes allow investors to
catch their breath and rethink their ideas. However, the change to technology-driven
trading is unavoidable, and it is expected to continue to provide significant benefits, such
as higher liquidity and smaller bid/ask spreads — both of which are beneficial to
investors.

C. Bubbles
A bubble is an economic cycle marked by a rapid rise in asset prices followed by a
fall in value. It is caused by an increase in asset prices that is unjustified by the asset's
fundamentals and is driven by irrational market activity. A big sell-off occurs when no
more investors are prepared to buy at the inflated price, leading the bubble to burst.

48
 A stock market bubble occurs when market players drive stock prices above their
value in accordance to some method of stock valuation.
Bubbles can emerge in highly predictable experimental markets as well as in real-
world markets with their inherent unpredictability and noise. Because participants are
provided with assets that are defined to have a fixed lifespan and a known probability
distribution of dividends, uncertainty is eliminated in the laboratory, and calculating
predicted returns should be a simple mathematical exercise. Stock market bubbles have
been described as rational, inherent, and contagious in other theoretical interpretations.
The Five Steps of a Bubble
Hyman P. Minsky, an economist who was one of the first to explain how financial
instability develops and how it affects the economy, defined five stages in a normal credit
cycle.
1. Displacement: This stage occurs when investors become aware of a new paradigm,
such as a new product or technology, or historically low interest rates – in other
words, anything that catches their eye.
2. Boom: Prices begin to climb slowly at first, but as more investors enter the market,
they gain traction. This sets the scene for the big bang. There is a general sensation
of having missed out, prompting even more people to begin purchasing assets.
3. Euphoria: When euphoria sets in and asset prices surge, caution is abandoned.
4. Profit taking: It's difficult to predict when a bubble will burst; once a bubble has
burst, it will not inflate again. Anyone who pays attention to the warning indications,
on the other hand, will profit by selling off positions.
5. Panic: Asset prices fluctuate and fall at the same rate as they rise. Investors and
others are eager to get rid of them at any cost. As supply exceeds demand, asset
prices fall.

The First Bubble

Tulipomania
When a botanist brought tulip bulbs from Constantinople and grew them for his
own scientific purpose, the tulip bulb trade began accidently. The bulbs were
subsequently stolen and sold by neighbors. As a luxury item, the wealthy began to
collect some of the rarer types. Bulb prices skyrocketed as demand grew, with
uncommon kinds commanding stratospheric costs.
Bulbs were exchanged for anything with a monetary value, such as houses and
land. Tulipomania had built up such a fervor at its pinnacle that fortunes were made
overnight. The establishment of a futures exchange, where tulips could be purchased
and sold via contracts rather than real delivery, fanned the speculative pricing.

49
 When a seller planned a large purchase with a buyer, but the customer failed to
show up, the bubble burst. The realization that price hikes could not be sustained set in.
This sparked a panic that spread across Europe, lowering the value of every tulip bulb to
a fraction of its previous value.
Dot-Com Bubble
The dot-com bubble, which occurred in the late 1990s, was marked by a spike in
equity markets spurred by investments in internet and technology-based businesses. It
arose from a mix of speculative investing and an overflow of venture capital invested in
startups. In the 1990s, investors began pouring money into internet firms in the hopes
that they would be lucrative.
Startup dot-com enterprises helped fuel the stock market's rise, which began in
1995, as technology evolved and the internet began to be commercialized. Cheap
money and easy capital created the ensuing bubble. Many of these businesses didn't
make any money or even have a major product, but they were planning initial public
offerings (IPO). Their stock prices soared to new heights, causing a frenzy among
investors.
Housing Bubble
This was a real estate bubble in the mid-2000s that affected more than half of the
United States and was partly caused by the dot-com bubble. As the markets began to
tumble, real estate values began to climb, and the demand for homeownership grew to
dangerous proportions. Interest rates began to fall, and any severe lending restrictions
imposed by banks and lenders were largely abandoned, allowing nearly anyone to
become a homeowner.

Activity 2
Answer the following questions.

1. Compare and contrast with examples the behavioural theories

in the stock market.
2. How do these theories affect the decisions of investors when
buying stocks?
3. Discuss comprehensively tulipomania.
4. How does technology help in the success of dot-com bubble?
5. Illustrate the five steps of a bubble.

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 UNIT4: THE AGGREGATE PERSPECTIVE

According to Grossman and Stiglitz (1980), capital market clearing necessitates

active trading on relevant information by market participants. Many studies look at the impact
of institutional investors on anomalies since they play such a large role in the equities
market. On the one hand, Lewellen (2011) demonstrates that institutional investors tend to
hold the market portfolio and have little interest in betting on well-known anomalies.
Target Learning Outcomes
LO4 – Evaluate behavioral influences involving corporate (executive) financial decisions.

Lesson 1: Capital Market Anomalies

Learning Outcomes: Seven anomalies at the six-quarter

horizon tend to cause institutional
At the end of the lesson, you are investors to trade in the opposite
expected to: direction. Transient institutional investors,
• identify the capital market on the other hand, exploit the post-
anomalies; and
earnings announcement drift, according
• discuss how capital market
to Ke and Ramalingegowda (2005).
anomalies affect to investor
Cheng et al. (2017) show that informed
behaviour.
institutional trading lowers short-term
reversal profits. In this lesson, we take a
novel approach to the problem by looking
at how knowledgeable institutional
investors' entrances and exits (or
ownership breadth changes) interact with
anomaly signals to improve the success
of anomaly-based strategies.

51
Lesson Proper

Efficient Market Hypothesis (EMH)

The efficient market hypothesis (EMH), also known as the efficient market theory,
states that asset prices accurately reflect all available information. Stocks always trade at
their fair value on exchanges, according to the EMH, making it impossible for investors to
buy cheap stocks or sell for inflated prices. As a result, skilled stock selection or market
timing should be impossible to outperform the entire market, and the only way an investor
can earn higher returns is to buy riskier stocks.
Weak, Semi-Strong, and Strong-Form Tests
There are three forms of EMH tests: weak, semi-strong, and strong. Here's what each
says about the market.
• Weak Form EMH: Suggests that all previous knowledge is factored into the price of
securities. Fundamental examination of stocks can offer investors with knowledge
that allows them to outperform the market in the near term, but no "patterns" exist. As
a result, fundamental analysis will not provide a long-term benefit, and technical
analysis will not be effective.
• Semi-Strong Form EMH: Infers that neither fundamental nor technical analysis can
provide an investor with a competitive advantage, and that fresh information is
immediately priced into securities.
• Strong Form EMH. According to this theory, all public and private knowledge is
priced into equities, and no investor can obtain an advantage over the market as a
whole. Forms of Strength because there are always outliers in the averages, EMH
does not claim that some investors or money managers are incapable of achieving
abnormally large returns.

The EMH does not claim that no investor can outperform the market; rather, it claims
that there are outliers who can outperform the market averages, as well as outliers who
severely underperform the market. The majority of the people are closer to the median.
Those who "win" are fortunate, while those who "lose" are unfortunate.

Behavioral Psychology
Some of the more promising alternatives to EMH are behavioral psychology methods
to stock market trading (investment strategies such as momentum trading seek to exploit
exactly such inefficiencies). Behavioral Finance, according to proponents of EMH, enhances
the case for EMH by focusing on individual and committee biases rather than competitive
markets.

52
 Individuals use hyperbolic discounting, for example, according to a major result in
behavioral finance. Bonds, mortgages, annuities, and other comparable financial instruments
subject to competitive market dynamics do not demonstrate this.

How Passive and Active Investors Look at EMH

Because index funds and certain ETFs are passively managed, proponents of EMH,
even in its weak form, frequently invest in them (these funds simply attempt to match, not
beat, overall market returns). Index investors would argue that they are following the adage,
"If you can't beat 'em, join 'em." Rather than striving to outperform the market, they will invest
in an index fund that holds the same securities as the underlying benchmark index.
Some investors will continue to strive to outperform the market averages, believing
that stock price movements may be forecast to some extent. As a result, EMH does not fit
into a technical trading (also known as day trading) strategy. This is because technical
traders look at short-term trends and patterns to see if they can spot buying and selling
opportunities. The robust variant of EMH would almost certainly be rejected by traders.
Limits to Arbitrage
Arbitrage is defined as a costless investment that generates riskless gains by
exploiting mispricings across different instruments representing the same security. Because
underlying values are kept matched with market prices through the arbitrage process,
arbitrage is crucial to the preservation of efficient markets. In actuality, arbitrage implies both
costs and risk assumption, and as a result, arbitrage's usefulness in reducing certain
security mispricings is limited.
Fundamental Risk. Arbitrageurs may notice a mispricing of a securities for which there is no
close replacement that allows for risk-free arbitrage. If an unfavorable piece of news has an
impact on the replacement security used in hedging, the arbitrageur may face surprise
losses.
A pairs trading technique, which uses two virtually identical stocks in the arbitrage
process, is an excellent example. Let's say Coke and Pepsi have historically traded at a
comparable P/E of 10, but Coke has become highly pricey at 20X earnings, while Pepsi has
remained at a 10X multiple. The arbitrageur would take a long position in Pepsi and a short
position in Coke. The arbitrageur will profit when the multiples converge to historical equality
at some time in the future. But what if, over the next five years, Pepsi drops to a 5X multiple
while Coke rises to a 30X multiple? The arbitrageur is subject to each security's underlying
risks.
Noise Trader Risk. Arbitrage is limited by noise traders. Noise traders may drive prices
further away from intrinsic value once a position is taken, requiring the arbitrageur to invest
further capital that may not be available, necessitating an early liquidation of the position.

53
 The bankruptcy of MF Global in 2011 is a good illustration. MF Global was primarily
interested in arbitrage opportunities. The company purchased cheap European bonds
(backed by the European Stability Facility) and used them as security for fresh loans, which
were then used to purchase further bonds. As a result, the bonds were guaranteed, and MF
Global was only required to return the loans when the bonds matured at par — in an amount
equal to or greater than what was owing. It was the ideal arbitrage opportunity! The end
result, however, plainly exposes the limits of arbitrage: loud traders pushed bond spreads
wider, and MF Global was slapped with a margin call, which forced the company into
bankruptcy.
Implementation Costs. Short selling is frequently employed in arbitrage, but it can be costly
due to the "short rebate," which represents the cost of borrowing the stock to be sold short.
Borrowing expenses may, in some situations, exceed potential gains. If short rebate fees are
10% or 20%, arbitrage earnings must be more than these expenses in order to be profitable.
That's a difficult task.
Performance Requirements/Agency Costs. Another short-circuit in the arbitrage process
has to do with performance limits and how they affect money manager incentives. Consider
the strains imposed by "tracking error," or the tendency for returns to diverge from a
benchmark.
Assume you have a job where you are responsible for investing the pensions of 100,000
firefighters. You have a number of investment options. You can invest in:
• Strategy A:Over the course of 25 years, a strategy that you know (by some mystical
means) will outperform the market by 1% per year. You also know that in any given
year, you will never underperform the index by more than 1%; or
• Strategy B: Over the following 25 years, an arbitrage strategy that you know (again,
by some mystical way) will outperform the market by 5% per year on average will
outperform the market. The hitch is that you also know that you will underperform by
5% every year for the next five years.

Which strategy do you choose? If you are a professional money manager, the choice
is obvious: you choose A.
Why choose A? It a bad strategy relative to B.

It all comes down to tracking error and the fund manager's incentives. The fact that
fund managers are not the owners of the capital presents an issue known as the principle
agent problem. These executives make decisions that keep them employed, but do not
always maximize risk-adjusted returns for their investors. The ability to track errors is critical
for these executives. The tracking mistake on strategy B is really excruciating. Those

54
firemen will start screaming bloody murder in the third and fourth years of your
underperformance, and you won't be there to see the recovery when it happens in the fifth
year. However, if you stick to method A, you'll be able to keep a good work for a long time.

Fama and French Three Factor Model

The Fama and French Three-Component Model (or Fama French Model for short) is
a 1992 asset pricing model that builds on the capital asset pricing model (CAPM) by adding
size and value risk elements to the market risk factor. This model takes into account the fact
that value and small-cap stocks consistently beat the market. The model adjusts for this
outperforming tendency by integrating these two additional criteria, which is regarded to
make it a stronger tool for measuring management effectiveness.
The Fama-French Three-factor Model is a variation of the CAPM (CAPM). The
Fama-French model attempts to explain stock returns using three factors: (1) market risk, (2)
small-cap outperformance against large-cap outperformance, and (3) high book-to-market
value outperformance versus low book-to-market value outperformance. The concept is
based on the fact that high-value and small-cap companies consistently beat the general

market.Below shows the formula of Fama-French Three Factor Model:

Where:
• r = Expected rate of return
• rf = Risk-free rate
• ß = Factor’s coefficient (sensitivity)
• (rm – rf) = Market risk premium
• SMB (Small Minus Big) = Historic excess returns of small-cap companies over
large-cap companies
• HML (High Minus Low) = Historic excess returns of value stocks (high book-to-price
ratio) over growth stocks (low book-to-price ratio)
• ↋ = Risk
Market Risk Premium
The difference between the market's expected return and the risk-free rate is known
as the market risk premium. It compensates an investor for the greater volatility of returns
over and beyond the risk-free rate by providing an excess return.

55
SMB (Small Minus Big)
SMB (Small Minus Big) is a size impact depending on a company's market
capitalization. SMB is a metric that evaluates the historical advantage of small-cap
enterprises over large-cap companies. After identifying SMB, the beta coefficient () can be
calculated using linear regression. A beta coefficient can have both positive and negative
values.
The basic rationale for this component is that small-cap companies produce stronger
long-term returns than large-cap companies.

HML (High Minus Low)

The HML (High Minus Low) premium is a value premium. It is the difference in
returns between companies having a high book-to-market value ratio (value companies) and
those with a low book-to-market value ratio (growth companies). The HML factor's beta
coefficient may be obtained using linear regression, just like the SMB factor. The beta
coefficient of the HML might be positive or negative.
Value companies (high book-to-market ratio) outperform growth equities in the long
run, according to the HML factor (low book-to-market ratio).

How the Fama French Model Works

Nobel Laureate Eugene Fama and researcher Kenneth French, both former
professors at the University Of Chicago Booth School Of Business, set out to better
understand market returns and discovered that value equities outperform growth firms
through research. Small-cap stocks, on the other hand, tend to outperform large-cap
equities. Because the Three-Factor Model adjusts downward for observed small-cap and
value stock out-performance, the performance of portfolios containing a large number of
small-cap or value companies would be lower than the CAPM outcome as an evaluation
tool.

Fama and French’s Five Factor Model

In recent years, researchers have modified the Three-Factor model to incorporate
other components. "Momentum," "quality," and "low volatility" are just a few examples. Fama
and French revised their model in 2014 to add five elements.
Along with the original three criteria, the new model incorporates the idea that
companies with larger future earnings have better stock market returns, a concept known as
profitability. The fifth element, referred to as investment, connects the concepts of internal
investment and returns, implying that businesses that invest profits in large growth projects
are more likely to lose money in the stock market.

56
 Whilst a momentum factor wasn't included in the model since few portfolios had
statistically significant loading on it, has made the case for its inclusion. Foye (2018) tested
the five-factor model in the UK and raises some serious concerns. Firstly, he questions the
way in which Fama and French measure profitability. Furthermore, he shows that the five-
factor model is unable to offer a convincing asset pricing model for the UK.

Activity 8
Answer the following questions.

1. Compare and contrast with examples the capital market anomalies.

2. Elucidate the difference between the Fama-French Three Factor Model and
Fama-French Five Factor Model.
3. Describe Strategy A and Strategy B through a situational example.

Lesson 2: Behavioral Theories in Corporate Finances

Learning Outcomes: When it comes to a company's

financing and investment decisions,
At the end of the lesson, you are sensible leaders are driven by their faith
expected to: in market efficiency. What if, though,
• identify the different corporate markets aren't always as efficient as we
finance theories; and think they are? What if the CEOs aren't
• explain the implication of the reasonable themselves, and their
theories to investor behaviour. decisions are skewed in some
predictable way? This second question,
which is at the heart of research in a new
academic discipline known as behavioral
corporate finance, challenges us to
rethink how we think about corporate
finance and remuneration.
Differences in business financial
practices and capital structures are being
explained using behavioral finance

57
 theories. Most importantly, behavioral
corporate finance has brought humanity
— in all its complexity and nuance —
back into corporate finance, where it
rightfully belongs.
Lesson Proper

A. Capital Budgeting Decisions

Capital budgeting considerations are among the most crucial business decisions.
These decisions involve enormous sums of money, and they have a significant impact
on an organization's long-term success. Firms use capital investments to achieve and
maintain competitive advantages that are necessary for generating income and creating
jobs.
Traditional investment assessment methods emphasize the expected value of
investment alternatives, assuming that managers evaluate all possibilities before
choosing the one with the highest expected value. Managers should, in reality, only
accept investment projects that add value to the company.

The Manager and the Investment

Given the importance of investment to businesses and the economy as a whole,
it's critical to understand how managers make investment decisions. When we state that
a capital budgeting choice is made by the firm, we are oversimplifying things. Actually,
the decision is made by the manager, either individually or as part of a team. As a result,
the manager's behavior, as well as his personal traits (psychological or otherwise), are
important to comprehending the judgments made.
The primary issue in investment selection in an uncertain environment is to
forecast the future. These related predictions, in turn, are based on managers'
expectations. The way the human mind processes information and, as a result, makes
judgments, has been found to be influenced by a number of decisional biases, according
to research in the field of psychology.
To begin with, non-financial elements have been shown to affect capital
budgeting decisions. Decisions about money aren't made in a vacuum. In a specific
situation where he interacts with other people and where there are important
interpersonal relationships that can emotionally affect agents, the manager makes a
decision. As a human being, the manager is not immune to feelings of frustration, wrath,
unfairness, and so on. These elements are especially significant in capital budgeting

58
 decisions because they frequently include human interactions as a result of party
discussions, team assignments, and power sharing and delegation.
Other variables in organizational life might aggravate the investor's sense of
personal commitment and raise their reluctance to abandon initiatives, in addition to
matching managers with investments.
a. The first of these criteria has to do with the degree of competition among corporate
management. Internal competition among managers in the same organization is
often regarded as beneficial, since it can help to their motivation, among other things.
When managers are faced with a disinvestment decision, however, the results are
not always favourable.
b. The second factor that can exacerbate a sense of personal responsibility is a sense
of professional uneasiness among managers. Managers who operate in an
environment of increased professional uncertainty, in the sense that their job
depends on the project's success, are more devoted to it, according to research. In
that situation, admitting a mistake could result in job loss, thus the manager will be
more adamant about not abandoning the project.
c. A third important consideration is whether the project abandonment is unique or part
of a series of comparable abandonments. Abandoning a project may make it easier
for other managers to make similar decisions in the future. The existence of similar
earlier occurrences lessens the sorrow and some of the professional's personal
accountability by allowing information to be shared across the organization that the
reasons for the desertion are not only due to the manager in question's specific
capabilities. project.
d. Finally, it indicates that project managers who are confronted with different
viewpoints from other parts of the firm (departments, consulting bodies, etc.) about
project management are more hesitant to abandon initiatives.

B. Financing Decisions
The capital structure that businesses must pick in order to reduce their capital costs
is a topic of both academic and practical relevance.
The theory of capital structure is made up of numerous approaches. Let's start with
the classic trade-off and pecking order notions.Managers' financing options are unable to
cut the cost of capital in a frictionless and efficient market, according to Modigliani and
Miller (1958). In this idea, also known as trade-off theory, the costs of various financing
choices are so entangled that switching between them, such as replacing debt with
equity or short-term debt with long-term debt, has no benefit. The conclusion is that the
capital structure has no bearing on the outcome.

59
 The Manager and the Financing Decisions
Even after accounting for the variables given by classic models such as fiscal
impacts, bankruptcy costs, and asymmetrical knowledge, a significant portion of the
observed financing decisions remains unaccounted for.
We can comprehend the diversity in financing decisions made by organizations in
the same industry and facing similar fundamentals by looking at managers' distinct
psychological and socio demographic traits. Managers appear to be highly different from
one another, and this diversity is reflected in the array of corporate financing options
available to them.
Managerial heterogeneity and differences of opinion among managers and
shareholders about the company's future provide useful insights into financing decisions.
We'll start by looking at the consequences of differences in opinion between managers
and shareholders.

C. Dividends
To begin, we'll look at theories based on perfect information models. According to
neoclassical theory, the dividend policy of a corporation should not play a significant
influence in managerial decisions because, in the absence of taxes and transaction
costs, dividends and capital gains should be perfect substitutes in efficient capital
markets. The distribution of one euro in dividends would have the direct effect of
lowering the firm's share price by one euro, as the company invests over time. As a
result, whether an investor receives one euro in dividends or capital gains from the
selling of shares of that value is irrelevant.In this simple economy, a company's value is
only defined by its ability to generate cash flow, not by how it is dispersed. As a result,
dividend policy should be ignored.
A second theory, which is based on budgetary considerations, opposes dividend
payments. Dividends are taxed twice: once at the corporate level since they are part of
the company's earnings, and again at the individual level because the investor is taxed
separately. As a result, because the tax rate on dividends is higher than the tax rate on
capital gains–and capital gains are a function of retained earnings–investors should
prefer not to be Dividends paid any dividends if the company has investment
opportunities with profitability rates equal to or higher than its cost of capital.

60
 The Managers and Dividend Supply

It is vital to consider many parts of the problem in order to comprehend how

managers decide on the dividends to be given. To begin, it is believed that managers
evaluate the behavioural impacts that influence investors' dividend preferences while
determining dividend policy.

However, when considering dividends from a behavioral standpoint, there are two
further considerations to consider. The first covers managers' statements when asked
about their decisions, while the second concerns managers' behavioural motivations
when deciding how much to pay in dividends.
a. Managers' Surveys. The results of management surveys can help us
supplement the available data with decision-makers' perspectives. They are
significant because managers decide on dividend policy, and their decisions are
based on their impressions of corporate policy.
b. Managers' Behavioural Motivation.Understanding what motivates managers is
critical in the Behavioural Finance paradigm. Financial decisions made by
economic agents, including managers, are not solely based on financial factors,
according to the data.

D. Mergers and Acquisitions

For two key reasons, mergers and acquisitions (M&As) are extremely important in
the set of financial decisions that managers make. For starters, this is due to their
financial importance. Second, M&As are significant because they have the potential to
significantly alter how the economy's resources are utilised.
As a result of the financial operations, M&As justify the financial operations with
several outcomes: the companies' increased market power; the operational expansion of
their geographical scope; the gains that result from economies of scale or economies of
scope; fiscal advantages; and, most importantly, the creation of synergies between the
participating companies in the M&A process.

Managerial Overconfidence
Mergers and acquisitions are the result of individual decisions made by
managers. Because these agents make the decision, it's only logical to think about the
behavioural aspects that explain the empirical evidence. One of the most striking
empirical findings is that executives typically overpay for the stock of the company they
are buying or merging with. In other words, the acquisition premium is frequently very

61
 substantial, defined as the difference between the price provided by the acquirer and the
current market value of the target firm's shares.
Overconfidence can lead to an overestimation of the manager's ability to produce
value, an overestimation of the synergistic value created by an M&A, or an
underestimation of the negative effects of the many corporate cultures engaged in the
transaction. In any case, overconfidence causes the manager to overestimate the growth
in value generated by the financial operation and, as a result, to overpay for the target
company's shares.

Other Behavioural Factors that affect the Manager

As previously stated, confirmation bias causes managers to place an excessive
amount of weight on information that supports their choices while undervaluing information
that contradicts them. The confirmation bias, on the other hand, may have an impact on the
information that managers seek. And it appears that this is the case when it comes to
financial transactions. Managers that are eager to pursue an M&A from the start prefer to
seek information that supports their position (for example, information about synergies) and
avoid learning about information that could jeopardize the deal (for example, information
about the operation's costs).In this context, confirmation bias is relevant since it can be
another behavioural rationale for managers carrying out ill-advised corporate restructuring
activities that result in negative returns for the acquiring company.
Understanding the creation of some of the essential variables in M&A processes
can also benefit from the anchoring bias. As we all know, this bias is characterized by the
overvaluation of a piece of information that serves as a reference ("the anchor") and from
which insufficient adjustments are made. Managers of acquirers and target firms appear to
use the most recent maximum market price as a reference in financial transactions. That
price level, while widely publicized and disseminated by the media, should not, in theory, be
significant in determining the price to pay in a merger and acquisition.

The "Competitive Arousal"

As previously stated, the conditions of an acquisition process are frequently
negotiated between the purchasing corporation and the board of directors of the firm being
purchased. It is also common for multiple contenders to be interested in purchasing a
company, resulting in a bidding procedure in which one or more companies compete with
one another.
The conditions that lead to unfavorable competitive behavior have been
investigated. Agents may unknowingly be led to exchange the "motivation to compete"
(which can be defined as a positive will to fight for scarce resources that leads to success

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and survivability conditions) for the mere "motivation to win" depending on the characteristics
of the environment where the competition takes place. Agents that are motivated to win aim
to maximize their relative performance (that is, relative to their competitors) even if it means
incurring large personal costs.

The Manager's Opposition to a Merger or Acquisition

Managers on the receiving end of a merger or acquisition attempt may be
influenced by a number of decisional biases. These biases, in theory, make managers more
likely to reject a hostile takeover, even though the deal serves their shareholders' best
interests and the rejection is objectively harmful to them.
Refusing an offer may result in the target company's managers not receiving
severance packages or gains from share price increases, for example. We'd like to call
attention to two biases that can lead to these decisions: cognitive dissonance and
overconfidence. Mergers and acquisitions may produce a clash with the manager's self-
image if the offer is viewed as a threat to his professional ability and performance. Managers
on the receiving end of a merger or acquisition attempt may be influenced by a number of
decisional biases.
This contradiction, or cognitive dissonance, may drive them to dismiss the
possible buyer's motivations and make promises to his shareholders of increased
performance. This attempt to alleviate cognitive dissonance may be aided by the manager's
arrogance: his defense is believed to be bolstered by an overestimation of his own abilities
and exaggerated optimism about the company's future performance.

Activity 9
Answer the following questions.

1. Compare and contrast with examples the different corporate

finance theories.
2. How do these theories affect investor behaviour on the
corporation?
3. Explain with examples the biases that are relevant in every
corporate finance theories.

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 UNIT5: BEHAVIORALLY PLAN AND ACT

You have now completed each of the lessons describing the four behavioral
investor types. In this chapter, you will learn practical subject that will enhance your
learning and give you real world application opportunities. In Lesson 1, we will discuss
the fundamentals of Capital Markets and Asset Classes. Lesson 2 reviews key
concepts related to asset allocation. Lesson 3 ties the entire module together with
investment strategies for each behavioral investor type.

Target Learning Outcomes

LO 4 - Evaluate behavioral influences involving corporate (executive) financial decisions.

LO 5 - Assess important developments in this new area and the associated practical
insights they provide.

Lesson 1: Capital Markets and Asset Classes

Learning Outcomes: Knowing the fundamentals of the capital

markets, the financial assets in which
At the end of the lesson, you are one can invest, and the risks connected
expected to: with each is essential to putting together
• identify the different asset a successful investing portfolio. Asset
classes; and allocation, as discussed in the last
• discuss the uses of the asset lesson, is the process of deciding which
classes with regards to investing types of investments to invest in and how
decisions. much of each to include in a portfolio.
The best asset allocation for a particular
investor will be determined by how
closely the allocation's attributes and
behavior meet the client's goals and
limits.Regardless matter the level of risk
one is ready to take, modern portfolio
theory emphasizes broad diversification

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 across asset classes with varying
correlations (i.e., they are less than 1).
Investors can accomplish a target return
with the least amount of risk assumed or,
conversely, maximize return for a given
level of risk assumed by doing so.

Lesson Proper

If asset classes are so important in portfolio creation, it begs the question, "What is
an asset class?" At its most basic level, an asset class is a collection of securities with
comparable features and behaviors. The expected return, expected standard deviation, and
expected correlation with other asset classes are the three key features used to identify an
asset class. The key to reaping the benefits of diversity is to introduce a lack of correlation
between the asset classes employed in the portfolio's construction.Using a basic example,
asset A may be increasing in value while asset B remains steady and asset C is decreasing
in value in a particular market situation. Then, in a new market scenario, asset A may
depreciate while asset B appreciates, and asset C remains unchanged. As a result, the
portfolio's overall returns are smoothed out. However, it's important to remember that the
accuracy of portfolio-level expected return and risk (standard deviation) is only as good as
the assumptions made regarding individual asset class expected return and standard
deviation, as well as expected correlations between asset classes.

OVERVIEW OF ASSET CLASSES

Building blocks can be thought of as asset classes. Some assets go on the offensive,
attempting to gain ground and boost portfolio value. Other asset types are defensive in
nature, attempting to avoid market volatility from eroding returns too much. On each side of
the ball, just like in football, there are many different types of players. You may think of large-
cap equities in the United States, and even global large-cap equities, as offensive linemen
who do the grunt job of just keeping the portfolio going with market exposure.Small-cap
equities and private equity, on the other hand, can be compared to flashier running backs
and receivers; they can make big plays, but they can also fumble and put you in a tough
spot, pushing your defense to perform.

Similarly, the defense has a variety of players. Cash is like a big defensive lineman
who can't be moved, but it’s worth is vulnerable to inflation. Bonds can be compared to

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linebackers who undertake the most of the heavy lifting in terms of shielding a portfolio
against excessive volatility. Finally, hedge funds, like defensive backs, are quick to react.
They may come up and stop the run by being defensively positioned at times, but they can
also take a chance with one-on-one coverage; they may get beat at times, but they can also
come up with a great interception at other times.The head coach (the portfolio manager) is in
charge of putting together the portfolio, and he selects the best player for each position as
well as the proper balance of teammates to ensure a positive outcome.

There are three types of asset classes to consider. Capital assets, economic input
assets, and value storage assets are the three types.

• Capital assets: Capital assets are a claim on a company's future cash flows, and its
worth is calculated using the projected net present value of those cash flows. The
claim on cash flows is usually used to rank capital assets. Bonds, for example, have
a larger claim than stocks, but because of their higher position in the capital
structure, they typically give a lower, often fixed, projected return, which is dependent
on the issuer's credit quality. Equity holders, on the other hand, are at the bottom of
the capital structure, but they get unlimited upside from residual cash
flows.Alternative assets, such as hedge funds and private equity funds, are valued in
part by the present value of future cash flows from the securities in which they invest,
and are thus included in this category.
• Economic input assets: Economic input assets are commodities that are used or
altered as part of the manufacturing process and finally become usable goods.
Metals such as copper, which is used in wiring, plumbing, telecommunications, and
auto parts; grains that can be turned into food for humans or feed for livestock that
we will consume later; and energy products such as oil, which is used for everything
from powering cars to making the plastic in the pen you will use to write with today
are just a few examples.
• Value storage assets: Worth storage assets do not generate financial flows or serve
as economic inputs; instead, their value is appreciated only when they are sold.
Artwork and gold are two examples of valuable assets.

These groups, however, are not necessarily distinct. Because gold is utilized in both
jewelry and the manufacture of various technology products, it might be considered an
economic input.

While financial services organizations of all types provide a dizzying assortment of

products to access financial markets around the world, the three main types of capital asset

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investments are shares, bonds, and real assets. There are some economic input assets
among real assets.

Equity investments are shares of stock in a corporation that include the company's
assets as well as the right to future earnings. Equity investments, both public and private,
have proven to be the best way to generate wealth over time, but they also come with a high
level of risk. Bonds are loans to a firm or government that must be repaid over the course of
the loan's life (term) plus interest. While the price of a bond may fluctuate over time due to
interest rate changes, investors will be repaid at maturity unless the issuer defaults.As a
result, bond prices have varied less in the past than stock values, resulting in fewer volatility
but poorer returns. Finally, in addition to financial assets, actual assets are becoming
increasingly available to investors. Because of the utility they give, real assets are
fundamentally valued. Real estate, commodities of all kinds (oil and gas, industrial metals,
precious metals, lumber), and even coin and art collections are examples of real assets.

PUBLICLY TRADED EQUITY INVESTMENTS (STOCKS)

People and organizations who engage in publicly traded U.S. and international
equities securities control a piece of the global economy. Throughout the last ten years,
more Americans have held a part of their country's firms than ever before, and since the
emergence of riches in emerging nations, more Americans and foreign investors have
bought global equities than ever before.

So why do investors prefer to invest in equities over other asset types like bonds?
The solution can be found in the equity risk premium, which is defined as the additional
return to stock investors for taking on more risk than a lower-risk bond investment.According
to Roger Ibbotson of Ibbotson Associates and Yale University, U.S. equities investors have
received a 5% annual return above bond investors. For context, this analysis is based on the
building-block methodology he developed based on asset class premiums over one another
throughout the history of capital markets. In summary, equities outperform bonds by a
significant margin over time. The amount of money invested in equities is largely determined
by one's expectations for the risk premium on stocks in the future: The allocation will be
higher if the risk premium is higher.However, the bigger the stock allocation, the higher the
portfolio's total risk.

Investors might anticipate to earn a risk premium equivalent to that earned in U.S.
equities when investing in international stocks of developed countries. Naturally, these two
asset classes have distinctions that will cause them to perform differently over time. Equities
from different countries and marketplaces, for example, will react to economic trends and
capital market activity differently than domestic equities.Foreign currencies also have a big

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impact on the kind of stock returns a U.S. investor gets. For example, a country like France
may only provide a 4% return on equity, but if its currency, the euro, develops 5% strength
versus the dollar or other currencies, the return to an American investor will be 9%.

Domestic and foreign large-capitalization equities should be fundamental portfolio

assets in a well-diversified portfolio. The link between these two asset classes (and, for that
matter, nonequity asset classes), as I will explain shortly, is a major worry. Due to a historical
lack of perfect correlation with U.S. stocks, foreign equities have historically given
diversification benefits to investors. Correlations have usually increased during the previous
two decades as global economies have become more integrated, and this tendency may
continue. The following factors contribute to a higher overall level of correlation among
international markets:

• The number of huge international corporations is increasing. Communication and

information technology advancements.
• Deregulation of the G-7 countries' financial and banking systems, resulting in
significant increases in international capital flows.
• Free trade of goods and services between countries.
• Investors should maintain track of changes in cross-country correlations as much as
possible.

Equity Asset Classes

The most simple methods in which the financial services sector divides the equity
markets into bite-size sections with comparable risk and return attributes are: (1) the
stage of development of the local economy (developed, emerging, or frontier market); (2)
the size of the company involved (large-, mid-, or small-cap); and (3) the valuation
feature (growth or value). Some managers are referred to as "global" because they
invest in equities securities all around the world with little restriction.

MSCI's All-Country World Index, or MSCI ACWI, captures the global public
equities universe. The weightings in this index are determined by world market
capitalization, which is calculated by multiplying the number of outstanding shares by the
current stock price (see Figure 10.1).

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 FIGURE 10.1 MSCI ACWI Weights as of 6/30/11

Source: MSCI.

Some suggest that other indicators, such as gross domestic product, should be used
to weight equities portfolios (GDP). Other techniques, on the other hand, provide substantial
difficulties since they do not accurately represent the investable universe. Furthermore, there
has been minimal association between a country's GDP growth and its stock market returns
throughout time.

FIGURE 10.2 World GDP in U.S. Dollars

Source: Ibbotson and Brinson, Investment Markets, IMF.

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 The most typical segmentation of the market in US equities is based on both the size
of the company and its value feature, resulting in the matrix style box depicted in Table 10.1.

TABLE 10.1 U.S. Equity Style Box Matrix

Value Blend Growth

Large – cap
Mid – cap
Small – cap

The most popular way to segment foreign equities is by a nation's development

stage. The placement of nations under these categories varies per index provider, but we'll
try to stick to MSCI's classifications for consistency. MSCI EAFE (Europe, Asia, and the Far
East) plus Canada can be used to characterize developed markets.

Emerging markets are countries that have less economically developed than
industrialized countries, but are likely to be experiencing social or commercial activity as a
result of rapid growth and modernization.The liquidity of their markets and the ease with
which foreign investors can access them is often the most significant difference between
developed and emerging markets. Despite the fact that the term emerging market implies
that these countries should be graduating into developed markets on a regular basis, just
three countries (Portugal, Greece, and Israel) have moved from emerging to developed
markets according to MSCI in the last 15 years.

Frontier markets countries are the developing countries that are the least developed.
Frontier markets have even less liquidity, transparency, and ability to access capital markets
for foreign investors than emerging markets.

Private Equity

Some companies' equity isn't available on the open market and must be purchased
through private equity or partnership transactions. Venture money, buyouts, and distressed
investments are all examples of public equity. Although private equity has had times of poor
performance and funds may call capital without releasing any cash, it has proven to be a
successful endeavor over time. The highest average nominal return was in private
equity.Because they are illiquid, have a life of 10 years or more, and only repay investor
funds at the discretion of the private equity fund manager, investing in private equity
partnerships can be difficult and requires discipline. Early-stage venture capital has
historically provided the best returns of the three main types of private equity, followed by
buyouts and mezzanine.

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How to Invest in Private Equity

While many countries have varied approaches to the relationship between investors
and management, we will now look at the structure that is most typical in the United States.
Private equity partnerships of institutional caliber are usually always organized as limited
partnerships. A limited partnership has a set duration, which is usually ten years (though it
can be longer). There is a general partner (GP) and a limited partner (LP) in a limited
partnership (LP). The managing partner, or GP, is in charge of the partnership's activities as
well as any debts it has taken on. Please keep in mind that portfolio company debt has no
recourse against LPs, and fund documents rarely allow leverage except in exceptional
circumstances.The general partner also selects the companies in which the partnership will
invest, oversees those investments, and handles the process of exiting assets in order to
generate a profit for its limited partners. The general partner (GP) normally invests the
partnership's capital throughout the first three to five years, but the limited partnership may
have assets that last longer than the fund's lifespan. When this occurs, the period of the
partnership can be extended beyond the original length.In exchange for these services, the
GP receives management fees and a share of the partnership's ownership. LPs put money
into the partnership and are limited in their liability, but they aren't involved in day-to-day
management and can't lose more than their initial investment. They get money, capital
gains, and tax breaks. In a nutshell, the LP is the investor, and the GP is the manager, both
of whom are bound by a complicated partnership agreement.

A private equity fund's investors each commit a certain amount of money to be

invested in the fund partnership for a set length of time, usually ten years. The capital
commitment of the limited partner is this amount. The entire amount of the fund is equal to
the sum of all LP capital commitments plus the GP commitment (the general partner must
also make a capital commitment to participate in the fund). In practice, LP investors make
their contributions through a capital call system, which means that money is called when the
GP needs money to make investments, usually every three to five years.Because capital
calls can be made with as little as five days' notice, sufficient funds must be available when
the notices arrive. This type of investing is serious business because the duty to fund a
capital call is legally binding. The general partner then invests the called money to complete
the portfolio.

When investments are realized and capital is divided, the good part begins. An
investor's returns from a private equity fund might include both income and capital gains
from assets (less expenses and any liabilities).Following the initial capital investment return,
an LP's successive distributions are regarded as profits. The partnership agreement

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specifies the timing of distributions to the limited partners (LPs) as well as how earnings are
split between the LPs and the general partners (GPs). Once a fund is largely committed, and
provided the management is successfully managing its funds and finds further opportunities
in the market, the GP will raise its next fund and ask its existing investors whether they want
to re-up.

Creating a Private Equity Portfolio

Now that we've gone over the key private equity tactics, we're ready to put together a
private equity program. The first step in putting together a private equity portfolio is
determining whether or not a private equity allocation should be made and, if so, what
percentage of the portfolio should be allocated to it. The factors that influence the inclusion
of private equity strategies in an individual or family office private equity portfolio are largely
the same as those that influence asset allocation decisions in general: return objective, risk
tolerance, liquidity requirements, and time horizon, to name a few. Liquidity, on the other
hand, is the most important factor for most investors.Private equity cash can be locked up for
years, and investors must be rewarded for this. Clients should only invest in private equity if
they believe they can make a marginal return over public equity, which changes depending
on market conditions (but 500 basis points above the S&P 500 is about right).

The next step is to determine how much money will be allocated to private equity
each year once an allocation has been made. A cash flow private equity commitment model
is commonly used for this. To fulfill the aim, customers should make annual commitments of
one-third of a percent for every percent allocated to private equity (in USD). Clients should
not expect to get their complete allotment in a year or two. Instead, they should aim for
vintage year diversification, which, like wine collecting, helps investors avoid losing too much
money in a single terrible year.There are excellent years and terrible years for private equity
returns. If less than a third of the commitment is invested annually, the possibility of meeting
the target private equity allocation within a reasonable time horizon is lowered; any more,
and the risk of having too much invested in a single vintage year increases. This method, in
addition to offering vintage year diversification, allows clients to alter commitments for the
inherent unpredictability in performance and cash flows, as well as address shifting
possibilities within the broader private equity market.

Once a customer has decided how much money to put into private equity, the next
step is to figure out how to get it: either through direct limited partnerships with underlying
companies or through a fund comprising many private equity partnerships (fund of funds).
The optimum approach is determined by the amount of money being spent, administrative
capabilities, due diligence resources, and access to top executives.

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 Following the decision on whether to utilize a direct or fund of funds method, the next
step is to define risk-and-return parameters for the private equity portfolio, similar to how one
would do so for the overall portfolio.Because some private equity managers are substantially
more conservative in their approach than others, an investor's risk-and-return profile will play
a factor in picking a manager. This is why the private equity portfolio's composition is so
important to the investor's performance.

After deciding on the amount of the commitment, the vehicle (fund of funds or direct),
and the industries to invest in, the investor must choose which private equity managers to
undertake due diligence on and commit cash to.

FIXED INCOME INVESTMENTS (BONDS)

There are a few essential qualities that investors should be aware of if they are new
with the foundations of bonds. It's worth noting that, for the sake of clarity, I'll sometimes
refer to a single bond. Keep in mind that the information provided on a single bond might be
extrapolated to describe groups of bonds in which a bond manager might invest. Maturity,
redemption features, credit quality, interest, price (implying yield), and tax status are some of
the bond characteristics you'll study about. These aspects work together to determine the
value of a bond and how well the bond (or bond manager) satisfies a client's investment
goals.

Maturity

The maturity of a bond refers to the date on which the principal will be repaid to the
investor. Bonds typically have a maturity period ranging from one day to thirty years. Bonds
are divided into three groups based on their maturity: short term, middle term, and long term.
Bonds with maturities of up to 5 years are called short-term bonds; intermediate-term bonds
have maturities of 5 to 12 years; and long-term bonds have maturities of 12 years or more.
The maturity date of a bond is significant because it influences the price and yield of the
bond, and investors are concerned about when their principal will be repaid.

Bond Quality and Credit Ratings

Bond value can vary from investment-grade (US Treasury securities), which are
supported by the US government's creditworthiness, to below investment-grade (junk
bonds), which are regarded highly speculative. Investors and advisors can assess a bond's
quality—that is, an issuer's capacity to make regularly scheduled interest payments and
repay principal—by relying on rating agencies that assign risk ratings to bonds at the time of
issuance and track the evolution of these bonds over time.These organizations assign a
rating to bonds based on a variety of variables, including the issuer's financial state and

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management, the debt's quantitative and qualitative qualities, and the broad sources of
interest and principal repayment.

Interest Rates

Bonds typically pay interest twice a year (semi-annually), although they can also pay
off the interest quarterly or monthly. Interest can also be paid on a fixed basis (i.e., the rate
paid does not fluctuate throughout the life of the bond); it can float (the interest rate floats
with applicable rate during the life of the bond); or it can be paid along with principle at
maturity. Payment-in-kind bonds, for example, can pay interest by issuing new bonds, but
this is a unique form of high-yield financing that I won't get into here.Zero-coupon bonds,
sometimes known as zeros, do not pay periodic interest and instead pay the entire principle
and interest at maturity, which is normally compounded semi-annually. They are sold at a
substantial discount from their face value to compensate for the lack of ongoing interest
payments with zeros. Taxable investors should be cautious if the investment they invest in is
taxable, as taxes accrue each year even if interest is paid at maturity.

Price and Yield

Current interest rates, supply and demand, credit quality, maturity, and taxation all
factor into the price a bond buyer pays. The yield on a bond is the return that is really earned
on the bond, based on the actual price paid and the future interest payments. Bond yields
are divided into three categories: current yield, yield-to-maturity, and yield-to-call. The
current yield is calculated by dividing the bond's purchase price by the interest payment.The
total amount of interest collected on a bond from the time it is purchased until it matures,
plus any gain generated if the bond is purchased below its face value, is referred to as yield-
to-maturity (or minus any loss if it is purchased above its face value). Yield-to-call is
computed similarly to yield-to-maturity, with the exception that it assumes the bond is called
as soon as feasible and the investor receives the face value on the call date. More
instructive than current yield, yield-to-maturity and yield-to-call provide information on the
entire return gained by holding the bond until it matures or is called.

Even skilled investors and even financial journalists misunderstand how bond prices
move in connection to interest rate changes. When interest rates rise, the price of
outstanding bonds falls, bringing the yield of existing bonds in line with new issues that pay
higher interest rates. The longer the maturity, the more likely bond values would fluctuate in
response to interest rate changes, a risk that investors will want to be compensated for. The
yield curve exemplifies this principle. A yield curve that is usually curved slopes upward and

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exhibits a fairly high rise in yields between short- and intermediate-term issues; it shows a
less noticeable rise between intermediate- and long-term problems.

When the yield curve is steep, it signifies that short-term securities have lower yields
than long-term securities. The difference between short- and long-term rates is quite minimal
if the yield curve is flat. The yield curve is said to be inverted when short-term issue yields
are higher than longer-term issue yields, indicating that bond market participants expect
interest rates to fall; an inverted yield curve is considered a reliable indicator that a recession
is approaching.

Bond Redemption

Numerous investors are only concerned with the bond's maturity, and they may fail to
recognise characteristics such as call and put provisions, which can have a massive effect
on the bond's average lifespan. Call provisions allow (or, in some cases, require) the issuer
to pay back principal before the bond's date of maturity. The most frequent cause for a bond
to be considered is that the issuer now has the option to reduce its interest costs as interest
rates have fallen.Instead of concentrating on yield-to-maturity, good bond managers
concentrate on yield-to-call, which implies that the bond is called at the earliest possible date
by the issuer. To compensate for the possibility of a bond being called before maturity,
bonds with call provisions must typically offer a larger annual return than bonds without call
provisions. Some bonds, on the other hand, have put provisions, which may oblige the
issuer to repurchase the bonds at the investor's request at defined dates before maturity.
When interest rates have risen since the bonds were issued, investors will typically exercise
this option (or they simply want their money returned to them).

Tax Treatment

Tax treatment varies depending on the type of bond. Interest on U.S. Treasury
bonds, for example, is tax-free at the state and municipal level but taxed at the federal level.
Municipal bond interest is exempt from federal income tax and, in most situations, state and
local income taxes. This could lead one to believe that taxable investors should always
invest in tax-free stocks. This isn't always the case, however.The appropriateness of taxable
or tax-exempt bond income is determined by the taxable client's income tax bracket as well
as other criteria such as tax loss carryforwards and alternative minimum tax status. Another
important consideration is the sort of account in which the securities are housed. In most, if
not all, circumstances, tax-deferred accounts such as business retirement plans, 401(k)s, or
IRAs should contain taxable bonds.

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Bond Asset Classes

We'll now go over the various bond asset classes. When deciding whether or not to
invest in certain bond asset classes, consider valuation as well as how the asset class's
characteristics meet the investor's goals. Geographic, type, and taxability are all factors that
can be used to categorize bonds.

U.S. Treasury and Agency Bonds

Treasury securities are direct debts of the United States government issued by the
Treasury Department. They are free of credit risk since they are backed by the United States
government's full faith and credit. In contrast, agency securities are the obligations of
specific entities that are either part of or sponsored by the United States government.
Despite the fact that agency securities are not normally backed by the government, they are
regarded as having a relatively low credit risk. These bonds still have interest rate risk, but
their liquidity makes them appealing. State and local taxes are free on almost all issues
(excluding Freddie Mac and Fannie Mae).

Even before to S&P's downgrade of US debt from AAA to AA+ in 2011, US Treasury
securities were regarded as risk-free or having zero credit risk. While Washington's budget
and debt ceiling debates have raised concerns about the United States' debt growth
trajectory, the government's ability to raise tax income and print money virtually guarantees
that interest and principal will be paid on time, even if the dollars repaid are worth less than
those borrowed.

Mortgage-Backed Securities (MBS)

Mortgage-backed securities (MBS) are debt obligations that represent claims on the
cash flows from a pool of mortgage loans, usually on residential property. MBS can range
from simple pass-through certificates to more complex arrangements like CMOs or mortgage
derivatives. Prepayment risk is a substantial risk associated with MBS; as interest rates fall,
homeowners are more likely to refinance, resulting in the return of principal to investors at a
time when their reinvestment alternatives are limited.

Corporate Bonds

Corporations issue corporate bonds, which are debt securities. These bonds, like Treasuries
and Agency bonds, are subject to interest rate risk. They do, however, have a higher yield
than Treasury securities due to the additional credit risk of the issuer and the liquidity risk of
a particular issuance. The “spread” on a corporate bond is the difference between its yield
and that of a Treasury bond of similar maturity.

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High Yield Bonds

Bonds rated below investment grade (below BBB from S&P or below Baa from
Moody's) are known as high yield bonds or "junk bonds." Due to the higher risk of default,
these bonds often pay higher interest rates than ordinary bonds. Many U.S. corporations,
certain U.S. banks, various foreign governments, and certain foreign firms all issue high-
yield debt.

Global Bonds

The approach of investing in the bonds of many countries is known as global bonds.
Global bond managers will try to leverage the difference in interest rates to take advantage
of currency rate changes, in addition to taking use of the varying yields supplied by various
countries' debts. For global bond managers, exchange rates are both a risk and an
opportunity.The two types of currencies are those that are tied to the US dollar and those
that are free-floating. Currency values that move in lockstep with the US dollar and shield it
from currency risk are known as pegged currency values. Free-floating currencies, on the
other hand, vary in value fully independently of the US dollar, creating a bigger risk while
also providing more opportunities.

Emerging Markets Local Currency Debt

Emerging market countries have traditionally issued debt in US dollars or euros.

More developing market issuers, on the other hand, have recently began issuing debt in
local currencies. Many of these countries, like high-yield bonds, offer larger yields in
exchange for poorer ratings and a higher chance of default. Due to the anticipation that their
higher growth rates and trade surpluses will cause emerging currencies to appreciate
against most developed country currencies, local currency emerging market debt has
recently been attractive.

Lastly, the growth of a local institutional investor base has aided the development of
emerging market debt. Local emerging market pension funds, for example, have increased
from under $100 billion in 1991 to over $1.4 trillion in 2010. As a result of these
strengthening fundamentals, considerable capital flows into emerging markets have begun
to emerge.

Municipal Bonds

State, city, and other local governments, as well as their agencies, issue municipal
bonds. The principal benefit of municipal bonds is that they are often tax-free at both the
federal and state levels. Municipal bond yields are often lower than comparable maturity

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Treasury bonds due to the tax-free nature of most municipal bond interest. Municipal bonds,
on the other hand, can trade at yields equivalent to or above that of Treasuries at times due
to their lower relative liquidity and higher perceived credit concerns. The interest on many
municipal bonds is not exempt in several states (for example, Illinois and Wisconsin).
Furthermore, the introduction of Build America Bonds in 2009 greatly increased the amount
of money available.

General obligation bonds and revenue bonds are the two most common types of
municipal bonds. A general obligation bond's principal and interest are secured by the
issuer's full faith and credit, rather than a specific project. These bonds were approved by
the voters and are backed by the issuer's taxing power. The principal and interest of a
revenue bond, on the other hand, are guaranteed by revenues generated by a specific
project, such as toll roads, hospitals, bridges, airports, sewage treatment plants, and so on.
While all municipal bonds can be divided into two categories: general obligation and revenue
bonds, each category contains a variety of municipal bonds.

Inflation-Protected Bonds

Most traditional (nominal) bonds face the major risk of inflation, which is addressed
by inflation-protected bonds. Inflation-protected bonds have a built-in inflation adjustment.
The Treasury Inflation-Protected Securities (TIPS) are the most liquid of the several
countries that have issued inflation-linked securities. TIPS principal amounts are modified
based on the rate of inflation as assessed by the Consumer Price Index in the United States
(CPI). TIPS often have low real yields due to the absence of inflation risk. Another factor that
makes TIPS less appealing is that taxes must be paid on principal changes even if no
income is earned.As a result, it's best to keep TIPS in tax-deferred accounts as much as
possible. This discussion of bond inflation risk leads us to alternative assets that may be
able to assist safeguard a portfolio's buying power from the scourge of inflation.

HEDGE FUNDS

A hedge fund is defined as “an investing group, usually in the form of a limited
partnership, that adopts speculative strategies in the goal of obtaining big capital gains,”
according to the Merriam-Webster online dictionary. Despite the hype surrounding hedge
funds, there is no legal definition for the term.

Active risk, broad mandates, limited liquidity, high fees, limited transparency, unique
trading tactics, and a lack of benchmark are all characteristics shared by most hedge funds
today. There are undoubtedly others, but this list encompasses the majority of the most
important common characteristics.

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 Hedge fund managers are not, by definition, the investment managers to whom
investors look for systematic or market risk management (i.e., beta). Hedge funds take on
particular or active risk with the expectation of being rewarded with alpha, which is defined
as risk-adjusted excess return. Indeed, what would be the sense of investing in a manager
who charges a 2% management fee and a 20% beta exposure incentive fee? Hedge funds
are intended to be able to do things like have better and faster access to information,
superior analysis of that information, the greatest talent money can buy, and more to earn
themselves unique sources of alpha.

Hedge fund managers have a lot of freedom when it comes to investing styles, asset
classes, security types, and trading strategies. One of the primary differences between a
hedge fund management and a regular equities manager, for example, is that the hedge
fund manager can focus his or her portfolio on a few securities or have thousands. These
securities can come in a variety of shapes and sizes. This adaptability gives the manager the
freedom she needs to respond to changing market conditions.

The liquidity (redemption) terms offered by hedge funds are perhaps the most difficult
aspect of investing in them. The majority of hedge funds have an initial period during which
the investor is unable to withdraw funds. This is known as a lock-up period, which varies in
length depending on the fund. Although lock-up periods have varied historically, the average
is two years, however some are one year and some are three years; anything longer than
three years is exceptional.After the lock-up date has elapsed, investors usually can only
redeem on certain timeframes. While all these concepts can appear inconvenient, hedge
funds sometimes have valid reasons for these kinds of liquidity terms. They don't want to
start an investment strategy that will take time to enact and realize value, only to have
investors withdraw their funds.

Hedge fund managers collect fees that are far higher than those charged by regular
asset managers. Management costs and incentive fees are the two types of expenses. Fees
for asset management typically range from 1% to 3% of assets under management.
Incentive fees allow the hedge fund management to share in the fund's favorable
performance. Typically, incentive fees vary from 15 to 25% of annual realized or unrealized
earnings. Certain hedge funds charge significantly more than these ranges. Of course, one
of the problems with this type of fee structure is that managers are enticed to take on
excessive risk in order to maximize profits.This isn't always in the investor's best interests. A
high-water mark is a tool used by many hedge fund managers. A high-water mark is a
measurement of previous losses in a fund that must be made up with new profits before an
incentive fee is paid. A hurdle rate, or a minimum rate of return performance level that the

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fund manager must meet in order to receive an incentive fee, is included in a few funds.
Investors benefit from both the hurdle rate and the high-water mark.

Many investors want to know what a hedge fund is up to in order to assess the risks
associated with the manager's strategy and holdings before putting their money into it.
Hedge fund managers prefer not to show their work to investors or anyone else for a variety
of reasons, the most important of which is to protect their intellectual property, which
includes their funds' holdings and strategies. As a result, there is a tense relationship
between investors and managers that is difficult to reconcile. This lack of openness
contributes to the mystique surrounding hedge funds. Those in charge of conducting due
diligence on managers must break through this mystique and unearth details. Managers are
gradually gaining confidence in disclosing information.At the end of the day, it's all about
trust. With such lax regulation, a hedge fund looking to defraud investors will almost certainly
succeed. To achieve alpha, hedge fund managers employ three basic trading tools that go
beyond traditional management: short selling, leverage, and derivatives. Short selling allows
managers to profit from falling stock prices by borrowing shares from others and
repurchasing them at a later date. Leverage, or borrowed money, is used to boost returns on
a variety of investment strategies, such as tiny price differences between securities.Hedge
fund managers can use derivatives to take meaningful holdings in a specific market segment
without actually owning the underlying security. These three methods are utilized in hedge
funds to varied degrees, with certain strategies using them more frequently than others
depending on the necessity.

The goal of hedge fund managers is to make money. This is referred to as absolute
returns by some in the industry. Hedge fund managers' investing techniques are unrestricted
in their quest of absolute profits. As a result, they have no set standard to beat (although
some hedge fund managers do compare themselves to certain benchmarks, such as cash
plus 4 percent or an individual strategy benchmark such as a convertible arbitrage
benchmark).

REAL ASSETS

The majority of the economic input and store of value investments we mentioned
before are real assets. Real assets differ from capital assets in that they have inherent value
due to the services they provide. Because of their intrinsic value, these assets should
increase in value in the event of unanticipated inflation. Real (or hard) assets, which are real
(as opposed to intangible) financial assets, retain their value over time due to their positive
association with inflation. They usually provide a portfolio with substantial diversification
benefits as well.Real assets are held in an investment portfolio to generate attractive

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nominal rates of return and provide a hedge against unexpected inflation. While stocks tend
to pass on inflation's long-term effects, there have been times when inflation was high and
stocks performed poorly (for example, during the 1970s).

Because of their long holding durations, real assets are fundamentally tax efficient,
with some providing particular tax benefits such as depreciation and long-term capital gains
tax rates when held for 12 months or longer, and generally providing some amount of cash
flow during the holding period. Timber, for example, creates a yield from harvesting trees
and other fees, whereas real estate pays out net income from operations. Oil and gas will
generate income from the sale of energy resources.

Real Estate

Even rented real estate could be considered a capital asset. Real estate investments
can help protect against inflation by assuming that landowners can raise rents during periods
of high inflation. This presumption, however, is based on the real estate market being
balanced in terms of supply and demand. Excess supply, as demonstrated by vacancy rates
of 10 percent plus, could make it difficult to raise the rent even during periods of strong
inflation.

Clients with typical low liquidity demands and long time horizons should invest in real
estate in private partnerships, just as they do in private equity. As previously said, vintage
year diversification is the greatest way to achieve a private investment program. The private
real estate portfolio's portfolio building is an issue of risk appetite. As an anchor, most
investors prefer a core, diversified fund.Satellite strategies, such as those in the value-added
and opportunistic strategies, can be adopted if more profit is required. Liquid real estate
investment trusts (albeit volatile) can operate as a proxy for private real estate during the five
or so years it takes to fully invest a private strategy while the vintage year diversification
comes into effect.

Commodities

Commodities of all kinds (oil and gas, industrial metals, precious metals, and timber)
provide a hedge against inflation because their prices tend to climb when inflation rises. As
demand for products and services grows, so does the price of those goods and services, as
well as the price of the commodities used to generate them.

The energy sector is divided into three segments: upstream, midstream, and
downstream. Energy products are explored and extracted from beneath the ground and
beneath the sea by companies engaged in upstream activities. Tankers and pipelines that
transport crude oil to refineries are provided by midstream companies. Market companies

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involved in refining, marketing, and distributing energy goods, as well as local gas stations
that service the end customer, make up the downstream. Two or more of these activities are
carried out by an integrated oil business. Upstream and midstream activities are the focus of
the majority of private energy investment funds.These funds put their money into domestic
oil and gas wells, with a focus on holding "proven reserves." There is evidence that oil or gas
is present and being pumped from the ground at these locations, as the name implies. Some
funds invest in exploration as well. Others put their money into midstream assets like
pipelines and energy technology. When investing in energy, the most significant risk is a
change in the underlying commodity price from the price assumed when the transaction is
made. Another risk aspect is the cost of production. Most energy investments hedge price
exposure for a period of time, which provides some protection but also limits upside and
inflation risk.

As previously stated, the risk and return spectrum available in the energy markets is
identical to that of real estate techniques. Core funds in real estate make the majority of their
money from income. Similar funds are known as royalty funds in the energy industry. In a
stable pricing environment, these funds' target returns are normally 8 to 10%, although they
can rise in a rising price environment. The energy counterpart of a core-plus real estate fund
is a resource fund, whose principal goal is to buy reserves and create value, primarily
through cost reduction and improved operations. The expected returns, net of fees, are 12 to
15%.A value-added energy strategy is a resource fund or a private equity fund that invests in
proven reserves and pursues lower-risk drilling and reengineering initiatives to boost
production. The target return for these funds, net of fees, is 15%. The final classification is
opportunistic. Drilling wells is the main activity here. This is a scenario with a higher risk and
a higher payoff. Private equity funds are responsible for many of these investments. These
funds have expected returns of more than 15%, although they are riskier than other forms of
energy funds.

Commodities are raw materials used to develop consumer goods and include
energy, industrial and precious metals, agricultural production and farm animals, and soft
commodities, perishable items like coffee and sugar. Commodities have developed as an
asset class with the growth of commodity futures exchanges and investment vehicles that
monitor resource indexes. On a worldwide scale, futures and options contracts on hard and
soft commodities can be exchanged. As a result, there is a huge demand for commodity-
based investments. According to Barclays Capital, around $175 billion is presently invested
in commodity index allocations.Two widely used benchmarks that define the composition of
the commodities market are the S&P GSCI (Standard & Poor's-Goldman Sachs Commodity
Index), Total Return Index, and Dow Jones–AIG (American International Group) Commodity

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Index. Rather than merely futures price returns over time, both indexes are built on a basket
of collateralized commodities futures returns. Each index calculates returns from three
different sources (thus the term "total return" in the classification):

• Interest earned on cash collateral put up as a deposit for futures trading (generally
Treasury bills).
• Changes in futures contract prices, which should approximate the return on the
reference index when combined with the aforementioned.
• The return from rolling futures into longer-dated contracts as they near expiration,
which has been a positive contribution in the long run but has recently been a
negative contributor.

There are four primary ways to add commodities to a portfolio:

1. Purchasing the physical commodity: This method provides a direct access to the
underlying product, but shipping, storage, and spoiling are all potential issues.
2. Investing in the futures or derivatives markets: This strategy has restricted access to
large institutional investors with the resources and skills to handle complex futures
portfolios directly, or to employ a total return exchange and handle the counterparty
risk associated with it.
3. Investing in pooled vehicles such as mutual funds: Until recently, mutual funds were
the most viable alternative for individual investors or small institutions since they
provided quick access to commodity-linked investments at low investment minimums
and at affordable prices.
4. Exchange Traded Notes (ETNs): ETNs offer a new way to gain access to markets
that are difficult to access, such as commodities. ETNs are unsecured debt securities
that provide exposure to the returns of a certain asset class or market while
maintaining the trading flexibility of a stock. ETNs linked to commodities indexes are
intended to provide investors with low-cost access to the returns of major commodity
benchmarks, minus a fee.

Coin or Art

Coin and art collections are long-term investments that provide some inflation
insurance, but they also bring extra dangers. The market of coin and art collecting is
relatively illiquid, and values are influenced by a variety of factors that are maybe even less
predictable than traditional markets, such as supply, changing tastes, the frequency with
which an object appears on the market, condition, and collector habits.

SIMPLE PORTFOLIO CONSTRUCTION

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 Now that we've gone through the various asset classifications, it's time to figure out
how to bring everything together. Portfolio creation is the process of using a total portfolio
perspective to design a portfolio of assets that can perform consistently within an investor's
goals across diverse economic and market circumstances. Having a comprehensive
understanding of how one investment in a portfolio interacts with the other assets is what a
total portfolio approach entails. As a result, it's important to know how this interaction affects
the portfolio's overall capacity to provide more stable risk-adjusted investment returns.This is
especially critical in today's market, as investors seek portfolios that are simple, consistent,
and achieve their goals.

The expected rate of return on the portfolio is simple to calculate; it is simply the
weighted average of the individual asset class projected returns. We'll utilize historical asset
class returns and standard deviations as projected returns for simplicity's sake. Return
expectations should, however, be altered in practice to account for actual valuations.

The expected return on a portfolio can be computed as follows:

where E[Rp] = the expected return on the portfolio

N = the number of investments in the portfolio

wi = the proportion of the portfolio invested in investment i, and

E[Ri] = the expected return on investment i.

The expected standard deviation of the portfolio is determined not only by the
expected standard deviations of the portfolio's components, but also by the correlation
between those assets. Table 10.2 summarizes the relationships discussed earlier in this
chapter. Our representative equity class is the S&P 500, our representative bond class is the
Barclays (previously Lehman) Aggregate, and our cash proxy is the Citi 3-Month Treasury
Bill Index.

TABLE 10.2 Correlation Matrix

S & P 500 Barclays Agg Citi 3-Month T-Bill

S&P 500 1.00 0.19 0.06
Barclays Agg 0.19 1.00 -0.07

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Citi 3-Month T-Bill 0.06 -0.07 1.00

The variance of a portfolio of three or more assets can be stated as a function of the
variances of each asset, the portfolio weights on each, and the correlations between pairs of
assets, however it's a little more involved than the expected return.

Activity 1
Answer the following questions.

1. What are the different asset classes? Describe each of the

asset classes.
2. How these asset classes do helps in the investing
decisions of investors?

Lesson 2: WhatIs AssetAllocation?

Learning Outcomes: This session will provide you an

understanding of why asset allocation is
At the end of the lesson, you are so important. The following is how the
expected to: lesson will be structured: For non-
• demonstrate the importance of believers or those who need a reminder,
asset allocation; and we will first examine why asset allocation
• provide tools that helps in the is so crucial and review some academic
asset allocation process. data illustrating how critical the asset
allocation decision is. Next, we'll talk
about the importance of the assumptions
utilized when estimating probable asset
allocations for customers, without
becoming too technical. Before we go
into the relevance of asset allocation,

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 let's establish what the phrase means.
We'll go through some asset allocations
for each of the behavioral investor
categories later in the module.

Lesson Proper

Asset allocation, in its most basic form, is the process of selecting the number and
types of asset classes that will be included in a client's portfolio, as well as the percentages
that each class will represent. The best asset allocation for a client (which asset classes to
invest in and in what amounts) is determined by how well the allocation's features and
behavior meet the client's objectives and restrictions, which are often expressed in the
investor's investment policy statement (IPS). Regardless of a client's comfort level with risk,
modern portfolio theory, which emphasizes diversity, teaches us that our role as advisors is
to obtain the best possible projected return for a given investment.The Sharpe ratio (return
per unit of risk) is maximized for each portfolio allocation combination offered to the
customer during the asset allocation research to achieve this goal.

There are two forms of asset allocation used for customers, regardless of which
allocation is eventually chosen: strategic and tactical. When integrated into an investing
policy statement, strategic asset allocation (SAA) means that the mix of investments is
meant to meet the client's objectives and restrictions. SAA is a critical component of the
portfolio development and management process. The most common approach of
determining strategic allocation is to employ an asset allocation study.After a thorough fact-
finding and profiling session (investment policy statement inputs), this procedure comprises
presenting the client with a range of alternative asset allocations that may be beneficial for
the customer. The study gives risk and return statistics for the various asset mixes offered so
that a client can obtain a sense of the expected behavior from the chosen allocation.
Naturally, this is not a precise science. Using historical or even forward-looking capital
market predictions, it is impossible to predict how a portfolio will perform in any given year
with precision. However, utilizing a strategic asset allocation, behavior can be predicted over
time.

The process of making temporary adjustments to the asset class percentages

selected in the SAA is known as tactical asset allocation (TAA). These adjustments are
based on the client's portfolio's predicted short-to medium-term (defined as one to five years,
depending on the time horizon of the tactical decision) relative performance of asset classes.
Some may mistake this for market timing, but the two are not the same. Market timing is

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described as straying into asset classes that are not part of the policy allocation in order to
reap short-term benefits. TAA can be considered of as a strategy that favors certain asset
classes while avoiding others while retaining exposure to client's policy allocation.

Some financial advisors don't differentiate between strategic and tactical asset
allocation, instead combining the two as their recommendations change over time. Both
strategic and tactical asset allocations are often made using a modeling approach that
depends on assumptions about returns, risk, and asset class correlations. Many advisors
don't spend the effort to investigate these assumptions in depth.

THE IMPORTANCE OF ASSUMPTIONS

Efficient frontier analysis is the most extensively utilized implementation technique for
current portfolio theory's main concept of diversification. For several reasons, efficient
frontier analysis, the process of minimizing risk per unit of return, is held in high respect, not
least because it is based on the work of a Nobel laureate, Harry Markowitz. Mean-variance
optimization, developed by Mr. Markowitz as a tool for investors and professionals, lies at
the heart of asset allocation in application.Many advisors utilize this tool with their clients
because diversification into several asset classes can help investors achieve the maximum
Sharpe ratio in their portfolios by reducing volatility per unit of return.

This technique works because there isn't a perfect correlation between the asset
classes in the portfolio; this is referred to as covariance among asset class pairs statistically.
Simply said, in one market situation, one asset class can be declining, while another might
be gaining, and yet another might be flat. In a different market context, a flat market could be
rising, a rising market could be dropping, and a falling market could be flat.As a result, the
portfolio's overall returns are smoothed out. However, we must remember that the efficiency
of the efficient frontier modeling method is predicated on assumptions about expected
return, expected standard deviation (risk), and expected asset class correlations. The
assumptions utilized in this research can result in a broad range of results. Advisors must be
aware of the sensitivity of these assumptions in order to appropriately communicate with
their customers about the performance of their portfolios over time.

Advisors must address questions like how many asset classes to include in the
client's portfolio, which asset classes to utilize, and how much of the client's assets to
allocate to each class selected while attempting to design efficient portfolios for their
customers. To answer these questions, advisers calculate predicted return, volatility, and
correlations across all asset classes for each asset class. The efficient frontier, which
represents the optimum feasible combination of risk and return for a particular set of asset
classes, is then created by optimizing the mix of asset classes.So, what's the big deal? The

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efficient frontier is a model in which the output is determined by assumptions. Expected
returns, volatility, and correlation are all assumptions that rarely come true in practice. As a
result, advisers who wish to add value to their clients' portfolios must make estimations while
simultaneously looking back and forward—a difficult challenge. They must also understand
that forecasts are nothing more than an educated guess about the future.

Using historical data is the simplest technique to estimate input assumptions. Back
testing and determining which portfolios were best in the past can be done using average
return, standard deviation, and historical correlations.Obviously, you can only use historical
facts if you believe that history tends to repeat itself. The obvious question is: if you're going
to use historical data, which historical period should you choose? Should a long period of
time, such as 100 years, be used to capture the most data, or should more mature capital
market periods, such as the recent 30 years, be used? What about the maturity of asset
classes? Should one use a different period for emerging market bonds and a different period
for Treasuries to reflect the two asset classes' founding dates? These questions have no
right or wrong answers. It is a matter of opinion. However, there are a few things to bear in
mind.To begin, previous data should be deemed to be of significant value, and any changes
in estimations should be based on a well-defined reasoning. The link between U.S. large-
capitalization stocks and overseas large-capitalization equities is one example. These asset
classes have historically been weakly correlated, but given the increasing integration of
global economies and capital markets, it may be argued that major international business
equities will react similarly regardless of where they are headquartered.Second, predicted
return projections will have a significant impact on the optimality of alternative asset mix
selections. As a result, advisors must think carefully about predicted return predictions. The
impact of standard deviations and correlation assumptions on optimality decisions is
minimal. Furthermore, some return projections include alpha, or outperformance above an
index, which can cause asset allocation models to be distorted. Finally, whatever approach
is utilized to determine assumptions should be comparable across asset types.

THE IMPORTANCE OF STRATEGIC ASSET

Allocation

Strategic asset allocation is critical in determining the risk exposure a client may bear
in his or her portfolio, according to practitioners who rely on asset allocation as the major
driver of returns. Risk management is one of the most important advantages of diversifying a
portfolio across multiple asset classes. Although no asset allocation will stop a portfolio from
losing value in a catastrophic market downturn, it can protect it in most market
circumstances because when certain asset classes decline, others rise.Based on a seminal

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article produced by Brinson, Hood, and Beebower (BHB) in 1986 titled "Determinants of
Portfolio Performance," many advisors consider asset allocation to be extremely significant.

From 1973 to 1985, BHB examined the asset allocations of 91 big pension plans.
They swapped out the pension funds' stock, bond, and cash holdings for market indexes.
The indexed quarterly returns were found to be higher than the actual quarterly returns of the
pension schemes. The linear correlation between the two quarterly return series was 96.7
percent, with 93.6 percent shared variance. Return variability was explained by 6.4 percent
on average by time and security selection.Timing and security selection were found to have
negative contributions to active returns on average, meaning that investing effort on these
activities is not rewarded (on average).

On the basis of a regression analysis of the data, the authors evaluated the
importance of asset allocation as the “fraction of the fluctuation in returns over time”
attributable to asset allocation.Many financial advisors are unaware that this study answered
the question, "How much of the variability of returns across time for one portfolio is explained
by asset allocation (or how much of a fund's volatility is explained by its policy allocation)?"
rather than "What portion of a portfolio's return is explained by its asset allocation policy?"
This may appear to be a little distinction, but it is actually quite crucial.

In a study titled “Does Asset Allocation Policy Explain 40, 90, or 100% of
Performance?” published in 2000, Roger G. Ibbotson and Paul D. Kaplan answered this
second and more crucial question. Ibbotson and Kaplan examined the 10-year returns of 94
U.S.-balanced mutual funds vs the comparable indexed returns using five asset classes:
U.S. large-capitalization stocks, U.S. small-capitalization stocks, international stocks, U.S.
fixed-income securities, and cash. After accounting for index fund expenses, active returns
failed to outperform the index.The monthly index returns had a linear correlation of 90.2
percent with the actual monthly return series, with a shared variance of 81.4 percent. Asset
allocation explained 40% of the range in fund returns and nearly 100% of the level of fund
returns. Active management (market timing and manager selection) adds virtually nothing to
returns, according to Ibbotson and Kaplan. This isn't to say that hiring active managers won't
help you succeed as an investment. However, advisors should focus the majority of their
investment policy design work on asset allocation rather than active management.

Finally, alternative investments such as hedge funds, private equity, and other private
investments such as real estate or natural resources are not included in these research.
Active management is almost always what defines performance in various asset classes.
Hiring top decile (top 10%) managers is important to venture capital investment success.
Because there is no way to invest in a venture capital index, manager selection is crucial.

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Index returns are less than ideal in hedge funds.Getting active exposure in alternatives and
indexing traditional assets, particularly highly efficient asset classes like large-cap U.S. and
large-cap international, is a good strategy.

CONSIDERATIONS FOR INDIVIDUAL INVESTORS

The challenge of selecting an ideal asset allocation is a unique procedure for each
individual, and it is as much art as science, as previously said. What advisors must
understand is that many investors desire to maximize their asset allocation for several
objectives, which is often impossible to achieve. Maximum income, maximum philanthropic
giving, maximum growth, and minimal taxes cannot all be optimized at the same time. It is
feasible to have several objectives and develop investment strategies for each of them, but it
is not possible to optimize a single allocation for each of them.Investors must first evaluate
what is most essential to them, and then adapt their asset allocation to meet those goals.

Reviewing the categories that make up an investing policy statement is perhaps the
greatest method to understand the process of customizing asset allocation. Return targets,
risk tolerance, and constraints like as liquidity, time horizon, taxes, legal and regulatory
requirements, and special circumstances are all factors to consider.For clarification, a
section titled "effect on asset allocation" will be included in each of these sections to show
how each of these categories influences the asset allocation process. The key is for advisers
to understand how to talk to their customers about their investing goals and prioritize them
so that they can recommend the best asset allocation.

Return Objectives

The return target of an investor must be clearly specified, both quantitatively and
qualitatively, with the focus on the qualitative side. Advisors must assist their customers in
defining exactly what they want their money to do for them. The return target is a great place
to start because it starts customers thinking about what long-term financial goals they have
and how their current wealth may help them accomplish them.Ironically, return objectives are
one of the most crucial discussion areas, but they are frequently pushed to the end of the
process after the client has given considerable thought and planning to the question of what
the money should be used for. While quantitative criteria are simple to assess (“Did I earn
9% or not?”), qualitative return objectives are more difficult to assess, though they can still
be assessed. A qualitative goal such as "to obtain returns that will provide appropriate
spending income while maintaining a fund's real purchasing power" can be concretely
determined, for example.

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 The asset allocation decision is heavily influenced by the return aim. If the return
target is high, an asset mix that favors greater returns and riskier asset classes will be used.
Naturally, if the return aim is low, the opposite is true. When dealing with a client that wants
or needs a high return objective, advisors must carefully consider whether the customer
wants or needs a high return objective. Clients frequently take on more risk than is
necessary just because they believe they should be aiming for a high return.

Risk Tolerance

Risk tolerance is a natural complement to return target when designing an asset

allocation policy. Both qualitative and quantitative risk objectives are significant
considerations, just as they are with return objectives. A risk tolerance questionnaire, which
examines both quantitative and qualitative components of an investor's risk tolerance, is
often used to start the risk assessment process. Based on the investor's willingness and
ability to absorb risk, the investor is usually classified into one of four or five risk categories,
ranging from low to high. But how can a financial advisor match a client's risk tolerance to a
suitable investment strategy?

Risk tolerance can be evaluated in terms of a tolerable degree of volatility, which is

measured by the standard deviation of return. An investor who is comfortable with the
volatility associated with a standard deviation of return of 12% or less, for instance, can rule
out allocations with a standard deviation of return of more than 12%. Another technique to
measure risk tolerance is to calculate the probability of a loss year. A client can be supplied
with an array of allocations, some of which will have a high likelihood of a return less than
zero and some of which will have a low probability of a return less than zero, using this
method.A cautious investor might only allow a 10% probability of a negative return in any
given year. A more daring investor might accept a 40% probability of losing money in a given
year. Finally, shortfall risk is the risk that the value of a portfolio will go below some minimum
acceptable level, such as the inflation rate or a spending rate, over a specified time horizon.
An adequate shortfall risk objective improves the definition of an investor's attitude toward
risk when shortfall risk is a major concern.

The desire and ability to take risks have a big influence on asset allocation decisions.
As risk tolerance rises, more dangerous asset classes will inevitably be incorporated.
Investors must distinguish between the ability to accept risk and the requirement to take risk.

Liquidity

The liquidity of a client's portfolio is a crucial factor that is frequently disregarded.

Significant liquidity requirements, in general, limit an investor's ability to bear risk. An

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investment policy statement's liquidity part is divided into two sections. The first is how much
liquid cash is required to cover both projected expenses and cash needs, such as capital
requests for private investments, as well as any unexpected financial demands, such as
medical expenses or home repairs. The second section deals with the overall percentage of
liquid, semi-liquid, and illiquid investments that can be held in the portfolio.

Some investors rely on portfolio returns (both income and capital gains) for their daily
living costs, while others earn a living and do not require portfolio withdrawals for living
expenditures. A predictable living expense amount (a spend rate) is a high priority for the
investment portfolio in the former circumstance. Anticipated expenses are often
compensated for with cash held in a section of the investment portfolio due to their
predictability.Cash reserves are less of an issue in the latter instance because cash is not
required for a spend rate, allowing more of the portfolio's capital to be invested. Unexpected
cash needs can be supplied in either instance by a cash cushion, the size of which is
determined by the client. Anticipated negative liquidity events, such as home purchases,
education expenses, big philanthropic gifts, or other significant expenses, must be managed
for in both circumstances.If the family is comfortable discussing such matters openly,
positive liquidity occurrences such as inheritance or other anticipated cash inflows can also
be mentioned in the liquidity portion of the investing policy statement.

Many investors, particularly those in their latter years, are sensitive to their portfolios'
overall illiquidity. Despite the fact that some investors have the financial resources to invest
in private equity, private real estate, natural resources, hedge funds, and other illiquid or
semi-illiquid investments, they often want to keep the overall illiquidity in their portfolio to a
minimum in order to maximize the flexibility of obtaining funds.Even though there is no strict
rule, I find that reviewing the client's solvency needs at 50% of the portfolio is a logical
starting point. To put it another way, if a client's portfolio has 50% or more illiquid and semi-
liquid investments, it's time to talk about it. Some clients may set a restriction on their
portfolios, such as 35 or 40 percent.

Some investors prefer liquidity, and this preference can have a big impact on asset
allocation decisions. Clients who limit their private equity and hedge fund investments in
favor of more liquid equities, as previously said, subject themselves to more day-to-day
volatility (depending on which asset classes are ultimately chosen). A long-term investment
portfolio with a lot of cash and bonds can suffer from a return drag.

Time Horizon

The asset allocation option is heavily influenced by the investing time horizon. The
time horizon, in particular, determines the amount of volatility that can be expected in the

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portfolio. The client can accept less volatility the shorter the time horizon is, and vice versa.
Many advisors divide time horizons into three categories: short-term, medium-term, and
long-term, however there are no commonly agreed meanings for these terms. When
describing a time horizon, I like to utilize ranges rather than absolute phrases whenever
practical.For instance, I consider time horizons of larger than 15 to 20 years to be long-term,
those of 3 to 15 years to be medium-term, and those of fewer than 3 years to be short-term.
While I consider 10 years to be medium-term, some clients may see it as short-term, while
others may see it as long-term. In any case, portfolio allocations must take the client's
understanding of time horizon into account.

A second and equally essential consideration is whether the investor is dealing with a
single or multistage time horizon. Certain investors, particularly those over the age of 50,
may be satisfied with a single-stage time horizon of ten years. Some investors, on the other
hand, might benefit from a multistage time horizon, which would require various asset
allocations for different time horizons.

Because the time horizon selected might limit the amount of volatility that can be
assumed by the client and the types of investments that can be used, the time horizon has a
substantial impact on the asset allocation decision. A 5- to 10-year time horizon, for
example, has plenty of room for equities, but private equities aren't going to cut it.

Taxes

When investing for taxable clients, the problem of taxes is likely the most universal
and challenging investment constraint. Income and property taxation is a global reality that
provides a considerable barrier to wealth expansion.

Income tax, capital gains tax, wealth transfer tax, and property tax are only a few of
the taxes that must be dealt with. With such high tax costs, the individual investor must
consider the investment process from an after-tax standpoint. Table 11.1 depicts the top
marginal tax rates in the world as of 2005, just to give readers a sense of the worldwide
reality of taxes.

TABLE 11.1 Tax Rates around the World

Country Income Tax Gains Tax Wealth Transfer Tax

Brazil 27.5% 15.0% 8.0%
Canada (Ontario) 46.4% 23.2% 0.0%
Chile 40.0% 17.0% 25.0%
China (PRC) 45.0% 20.0% 0.0%

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Egypt 32% 0.0% 0.0%
France 48.1% 27.0% 60.0%
Germany 42.0% 50.0% 50.0%
India 30.0% 20.0% 0.0%
Israel 49.0% 25.0% 0.0%
Italy 43.0% 12.5% 0.0%
Japan 37.0% 26.0% 70.0%
Jordan 25.0% 0.0% 0.0%
Korea 35.0% 70.0% 50.0%
Mexico 30.0% 30.0% 0.0%
New Zealand 39.0% 0.0% 25.0%
Pakistan 35.0% 35.0% 0.0%
Philippines 32.0% 32.0% 20.0%
Russian Federation 35.0% 30.0% 30.0%
South Africa 40.0% 10.0% 20.0%
Taiwan 40.0% 0.0% 50.0%
United Kingdom 40.0% 40.0% 40.0%
United States 35.0% 35.0% 47.0%
Data source: Ernst & Young

Taxes have a detrimental impact on portfolio performance in two ways: on a regular

basis and over time. Cumulative taxation, which occurs when taxes are paid at the
conclusion of a certain measuring period, is the preferred method (if any taxation can be
considered preferable). Periodic payments, which occur when a tax is assessed on a regular
basis throughout a measurement period, are less desirable since the beginning balance of
the next period is decreased by the amount of the tax paid, preventing funds from
compounding at the portfolio growth rate.

Given these two sorts of tax consequences, the advisor's responsibility is to reduce
or eliminate the tax burden incurred during the investing process to the extent lawfully
possible. Each client's tax strategy is naturally unique, depending on the substance of
current IRS laws and the client's location. Despite the fact that tax minimization tactics are
often complicated, there are two basic strategies that may be used to practically any client.
There are two types of tax-deferral and tax-reduction schemes.

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Tax-Deferral Strategies

Periodic tax payments, as we discussed previously, severely stifle the growth of a

taxable portfolio. Taxable investors should always want to postpone paying taxes so that
they can maximize the amount of time their investment profits can be reinvested and
compounded. Low turnover and tax loss harvesting are two ways that help with this
approach. Low turnover investment managers, who acquire and retain their portfolios rather
than exchanging them, increase the average holding period of their investments, delaying
the activation of taxable gains.Tax loss harvesting is the process of incurring capital losses
in order to offset taxable profits while maintaining the portfolio's investment performance.
Low turnover and tax loss harvesting tactics are designed to reduce capital gains realization
to a bare minimum, resulting in tax payments that are postponed.

Tax-Reduction Strategies

If taxes cannot be postponed, there may still be ways to lessen their impact. Advisors
can propose investment managers who adopt a capital gains vs ordinary income approach
when income tax rates are higher than capital gains tax rates, as they are under the present
US tax system. Due to the fact that capital gains tax is only assessed at the moment of sale,
such tactics may profit from both tax deferral and a reduced tax rate. Investments that
completely avoid taxes might also be included in the portfolio.For example, tax-exempt
bonds are the prototypical tax-avoidance investment. Tax-exempt securities often have
lower returns or higher expenses (including higher transaction costs) than taxable securities,
and thus are only appealing when the following relationship exists: [Taxable return (1 – Tax
rate)] > [Tax-free return].

Taxes have a significant impact on the asset classes and managers who are chosen.
The following are important factors to consider. Because of its inherent tax efficiency,
indexing (rather than active management) is an ideal choice for equity asset classes. Long-
term capital gains asset classes are preferred above short-term capital gains (income tax)
asset classes (at the time this chapter was written). Hedge funds and Treasury Inflation-
Protected Securities, neither of which are highly tax-sensitive investments, may play a
smaller role in the taxable portfolio.Longer-term asset types like real estate and energy are
also good choices for a taxed portfolio. The ideal way to approach asset allocation is to
optimize a portfolio for after-tax returns. Later in the module, we will examine asset
placement; this discussion will focus on the optimum location for specific investments in
order to achieve the best tax treatment.

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Legal and Regulatory Environment

Legal and regulatory constraints, with the exception of taxes, are most typically
encountered in the asset allocation process when dealing with pools of investment money
that are subject to legal restrictions, such as trusts or family foundations.

Affluent clients frequently employ trusts to implement investing and estate planning
strategies, and advisors should become familiar with these techniques. In a nutshell, a trust
is a legally formed entity that keeps and manages assets according to set rules.A trust is the
legally recognized owner of any assets it holds, and it is taxed in the same manner as
individuals. Equities, bonds, real estate, actual assets, and even art or coins are examples of
these assets. Trusts are a mechanism to implement an investing or estate planning strategy,
not an investment strategy. The flexibility and control offered to the grantor, who can specify
how trust assets will be managed and dispersed both before and after his or her death, is the
appeal of a trust.

The foundation for making investment decisions inside a trust frequently focuses
around the competing requirements and interests of present income beneficiaries vs the
remaindermen, who will eventually inherit the trust corpus or capital. This clash poses a
problem for the trustee and portfolio manager of a trust. Beneficiaries of current income often
want the trustee to select income-producing assets that will maximize current income. Even
if this reduces current income, the remaindermen recipients will prefer investments with long-
term growth potential.The trustee is accountable for taking into account the demands of both
parties while adhering to the trust document's principles and criteria. The majority of trustees
have accepted current portfolio theory ideas and use a total return approach, which allows
for distributions from both realized capital gains and income-oriented investments.

Legal and regulatory constraints can and do influence asset allocation decisions, as
seen in the last section. When it comes to trusts, there are frequently competing interests to
manage, and the final asset allocation decision can be highly influenced. Advisors must work
within these constraints while also meeting the demands of their customers, which is difficult
but not impossible.

Unique Circumstances

All investors have distinct circumstances that offer investment advisors with
problems. These situations limit portfolio alternatives and complicate the asset allocation
decision-making process. A concentrated equity position, specific company interests that
must be addressed in the context of the total portfolio, real estate assets outside of the liquid
portfolio, socially responsible rules, and a variety of other situations fall into this category.

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Investors must carefully analyze their particular circumstances because they might have a
long-term impact on asset allocation, resulting in under- or overrepresentation of specific
asset classes in the portfolio.

When creating an asset allocation, some rich individuals may have assets that they
want to account for. Real estate holdings, concentrated equity positions, big bond portfolios,
private business investments, and so on are examples of these types of investments. If a
client chooses an ultimate asset allocation that excludes particular asset classes, the client
should be aware that the allocation's behavior will be choppy or less even than that of a well-
diversified portfolio.However, when seen as a whole, the portfolio may be fine—or not, in the
case of a declining-value concentrated stock holding. When reporting on the portfolio, UAC
advisors may want to include these assets to show the impact that unusual events had on
total investment performance.

WHY ASSET ALLOCATION IS SO IMPORTANT

An investor can defend against severe losses by including asset categories with
investment returns that fluctuate with market circumstances in their portfolio. The returns of
the three major asset classes have never moved up and down at the same time in the past.
Market dynamics that cause one asset category to perform well often result in ordinary or
bad returns in another asset category. You can lessen the danger of losing money by
investing in multiple asset categories, and your portfolio's overall investment returns will be
smoother. If the investment return on one asset group falls, you'll be able to offset your
losses in that asset category.

The Magic of Diversification

Diversification is the process of dispersing money among several investments in

order to lessen risk. You may be able to limit your losses and reduce investment return
variations by selecting the correct set of investments without losing too much potential gain.

Furthermore, asset allocation is critical since it has a significant impact on whether

you will reach your financial objectives. Your investments may not produce a significant
enough return to fulfill your goal if you don't include enough risk in your portfolio.For
instance, most financial experts believe that if you're saving for a long-term goal like
retirement or college, you'll need to incorporate at least some stock or stock mutual funds in
your portfolio. However, if you take on too much risk in your portfolio, the money you need to
achieve your goal may not be available when you need it. For a short-term aim, such as
saving for a family's summer vacation, a portfolio strongly weighted in stocks or stock mutual
funds would be improper.

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Getting Started

Choosing the right asset allocation strategy for a specific financial goal is a difficult
undertaking. Essentially, you're attempting to select a portfolio of assets that has the best
chance of achieving your objective while posing a risk level that you're comfortable with.
You'll need to be able to change your asset mix as you get closer to your target.

You may feel comfortable designing your own asset allocation model if you know
your time horizon and risk tolerance, as well as if you have some investing expertise.
Investing "how to" books frequently address general investing rules of thumb, and a variety
of online resources can assist you in making your decision.The Iowa Public Employees
Retirement System, for example, offers an online asset allocation calculator, despite the fact
that the SEC cannot approve any particular formula or technique. Finally, you'll have to
make a very personal decision. There is no one-size-fits-all asset allocation methodology
that is suitable for all financial objectives. You must select the one that is most appropriate
for you.

Some financial gurus say that deciding on your asset allocation is the most crucial
investing decision you'll make, even more essential than the individual investments you
purchase.With that in mind, you might wish to hire a financial advisor to assist you select
your initial asset allocation and make future revisions. However, before you hire anyone to
assist you with these crucial decisions, make sure you thoroughly investigate their
credentials and disciplinary past.

Changing Your Asset Allocation

A change in your time horizon is the most prevalent cause for adjusting your asset
allocation. To put it another way, as you approach closer to your financial goal, you'll almost
certainly need to adjust your asset allocation. Most people planning for retirement, for
example, keep less stocks and more bonds and cash equivalents as they approach
retirement age. If your risk tolerance, financial status, or the financial goal itself changes, you
may need to adjust your asset allocation.

Smart investors, on the other hand, rarely adjust their asset allocation depending on
the relative performance of asset categories, such as raising the proportion of equities in
their portfolio when the stock market is performing well. Instead, they "rebalance" their
portfolios at such time.

Rebalancing 101

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 Rebalancing is the process of returning your portfolio to its original asset allocation
balance. This is crucial since some of your investments may drift away from your investment
objectives over time. Some of your investments will increase at a higher rate than others.
Rebalancing your portfolio ensures that one or more asset categories are not
overemphasized, and it returns your portfolio to a reasonable level of risk.

Let's imagine you've decided that stock investments should account for 60% of your
whole portfolio. However, following a recent stock market rise, equity investments now
account for 80% of your wealth. To reinstate your original asset allocation mix, you'll need to
sell some of your stock assets or buy investments from an underweighted asset category.

You'll need to analyze the investments inside each asset allocation category when
you rebalance. If any of these investments aren't aligned with your investment objectives,
you'll need to make adjustments to return them to their original asset allocation.

Rebalancing your portfolio can be accomplished in one of three ways:

1. You can sell overweighted asset categories' investments and use the money to buy
underweighted asset categories' investments.
2. You can buy fresh investments in asset classes that are underweighted.
3. If you're contributing to the portfolio on a regular basis, you can adjust your
contributions such that more money goes to underweighted asset categories until
your portfolio is balanced again.

Before you rebalance your portfolio, think about whether the rebalancing technique you
choose may result in transaction fees or tax ramifications. Your financial counselor or tax
expert can assist you in identifying strategies to reduce these possible expenditures.

Activity 2
Answer the following questions.

1. What is asset allocation? Why is it important?

2. Do you believe in the saying that “you should not put all of your eggs in one
basket”? Support your answer. How does this relate to asset allocation?

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Lesson 3: Investment Advice for Each Behavioral
Investor Type

Learning Outcomes: We've reached the end of the module

and are now ready to put all we've learnt
At the end of the lesson, you are into practice. We'll go through how to
expected to: create an asset allocation program that's
• demonstrate on how to create a tailored to each behavioral investor type
behaviourally modified asset in this course. We've already covered
allocation for each behavioural how capital markets work and how to
investor type. invest using asset classes, asset
allocation, and creating an investment
plan, as well as the necessity of financial
planning and how it can be crucial to
investing success. We'll put it all together
in this session and show you how to
adjust an investing plan for each
behavioral investor type. We'll start with
an overview of behaviorally modified
asset allocations (BMAA), also known as
risk-adjusted asset allocations.

Lesson Proper

Creating viable and distinctive investment solutions in response to the variety of

financial conditions and personalities clients offer is the heart and soul of the profession for
today's financial advisor, private banker, or generalist wealth management practitioner
(hereinafter "financial advisor"). The task can be simple at times: The client being advised
looks to be sensible in his or her approach, in that he or she appears to recognize the
importance of asset allocation and has realistic return expectations. The conventional way
for determining an asset allocation for these clients is to administer a risk tolerance
questionnaire and utilize financial planning software to establish a mean-variance-optimized
asset allocation.Financial advisors occasionally meet illogical conduct in their clients.
Because they are not anchored in logical investment principles and are reluctant to learning

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them, irrational customers overestimate their risk tolerance, have unrealistic return
expectations, and generally behave in a way that makes advising them difficult. In the first
example, the easy clientele, most advisers have no problems. When presented with an
illogical client, though, some advisors become frustrated and impatient. Risk tolerance
surveys and mean-variance software are frequently unsuccessful in these scenarios.

Clients can achieve their financial goals by understanding and implementing

behavioral finance solutions. However, when it comes to allocating their investment portfolio,
many advisors are perplexed by their customers' decision-making process. Why? In a typical
scenario, a client demands that his or her asset allocation be adjusted in reaction to short-
term market moves, such as those we saw in late 2008 and early 2009, and more recently in
the fall of 2011, to the expense of the long-term investment plan.For both the advisor and the
customer, this type of behavior is a lose-lose situation. The client loses because when they
deviate from their asset allocation policy targets, their portfolio is more likely to underperform
(think of those who "sold out" in March 2009 only to see the market bounce strongly). The
advisor loses because he or she becomes ineffective and may even be held responsible for
the client's decision to change allocation.

FOUNDATIONS OF BEST PRACTICAL ALLOCATION

Nobel Peace Prize laureate Financial advising is “a prescriptive activity whose major
purpose should be to guide investors to make decisions that suit their best interests,”
according to Daniel Kahneman and co-author Mark Riepe, who have made substantial
contributions to behavioral finance. Serving the client's best interests may entail
recommending an asset allocation that corresponds to the client's natural psychological
preferences, rather than one that maximizes expected return for a given degree of risk.
Simply put, a client's best practical allocation can be a slightly underperforming long-term
allocation advice that the advisor thinks the client can stick to.Another client's best practical
allocation, on the other hand, may go against his or her natural psychological proclivities, but
the client may be well served to accept more risk than he or she is comfortable with in order
to achieve a better return for that degree of risk. Note that allocation recommendations are
still on the efficient frontier; depending on the client's behavioral makeup, they may shift up
or down. As advisors, our goal should be to identify the most feasible allocation for each
client.

Answering the following central questions is necessary for developing proper

recommendations for incorporating biases in asset allocation decisions:

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 • When should advisers seek to moderate clients' natural behavior in order to
mitigate the consequences of behavioral biases and suit a predefined asset
allocation?
• When should advisers design asset allocations that adjust to their clients'
biases so that they can feel confident in their asset allocation decisions?
The next part discusses whether to modify or adapt an asset allocation to match a
client's biases.

GUIDELINES FOR DETERMINING WHEN TO MODERATE AND WHEN TO ADAPT

The following are two guidelines that financial advisors can use to determine when to
attempt to moderate (that is, change) their client's behavior in order to meet the financial
advisor's "rational" asset allocation, or when to change a "rational" asset allocation the
advisor would otherwise recommend in order to adapt to a client's behavioral biases.

The first rule is that whether a financial advisor should moderate or adapt to a client's
behavioral biases during the asset allocation process is largely determined by the client's
wealth level. The wealthier the customer, the more the advisor can adjust the asset
allocation to the client's behavioral biases safely. The less rich a customer is, the more the
advisor should try to restrain his or her biased behavior so that a logical asset allocation can
be achieved.

The basis for this recommendation is based on a notion known as "quality of life" risk.
If a client's assets are at risk of outliving him or her, or if their present asset allocation puts
their standard of living in jeopardy, this is a critical issue that the adviser must carefully
consider. No advisor wants to be held responsible for a client's financial ruin. If biased
behavior is likely to jeopardize a client's level of living, the wisest course of action is likely to
be to regulate the client's behavior. Both excessively conservative and too reckless
allocations can result in this.If, on the other hand, a client faces no risk of losing his or her
standard of living (that is, the client's standard of living is highly unlikely to be jeopardized
and will remain in the 99.9%ile unless there is a market crash of unprecedented
proportions), irrational biases become less important, and adapting the rational allocation to
the client's irrational behaviors may be the more appropriate action. In other words, a client's
inability to amass the biggest possible fortune is a far graver investment failure than
starvation.

The second rule is that the financial advisor's decision to moderate or adjust to a
client's behavioral biases during the asset allocation process is based on the type of
behavioral biases that the client is exhibiting. Clients with cognitive biases, which are based

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on erroneous reasoning, should be regulated, while those with emotional biases, which are
based on impulsive reactions, should be adapted to.

The reasoning behind guideline 2 is simple. As we've seen, behavioral biases can be
divided into two types: cognitive and emotional, both of which result in irrational actions.
Because cognitive biases are the result of faulty reasoning, they may often be corrected with
better information and counsel. Emotional biases, on the other hand, are harder to correct
since they arise from impulsive sentiments or intuition rather than from conscious reasoning.
This distinction is important for financial advisors to understand since attempting to eliminate
biases that they have little possibility of changing will leave them disappointed and
unproductive.Heuristics like anchoring and adjustment, availability, and representativeness
biases are examples of cognitive biases. Selective memory and overconfidence are two
further cognitive biases. Regret, self-control, loss aversion, hindsight, and denial are
examples of emotional biases.

Guidelines 1 and 2 are visually depicted in Figure 9.1. When dealing with less
wealthy customers that have cognitive biases, the best line of action is usually to try to
change the client's behavior so that the adviser may prescribe a logical asset allocation.
Advisors should adjust the rational asset allocation strategy for those clients with larger
levels of wealth who demonstrate emotional biases.Advisors should offer a balanced
suggestion to clients with low levels of wealth and emotional biases, as well as customers
with high levels of wealth and cognitive biases. What is the best way to implement this mixed
recommendation? The simple answer is that, for example, when adapting to a greater wealth
customer who exhibits emotional biases, a client's asset allocation may not vary as much as
when adapting to a higher wealth client who exhibits cognitive biases.In the instance of a
less affluent client with substantial emotional biases, the adviser may make minor
adjustments to the client's asset allocation decision rather than advocating the logical asset
allocation, as an advisor would for a less rich client with cognitive biases. The adaptive and
moderate activities advisers can take with their customers are summarized in Table 9.1.

FIGURE 9.1 Description of Guidelines 1 and 2

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 Source: Google

BEST PRACTICAL ALLOCATION FOR PRESERVERS

We'll now put these principles into practice by looking at each behavioral investor
type and how a behaviorally modified asset allocation (BMAA) may be created for each of
them. First, we'll look at the Preserver BIT. We shall not discuss standard of living risk in this
chapter for the sake of simplicity. See my other book, Behavioral Finance and Wealth
Management, for more detailed case examples, including a study of standard of living risk.
We'll go over the fundamentals of each BIT, talk about the most common workplace biases
and how we incorporate them into our allocation recommendations, and then talk about how
to adjust an asset allocation based on these biases.This information is being given from the
advisor's perspective. If you are an individual investor, you may read the analysis from the
investor's perspective, and hope it makes sense in the context of attempting to help you
know how to construct an allocation based on your unique situation.

Rather than taking chances to build wealth, preservers place a high value on
financial security and asset preservation. Some Preservers are obsessed with short-term
results and take their time making financial decisions because they are hesitant to change
(which is consistent with how they have treated their professional careers), being careful not
to take on too much risk.Several Preservers are concerned about providing for their families
and coming generations, particularly by sponsoring life-enhancing experiences like
education and property ownership. Preserver biases are more emotional than cognitive
since they are focused on family and security. This BIT grows more common as one's age
and wealth level rise. Endowment bias, loss aversion, and status quo tend to be emotional,
financial security–oriented behavioral biases in Preservers. Anchoring and mental
accounting are common cognitive biases among preservers.

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 Assume you're starting a new client relationship, Stan. You administer a risk
tolerance test to him and decide that he is a cautious investor. After that, you give him a test
to see if he has any conservative client behavioral biases. Stan is a Preserver, as
determined by the responses to the bias questions. Some of your other clientele are
conservative, but not as skewed as Stan. The goal of this exercise is to examine how a
BMAA for a Preserver versus a non-biased or minimally biased conservative investor can be
created.In general, this means that a Preserver should take on less risk in his portfolio than
non-biased clients. Stan is a Preserver, thus he isn't prone to adding risk to his portfolio in
the first place. Working with a Preserver is thus easier than working with other BITs.

The following analysis compares two investment strategies: one for Steve (a non-
biased conservative investor) and one for Stan (a more aggressive conservative investor) (a
Preserver). For Stan's portfolio allocation, you're utilizing Steve's as a starting point.The
basic objective at hand is to evaluate Stan's retirement goals and the risk associated with
the return required to achieve those goals. When you're working with real clients, you'll need
to tweak this analysis to fit your needs.

Preserver clientele, as we all know, are driven by emotion and, in general, want a
conservative portfolio.

We'll assume that Stan, a Preserver, will have trouble sticking to a portfolio that has a
greater than 15% chance of losing money in a given year. For Steve, a conservative client,
15% may be too low, and the figure should be a little higher.

Without getting too bogged down in the figures, it's clear that Stan has a more
conservative allocation than Steve, which will allow him to meet his financial objectives. This
is an illustration of how to alter an allocation for the Preserver BIT, and we'll go over some
tips for working with the Preserver BIT in the next section.

You may accurately deduce that Preservers dislike volatility after reading this section.
This is accurate; a reduced risk allocation may make them feel more at ease. Advisors
should also take the time to interpret the behavioral indications that Preserver clients
present. Preservers require big-picture counsel, and advisors should avoid obsessing on
specifics such as standard deviations and Sharpe ratios in order to avoid losing the client's
interest. Preservers must comprehend how the portfolio they choose will produce the ideal
outcomes for emotional concerns such as family members or future generations.They will
take action after they feel comfortable sharing these critical emotional matters with their
advisor and a bond of trust has been built. Preservers are likely to become an advisor's best
clients over time because they regard the advisor's professionalism, competence, and
objectivity in assisting them in making sound investment decisions.

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BEST PRACTICAL ALLOCATION FOR FOLLOWERS

We learnt how to establish a behaviorally modified asset allocation, or BMAA (also

known as Best Practical Allocation), for a Preserver behavioral investor type in the previous
part. We'll now look at the Follower as part of our learning process. We'll follow the same
procedure. We'll go through the foundations of the Follower and the biases that come into
play when working with them, then give a client scenario and talk about how to adjust an
asset allocation depending on the Follower's behavioral characteristics.

Followers are non-active investors who do not have their own investment ideas. They
frequently follow the investment advice of their friends and colleagues, and they want to be
in the newest, most popular assets without consideration for the long term. Working with
Followers is difficult because they frequently exaggerate their risk tolerance. Advisors must
be cautious about suggesting too many trendy investment ideas, as followers would most
likely want to try them all. Some people dislike, or even fear, the chore of investing, and as a
result, many put off making investment decisions without seeking professional assistance,
resulting in huge cash balances.Followers often follow professional advice and educate
themselves financially, but this can be difficult at times since they dislike or lack aptitude for
the investment process. Follower biases are cognitive in nature, including recency, hindsight,
framing, cognitive dissonance, and regret.

Assume you're starting a new customer relationship, Amy. You administer a typical
risk tolerance test to her and discover that she is a moderate risk taker. After that, you give
her a test to see if she has any moderate client behavioral biases. You determine that Amy
is a Follower based on her responses to the bias questions.Several of your other customers
have a modest risk tolerance but are not as prejudiced as Amy. The goal of this exercise is
to see how to make a BMAA for a Follower as opposed to a neutral or moderately biased
moderate investor. In general, this means that a Follower should take less risk in her
portfolio than non-biased clients. Amy, as a Follower, may exaggerate her risk tolerance.
Working with a Follower is a little more difficult than working with other BITs because of this.

Two investment programs are presented in the following analysis, one for Bill (a non-
biased moderate investor) and one for Amy (a Follower). For Amy's portfolio allocation,
you're utilizing Bill's as a starting point. Your basic duty is to evaluate Amy's retirement goals
and the risk associated with the required return. When you're working with real clients, you'll
need to tweak this analysis to fit your needs.

Follower clients, as we all know, are influenced by cognitive biases and tend to
overestimate their risk tolerance.

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 We'll assume Amy, a Follower, will have trouble sticking to a portfolio with a
likelihood of a loss year of more than 25%. For Bill, a moderate client, 25% may be too low
and should be a little higher.

Without getting too bogged down in the figures, it's clear that Amy has a more
conservative allocation than Bill, which will allow her to meet her financial objectives. This is
an example of how a Follower BIT allocation can be adjusted.

First and foremost, advisors to followers must know that followers frequently
overestimate their risk tolerance. Part of the reason for risky trend-following behavior is that
followers dislike uncertainty, which might arise when deciding to enter an asset class while it
is out of favor. When an investment concept pays off, individuals may convince themselves
that they "knew it all along," which boosts future risk-taking behavior. Advisors must be
cautious when dealing with followers, as they are more prone to say yes to investment ideas
that make logical to them, regardless of whether the advice is in their best long-term
interests.Followers must be led by Advisors to examine behavioral characteristics that may
cause them to overestimate their risk tolerance. Because follower biases are mostly
cognitive, the best line of action is usually to educate people about the benefits of portfolio
diversity and to stick to a long-term plan. Follower clients should be challenged to be
introspective and give data-backed justification for recommendations, according to advisors.
It's a good idea to provide education in simple, unambiguous ways so that they can
"understand it." This gradual, informative approach will develop customer loyalty and
commitment to long-term investment strategies if advisors take the time.

BEST PRACTICAL ALLOCATION FOR INDEPENDENTS

We learnt how to establish a behaviorally modified asset allocation, or BMAA, for a

Follower behavioral investor type in the previous section. We'll now look at the Independent
to continue our learning process. We'll follow the same procedure. We'll go through the
fundamentals of the Independent and biases at work with Independents, then provide a
client scenario and talk about how to adjust an asset allocation depending on the
Independent's behavioral characteristics.

An Independent is a strong-willed, independently minded thinker who is an active

investor with a medium-to-high risk tolerance. When it comes to investing, independents are
self-assured and trust their intuition; but, when conducting their own research, they may be
prone to acting on information that is readily available rather than seeking confirmation from
other sources. Advisors occasionally discover that an Independent client made a decision
without consulting anyone.This method can be troublesome since, because of their
Independent mindset, these clients sometimes hold irrationally to the opinions they had

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when they made an investment, even when market conditions change, making it difficult to
advise Independents. They often love investing and are willing to take risks, but they often
reject sticking to a strict financial plan.

Some Independents are fixated on beating the market and may have concentrated
holdings. Independents are the most likely of the behavioral investor types to be contrarian,
which might benefit them—and lead them to maintain their contrarian activities.
Conservatism, availability, and other cognitive biases are examples of independent biases.

Let's pretend you're starting a new client relationship, Leo. You administer a typical
risk tolerance test to him and decide that he is a risk tolerant growth investor. After that, you
give him a test to see if he has any moderate client behavioral biases. You find that Leo is
an Independent based on the responses to the bias questions. Some of your other clients
have a risk tolerance that is growth-oriented, but they are not as skewed as Leo. The goal of
this exercise is to see how to develop a BMAA for a non-biased or minimally biased growth
investor versus an independent.In general, this means that an Independent should take
fewer risks in his portfolio than clients who are not biased. Because Leo is an Independent,
he might desire to invest in his portfolio outside of a recommended strategy, which could
modify the risk level in his entire portfolio without his knowledge. Dealing with an
Independent is a little more difficult than working with other BITs because of this.

The following analysis compares two investing strategies: one for Jack (a non-biased
growth investor) and one for Leo (a conservative growth investor) (an Independent). For
Leo's portfolio allocation, you're utilizing Jack's as a starting point. Your main duty is to
evaluate Leo's retirement goals and the risk connected with the return required to achieve
those goals. When you're working with real clients, you'll need to tweak this analysis to fit
your needs.

Independent clients, as we all know, are influenced by cognitive biases and may
make investments outside of a recommended plan.

We'll assume that Leo, an Independent, will have trouble sticking to a portfolio with a
risk of a loss year of more than 35%. 35 percent may suffice for Jack, a non-biased growth
client. Let's take a look at Figure 9.4 and see how Leo's portfolio compares to Jack's.

Without getting too bogged down in the figures, it's clear that Leo has a more
cautious allocation than Jack, which will allow him to meet his financial objectives. This is an
illustration of how an allocation can be adjusted for the Independent BIT.

Due to their contrarian thinking, Independents can be tough customers to advise, but
they are usually grounded enough to listen to excellent advice when it is provided in a way

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that respects their Independent viewpoints. Independents, as we've seen, are steadfast in
their belief in themselves and their actions, yet they can be blinded to opposing viewpoints.
Independents, like Followers, require education to change their behavior; their biases are
primarily cognitive. Regular informative conversations during customer interactions is an
excellent strategy. This approach, the advisor doesn't draw attention to unusual or recent
failures, but instead educates on a regular basis and can integrate notions that he or she
finds useful.Because independent biases are mostly cognitive, the best line of action is
usually to educate yourself on the benefits of portfolio diversification and stick to a long-term
strategy. Advisors should push Independents to think about how they make financial
decisions and back up their recommendations with data. It is effective to provide education
in a clear and straightforward manner. This continuous, educative approach could offer great
results if advisers put in the effort.

BEST PRACTICAL ALLOCATION FOR ACCUMULATORS

We learnt how to establish a behaviorally modified asset allocation, or BMAA (also

known as Best Practical Allocation), for an Independent behavioral investor type in the
previous part. We'll now look at the Accumulator to continue our learning journey. We'll
follow the same procedure. We'll go through the basics of the Accumulator and the biases at
work with them, then show a client scenario and talk about how to adjust an asset allocation
based on the Accumulator's behavioral traits.

The most aggressive behavioral investor type is the Accumulator. These clients are
more strong-willed and confident than Independents because they are entrepreneurs and
frequently the first generation to create money. Accumulators with a lot of money believe
they can influence the outcomes of non-investment activities and believe they can do the
same with investing. This type of conduct might lead to overconfidence when it comes to
investing. Accumulators who are not advised often trade too much, which can have a
negative impact on investment performance. Accumulators are quick to make decisions, but
they may take on more risky investments than their peers.They like the thrill of achieving a
solid investment if they are good. Because they don't engage in basic investment principles
like diversification and asset allocation, some Accumulators might be difficult to counsel.
They are frequently hands-on, wishing to be involved in the investment decision-making
process to the fullest extent possible. Overconfidence, self-control, outcome, affinity, and the
perception of control are all Accumulator biases.

Assume you're starting a new client relationship, Bob. You administer a conventional
risk tolerance test to him and discover that he is a growth-oriented aggressive investor. After
that, you give him a test to see if he has any aggressive client behavioral biases.You find

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that Bob is an Accumulator based on his responses to the bias questions. Some of your
other clients have a risk tolerance that is aggressively growth-oriented, but they are not as
skewed as Bob. The goal of this exercise is to show how a BMAA for an Accumulator versus
a non-biased or minimally biased aggressive growth investor can be created. In general, this
means that an Accumulator should take fewer risks in his portfolio than clients who are not
biased.Because Bob is an Accumulator, he may assume that he can affect the result of his
investments or be too optimistic about the prospects, causing his whole portfolio's risk level
to fluctuate without his knowledge. Working with an Accumulator is a little more difficult than
working with other BITs because of this.

The following analysis compares two investing strategies: one for Brandon (a non-
biased aggressive growth investor) and one for Bob (a conservative growth investor) (an
Accumulator). For Bob's portfolio allocation, you're utilizing Brandon's as a starting
point.Your main duty is to evaluate Bob's retirement goals and the risk associated with the
return required to achieve those goals. When you're working with real clients, you'll need to
tweak this analysis to fit your needs.

Accumulator clients, as we all know, are driven by emotional biases, and may
assume they have control over the results of their investments. They can be overconfident in
the possibilities for their investments.

We're going to assume that Bob, an Accumulator, will have trouble sticking to a portfolio with
a likelihood of a loss year of more than 45 percent. Brandon, a non-biased ambitious growth
client, may be content with 45 percent. Clients who are aggressive, especially those who
have suffered losses, are the most difficult to advise. They prefer to avoid advice that might
keep their risk tolerance in check since they like to control or at least get fully involved in the
intricacies of investing decision making. And, even if their confidence is illogical, they are
emotionally invested and optimistic that their assets will perform well.Excessive purchasing
by some Accumulators must be controlled because it can stifle the profitability of a long-term
portfolio if left unchecked. Taking command of the issue is the best way to deal with these
clients. If the advisor lets the Accumulator client set the conditions of the advisory
partnership, they will constantly be at the hands of the client's emotionally based decision-
making, which will almost certainly result in a dissatisfied client and dissatisfied
adviser.Advisors to Accumulators must show how their financial actions affect family
members, lifestyle, and family legacy. If these advisers can demonstrate to their
Accumulator clients that they can assist them make solid long-term decisions, they will likely
see their Accumulator clients fall into line and become easier to advise.

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 Activity 12
Answer the following questions.

1. How do you make a behaviourally modified asset allocation

for every behavioural investor type?
2. As an investor, will you believe in all of the advises your
adviser will give you? How will this affect your investment
decisions?

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References

1. Ariely, D. (2008). Predictably irrational: The hidden forces that shape our decisions.
Harper.
2. Aronson, E., et.al, (2006). Social psychology. 6th ed. Prentice Hall.
3. Benartzi, S. and Thaler R. (2007). Heuristics and biases in retirementsavings behavior.
Journal of Economic Perspectives 21:3,81–108
4. Coates, J., and Herbert, J. (2008). Endogenous steroids and financial risk-taking on a
London trading floor. Proceedings of the National Academy of Sciences 105:16, 6167–
6172.
5. Fama,E. (2004, October 18). “Market Efficiency, Long-Term Returns, and Behavioral
Finance,” Wall Street Journal
6. Gigerenzer, G. ( 2004). Fast and frugal heuristics: The tools of bounded rationality. in
Blackwellhandbookofjudgmentanddecisionmaking. Blackwell.
7. Scott, W. (2007). Institutions and organizations: Ideas and interests. 3d ed. Sage.
8. Tuckett,D.,andTaffler. R. (2008).Phantasticobjectsandthefinancialmarket’s sense of
reality: A psychoanalytic contribution to the understanding of stock market instability.
International Journal of Psychoanalysis 89:2,389–412.

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 COURSE GUIDE

Course:BA Elective 4 Behavioral Finance

Course Description:

This course describes how individuals and firms makes financial decisions and
how those decisions might deviate from those predicted by traditional financial or
economic theory. Students explore the existence of psychological biases in financial
decision-making and examine the impacts of these biases in financial markets and other
financial settings. The course examine how the insights of behavioral finance
compliments the traditional finance paradigm. It will also introduce students to behavioral
and experimental methodologies used in finance, economics and other disciplines.

The course module is designed for self-learning of students who are taking up BA
Elective 4 this semester amidst COVID-19 pandemic. This module is subdivided into
parts, to wit:

CHAPTER 1: INTRODUCTION TO BEHAVIORAL FINANCE

CHAPTER 2: BEHAVIORALBIASES

CHAPTER 3:INVESTOR BEHAVIOR

CHAPTER 4:THE AGGREGATE PERSPECTIVE

CHAPTER 5:BEHAVIORALLY PLAN AND ACT

Each lesson could be learned in a self-paced or individual format and it is the

responsibility of the students to maximize their time and exert with determination in
completing the course with the best learning outcomes. However, contents presented in
this module may not the best learning needs, so it is suggested to consider reading other
references related to the topics. For each chapter, there are discussion, examples, and
exercises as a course requirement to contribute 60% of your grades. Ideally, all of the
exercises should be done and complied to be submitted during major exams. Students
may contact their professors for any clarifications about the topic, tasks, and/ or outputs
to be done.

As to major exam, midterm examination will cover Lesson 1-3, and final
examination will cover Chapter 4-5.

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Course Learning Outcomes:

After completing the course, the student must be able to:

CLO 1. Describe the differences between a behavioral finance perspectives and a traditional
perspective.

CLO 2. Discuss the cognitive biases and errors of judgment that affect financial decisions.

CLO 3. Evaluate behavioral influences involving individual’s investment decisions.

CLO 4. Evaluate behavioral influences involving corporate (executive) financial decisions.

CLO 5. Assess important developments in this new area and the associated practical
insights they provide.

Course Policies
1. You are required to attend the scheduled virtual sessions and submit the given
learning materials as scheduled.
2. You are expected to behave with academic honesty. It is not academically honest to
misrepresent another person’s work as your own, to take credit for someone else’s
work or ideas, to obtain advanced information on confidential test materials, or to act
in a way might harm another student’s chances for academic success. These
students will automatically have a grade of 5.0 after three (3) offenses of academic
dishonesty.
3. You are expected to take and submit major examinations (Midterm & Finals) on the
specified day or on the scheduled deadline. In general, no make-up test or re-test will
be given except when circumstances warrant but with valid supporting documents
presented.
4. Do all the activities, exercises, and tasks independently and submit as scheduled.

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Grading System
60% Class Activities (academic related tasks such as lesson exercises/learning
activities, written and oral presentations, etc.)
40% Major Examinations (Midterm, and Final Examination)
100%

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 Quality Policy

We commit to provide quality instruction, research, extension, and

production grounded on excellence, accountability, and service as we
move towards exceeding stakeholders’ satisfaction in compliance with
relevant requirements and well-defined continual improvement
measures.

Dekalidadngaedukasyon,
Kinabuhangamainuswagon.

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