FinQuiz curriculum note, study session 12, reading

Code of Ethics and Standards of Professional Conduct

Due to the nature of this reading, FinQuiz recommends reading it directly from the CFA
Institute’s Curriculum.
Reference:
CFA Level III, Volume 1, Reading 1.

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FinQuiz Notes 2 0 1 7

Reading 1


Guidance for Standards I–VII

Due to the nature of this reading, FinQuiz recommends reading it directly from the CFA
Institute’s Curriculum.
Reference:
CFA Level III, Volume 1, Reading 2.

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Reading 2

Applications of Codes and Standards

Due to the nature of this reading, FinQuiz recommends reading it directly from the CFA
Institute’s Curriculum.
Reference:
CFA Level III, Volume 1, Reading 3.

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Reading 3


Asset Manager Code of Professional Conduct

Due to the nature of this reading, FinQuiz recommends reading it directly from the CFA
Institute’s Curriculum.
Reference:
CFA Level III, Volume 1, Reading 4.

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Reading 4


The Behavioral Finance Perspective

1.

INTRODUCTION

Behavioral finance focuses on human behavior and
psychological mecahnisms involved in financial
decision-making and seeks to understand and predict
the impact of psychological decision-making on the
financial markets.
According to efficient market hypothesis, financial
markets are rational and efficient and the abnormal
returns are either by chance or due to statistical
problems associated with analyzing stock returns e.g.
neglecting common risk factors etc.
According to behavioral finance, although financial
markets are rational and efficient, but it is not necessary
that all the market participants will be rationale in their
decision making due to various behavioral biases
(particularly cognitive biases). This results in the
mispricing of securities and thus results in the market
anomalies.
The basic idea of behavioral finance is that since
investors are humans,
2.

• Investors are imperfect and can make irrational
decisions.
• As a result, investors may have heterogeneous
beliefs regarding asset's value.
Normative analysis: Normative analysis involves
analyzing how markets and market participants should
behave and make decisions. Traditional finance is
regarded as normative.
Descriptive analysis: Descriptive analysis involves
analyzing how markets and market participants actually
behave and make decisions. Behavioral finance is
regarded as descriptive.
Prescriptive analysis: Prescriptive analysis seeks to
analyze how markets and market participants should
behave and make decisions so that the achieved
outcomes are approximately close to those of normative
analysis. Efforts to use behavioral finance are regarded
as prescriptive.

BEHAVIORAL VERSUS TRADITIONAL PERSPECTIVES

Traditional finance assumes that:
• Market participants are rational;
• Market participants make decisions consistent with
the axioms of expected utility theory (explained
below);
• Market participants accurately maximize expected
utility;
• Market participants are self-interested;
• Market participants are risk-averse and thus, the

utility function is concave in shape i.e. exhibits a
diminishing marginal utility of wealth.
• Stock prices reflect all available and relevant
information.
• Market participants revise expectations consistent
with Bayes’ formula (explained below).
• Market participants have access to perfect
information;
• Market participants process all available information
in an unbiased way i.e. make unbiased forecasts
about the future.
However, in reality, these assumptions may not hold.
Behavioral finance assumes that:
• Market participants are “normal” not rational;
• Market participants do not necessarily always
process all available information in decision making;
• In some circumstances, financial markets are
informationally inefficient.

Two dimensions of Behavioral Finance:
1) Behavioral Finance Micro (BFMI): BFMI seeks to
understand behaviors or biases of market participants
and their impact of financial decision-making. It is
primarily used by wealth managers and investment
advisors to manage individual clients.
2) Behavioral Finance Macro (BFMA): BFMA seeks to
understand behavior of markets and market
anomalies that are in contrast to the efficient markets
of traditional finance. It is primarily used by fund
managers and economists.

Categories of Behavioral Biases:
1) Cognitive errors: Cognitive errors are mental errors
including basic statistical, information-processing, or
memory errors that may result from the use of
simplified information processing strategies or from
reasoning based on faulty thinking.
2) Emotional biases: Emotional biases are mental errors
that may result from impulse or intuition and/or
reasoning based on feelings.
2.1.1) Utility Theory and Bayes’ Formula
Under the utility theory, an individual always chooses the
alternative for which the expected value of the utility
(EXPECTED utility) is maximum, subject to their budget
constraints. In other words, an individual tends to
maximize the PV of utility subject to the PV of budget
constraint.

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Reading 5


Reading 5

The Behavioral Finance Perspective

• Utility refers to the level of relative satisfaction
received from consuming goods and services. Unlike

price, utility depends on the particular
circumstances and preferences of the decision
maker; as a result, it may vary among individuals.
Expected utility = Weighted sums of the utility values of
outcomes
Expected utility = Σ (Utility values of outcomes ×
Respective probabilities)
• The value of an item is based on its utility rather than
its price.
• According to the Expected utility theory, individuals
are risk-averse and thus, utility functions are concave
in shape and exhibit diminishing marginal utility of
wealth.
Subjective expected utility of an individual
=Σ [u (xi) × P (xi)]
Where,
u (xi) = Utility of each possible outcome xi
P (xi) = Subjective probability
Axioms of Utility Theory: The four basic axioms of utility
theory are as follows:
1) Completeness: Completeness assumes that given any
two alternatives, an individual can always specify and
decide exactly between any of these alternatives.
Axiom: Given alternatives A and B, an individual
• Prefers A to B
• Prefers B to A
• Is indifferent between A and B
2) Transitivity: Transitivity assumes that, as an individual
decides according to the completeness axiom, an
individual also decides consistently. According to

transitivity, the decisions made by an individual are
internally consistent.
Axiom: Given alternatives A, B and C, if an individual
• Prefers A to B
• Prefers B to C
Then an individual prefers to A to C.
If an individual
• Prefers A to B
• Is indifferent between B and C
Then an individual prefers to A to C.
If an individual
• Is indifferent between A and B
• Prefers A to C
Then an individual prefers to B to C.
3) Independence: Independence also assumes that
individuals have well-defined preferences and when

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a 3rd alternative is added to two alternatives, the
order of preference remains the same as when two
alternatives are presented independently.
Axiom: Given three alternatives A, B and C, if an
individual prefers A to B and some amount of C (say x) is
added to A and B, then an individual will prefer (A + xC)
to (B + xC).
IMPORTANT TO NOTE:
• If the utility of A depends on availability of
alternative C, then utilities are NOT additive.
4) Continuity: Continuity assumes that indifference

curves* are continuous, implying that an individual is
indifferent between all the points on a single
indifference curve.
Axiom: Given three alternatives A, B and C, if an
individual prefers A to B and B to C, then there should be
a possible combination of A and C on the indifference
curve in which an individual will be indifferent between
this combination and the alternative B.
Implication of axioms of utility theory: When an
individual makes decisions consistent with the axioms of
utility theory, he/she is said to be rational.
*Indifference curve (IC): An indifference curve shows
combinations of two goods among which the individual
is indifferent i.e. those bundles of goods provide same
level of satisfaction.
• The IC shows the marginal rate of substitution i.e. the
rate at which a consumer is willing to trade or
substitute one good for another, at any point.
• The indifference curve that is within budget
constraints and furthest from the origin provides the
highest utility.
• For perfect substitutes: IC represents a line with a
constant slope, implying that a consumer is willing to
trade or substitute one good for another in fixed
ratio.
• For perfect complements: IC curve is an L-shaped
curve, implying that no incremental utility can be
obtained by an additional amount of either good as
goods can only be used in combination.
Bayes’ formula: Bayes’ formula is used for revising a

probability value of the initial event based on additional
information that is later obtained.
Rule to apply Bayes’ formula: All possible events must be
mutually exclusive and must have known probabilities.
The formula is:
P (A|B) = [P (B|A) / P (B)]× P (A)
Where,
P(A|B) = Conditional probability of event A given B. It
represents the updated probability of A given
the new information B.


Reading 5

The Behavioral Finance Perspective

P(B|A) = Conditional probability of event B given A. It
represents the probability of the new
information (event) B given event A.
P(B)
= Prior (unconditional) probability of information
(event) B.
P(A)
= Prior (unconditional) probability of information
(event) A.

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• Risk-seeking individuals have convex utility functions,
reflecting that utility increases at an increasing rate

with increase in wealth (i.e. increasing marginal utility
of wealth).

In summary: In traditional finance, when market
participants make decisions under uncertainty, they
1. Act according to the axioms of utility theory.
2. Make decisions by assigning a probability measure
to possible events.
3. Process new information according to Bayes’
formula.
4. Select an alternative that generates the maximum
expected utility.

Practice: Example 1,
Volume 2, Reading 5

Certainty Equivalent: It refers to the maximum amount of
money an individual is willing to pay to participate or the
minimum amount of money an individual is willing to
accept to not participate in the opportunity.
Risk premium = Certainty equivalent – Expected value
See: Exhibit 2, Volume 2, Reading 5.

2.1.2) Rational Economic Man
Rational economic man (REM) pursues self-interest (sole
motive) to obtain the highest possible economic wellbeing (i.e. the highest utility) at the least possible costs
given available information about opportunities and
constraints on his ability to achieve his goals. In sum,
•
•

•
•

REM is Rational
REM is Self-interested
REM is Labor averse
REM possesses perfect information
2.1.4) Risk Aversion

Risk averse: An individual who prefers to invest to
receive an expected value with certainty rather than
invest in the uncertain alternative with the same
expected value is referred to as risk averse.
• Risk-averse individuals have concave utility functions,
reflecting that utility increases at a decreasing rate
with increase in wealth (i.e. diminishing marginal
utility of wealth).
• The greater the curvature of the utility function, the
higher the risk aversion.
Risk neutral: An individual who is indifferent between the
two investments is called risk-neutral.
• Risk-neutral individuals have linear utility functions,
reflecting that utility increases at a constant rate with
increase in wealth.
Risk-seeking: An individual who prefers to invest in the
uncertain alternative is called risk-seeking.

2.2.1) Challenges to Rational Economic Man
In reality, financial decisions are also governed by
human behavior and biases. This implies that:

• Individuals may sometimes behave in an irrational
manner.
• Individuals are not perfectly self-interested.
• Individuals do not have perfect information and
many economic decisions are made in the absence
of perfect information.
• REM fails to consider that people may suffer from
self-control bias i.e. it may be difficult for individuals
to prioritize between short-term versus long-term
goals (e.g. spending v/s saving).
Despite the limitations of REM, REM concept is useful as it
helps to define an optimal outcome.
Conclusion:
• Individuals are neither perfectly rational nor perfectly
irrational; rather, they tend to have diverse
combinations of rational and irrational
characteristics.
2.2.3) Attitudes toward Risk
An individual’s (investor’s) attitude toward risk depends
on his/her wealth level and circumstances. This implies
that the curvature of an individual’s utility function may
vary depending on the level of wealth and
circumstances.
1. At both low and high wealth (income) level, utility
functions tend to exhibit concave shape, reflecting


Reading 5

The Behavioral Finance Perspective

risk-aversion behavior (i.e. at points A and C). This
implies that
• At low level of wealth (point A), people may prefer
low probability, high payoff risks (e.g. lottery).
• Once certain reasonable level of wealth is reached
(point C), the individual becomes risk averse in order
to maintain this position.
2. At moderate wealth (income) level, utility functions
tend to exhibit convex shape, reflecting risk-seeking
behavior (i.e. between points B and C).
• This implies that individuals with moderate level of
wealth tend to prefer small, fair gambles.

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Assumptions of Decision Theory:
• Decision maker possess all relevant and available
information;
• Decision maker has the ability to make accurate
quantitative calculations;
• Decision maker is perfectly rational;
Expected value versus Expected Utility: Expected value
is not the same as expected utility.
• Expected value of an item depends on its price and
price is equal for everyone.
• Expected utility of an item depends on an
individual’s circumstances and it may vary among
individuals.
3.2

Bounded Rationality

Bounded rationality relaxes the assumption that an
individual processes all available information to achieve
a wealth-maximizing decision.

Double inflection utility function: A utility function that
changes with changes in the level of wealth is called
double inflection utility function (as shown above).
Risk versus uncertainty:
• Risk refers to randomness with knowable
probabilities. Risk is measurable.
• Uncertainty refers to randomness with unknowable
probabilities. Uncertainty is not measurable.
2.3

Neuro-economics

Neuro-economics is a combination of neuroscience,
psychology and economics. It seeks to explain the
influence of the brain activity on investor behavior and
attempts to understand the functioning of the brain with
respect to judgment and decision making.
Criticism of neuro-economics: It is argued that the brain
activity or chemical levels in the brain are unlikely to
have an impact on economic theory.
3.1

According to bounded rationality, an individual behaves

as rationally as possible given informational, intellectual,
and computational limitations of an individual. As a
result,
• Individuals do not necessarily make perfectly rational
decisions;
• Individuals tend to satisfice rather than optimize
while making decisions i.e. individuals seek to
achieve satisfactory and adequate decision
outcomes (given available information and limited
cognitive ability) rather than optimal (best)
outcomes given informational, intellectual, and
computational limitations and the cost and time
associated with determining an optimal (best)
choice.
NOTE:
Satisfice refers to achieving satisfactory and adequate
decision rather than an optimal (best) decision.

Practice: Example 2,
Volume 2, Reading 5

Decision Theory

Decision theory deals with the study of methods for
determining and identifying the optimal decision (i.e.
with highest total expected value) when a number of
alternatives with uncertain outcomes are available.
• Both Expected utility and decision theories are
normative.
• The decision theory facilitates investors to make

better decisions.

3.3

Prospect Theory

The Prospect theory relaxes the assumptions of expected
utility theory. It seeks to explain the behavior of
individuals to perceive prospects (alternatives) based on
their framing or reference point i.e. people respond
differently depending on how choices are framed e.g. in
terms of gains or losses.


Reading 5

The Behavioral Finance Perspective

• According to prospect theory,
o Individuals prefer a certain gain more than a
probable gain with an equal or greater expected
value and the opposite is true for losses.
o Individuals evaluate gains and losses from a
subjective reference point.
• Both Prospect theory and bounded rationality are
descriptive.
Three critical aspects of the value function of a Prospect
theory:
1. Value is assigned to changes in wealth (i.e.

gains/losses) rather than to absolute level of wealth;
and instead of probabilities, decision weights are
used in the value function.
2. The value function is S-shaped (see Figure below),
and predicted to be concave for gains(indicating risk
aversion) above the reference point and convex for
losses(indicating risk-seeking) below the reference
point.
3. The value function is steeper for losses than for gains
(See Figure below). This means that the displeasure
associated with the loss is greater than the pleasure
associated with the same amount of gains.
• This implies that individuals are loss-averse not riskaverse. In addition, an individual tends to be riskseeking in the domain of losses while risk-averse in
the domain of gains.
o People are risk averse for gains of moderate to
high probability and losses of low probability.
o People are risk seeking for gains of low probability
and losses of moderate to high probability.
• Loss aversion bias refers to the tendency of an
individual to hold on to losing stocks while selling
winning stocks too early. It is also known as
“disposition effect”.

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Six Operations in the Editing process:
1. Codification: Coding refers to categorizing outcomes

(prospects) in terms of gains and losses rather than in
terms of final absolute wealth level depending on the

reference point i.e.
• Outcomes below the reference point are viewed as
losses.
• Outcomes above the reference point are viewed as
gains.
o Prospects are coded as (Gain or loss, probability;
Gain or loss, probability;…)
o Initially, the sum of probabilities = 100% or 1.0.
2. Combination: Combination refers to adding together

the probabilities of prospects with identical gains or
losses to simplify a decision. E.g. winning 200 with 25%
or winning 200 with 25% can be simply reformulated
as winning 200 with 50%.
3. Segregation: In this step, the decision maker

separates the riskless component of any prospect
from its risky component. E.g. segregating the
prospect of winning 300 with 80% or 200 with 20% into
a sure gain of 200 with 100% and the prospect of
winning 100 with 80% or nothing (0) with 20%. The
same process is applied for losses.
4. Cancellation: Cancellation refers to discarding similar

outcomes probability pairs between prospects. E.g. if
pairs are (200, 0.25; 150, 0.40; 30, 0.35) and (200, 0.3;
150, 0.40; -50. 0.3), they will be simplified as (200, 0.25;
30, 0.35) and (200, 0.30; -50, 0.30).
• Cancellation operation fails to consider components
that distinguish prospects.

• Cancellation operation may give rise to isolation
effect because different choice problems can be
decomposed in different ways which may lead to
inconsistent preferences.
5. Simplification: Simplification operation involves

mathematical rounding of probabilities and/or
discarding (i.e. assigning probability of 0) very unlikely
prospects. E.g. if a prospect is coded as (49, 0.51), it is
simplified as (50, 0.50).
6. Detection of dominance: It involves rejecting (without

further evaluation) outcomes that are extremely
dominated.
Phases of decision making in Prospect Theory:
According to Prospect Theory, individuals go through
two distinct phases when making decisions about risky
and uncertain options.
1) Editing or Framing phase: In this phase, decision
makers edit or simplify a complicated decision. The
ways in which people edit or simplify a decision vary
depending on situational circumstances. Decisions
are made based on these edited prospects.

2) Evaluation phase: In this phase, once prospects are
edited or framed, the decision maker evaluates these
edited prospects and chooses between them. This
phase is composed of two parts i.e.
a) Value function: Unlike expected utility theory function,
prospect theory value function measures gains and

losses rather than absolute wealth and is referencedependent. The value function is s-shaped.
• The value function is generally concave for gains


Reading 5

The Behavioral Finance Perspective

and convex for losses.
• The value function is steeper for losses than for gains,
reflecting "loss aversion”.
b) Weighting function: It involves assigning decision
weights (rather than subjective probability) to those
prospects. Decision weights represent empirically
derived assessment of likelihood of an outcome. In
general,
• People tend to underweight moderate and highprobability outcomes.
• People tend to overweight low-probability
outcomes.
As a result, unlikely outcomes have unduly more
impact on decision making.
Perceived value of each outcome = Value of each
outcome ×
Decision weight
4.

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U = w (p1) v (x1) + w (p2) v (x2) + … + w (pn) v (xn)
Where,

xi
pi
v
w

=
=
=
=

potential outcomes
respective probabilities
Value function that assigns a value to an outcome
probability weighting function

• The decision makers select the prospect with the
highest perceived value.
IMPORTANT TO NOTE:
• Codification, combination and segregation
operations are applied to each prospect
individually; whereas, cancellation, simplification
and detection of dominance operations are applied
to two or more prospects together.

PERSPECTIVE ON MARKET BEHAVIOR AND PORTFOLIO
CONSTRUCTION

4.1.1) Review of the Efficient Market Hypothesis
An informationally efficient market (an efficient market)
is a market in which,

• Prices are informative i.e. they immediately, fully,
accurately and rationally reflect all the available
information about fundamental values.
• The market quickly and correctly adjusts to new
information.
• Asset prices reflect all past and present information.
• The actual price of an asset will represent a good
estimate of its intrinsic value at any point in time.
• Investors cannot consistently earn abnormal returns*
by trading on the basis of information.
*Abnormal return = Actual return – Expected return

Assumptions of Efficient Market Hypothesis (EMH):
• Markets are rational, self-interested, and make
optimal decisions;
• Market participants process all available information;
• Markets make unbiased forecasts of the future;
However, EMH is NOT universally accepted.
NOTE:
Grossman-Stiglitz paradox: Markets cannot be strongform informationally efficient because costly information
will not be gathered and processed by agents unless
they are compensated in the form of trading profits
(abnormal returns).
Inefficient market: When active investing can earn
excess returns after deducting transaction and

information acquisition costs, it is referred to as an
inefficient market.
Forms of market efficiency:
There are three forms of market efficiency.

1) Weak-form market efficiency: It assumes that security
prices fully reflect all the historical market data i.e.
past prices and trading volumes. Thus, when a market
is weak-form efficient, all past information regarding
price and trading volume is already incorporated in
the current prices, implying that technical analysis will
not generate excess returns.
• However, it is possible to beat the market and earn
superior profits in the weak-form of efficient market
by using the fundamental analysis or by insider
trading.
2) Semi-strong form market efficiency: It assumes that
security prices fully reflect all publicly available
information, both past and present. Thus, technical
and fundamental analysis will not generate excess
returns. However, insider traders can make abnormal
profits in semi-strong form of efficiency.
3) Strong-form market efficiency: It assumes that security
prices quickly and fully reflect all the information
including past prices, all publicly available
information, plus all private information (e.g. insider
information). Thus, when a market is strong-form
efficient, it should not be possible to consistently earn
abnormal returns from trading on the basis of private
or insider information.


Reading 5

The Behavioral Finance Perspective

4.1.2) Studies in Support of the EMH
A. Support for the Weak Form of the EMH: Weak form of
the efficient market hypothesis is supported and it is
NOT possible to consistently outperform the market
using technical analysis because it has been
observed that
• Daily changes in stock prices have almost zero
positive correlation.
• Market prices follow random patterns and thus,
future stock prices are unpredictable.
B. Support for the Semi-Strong Form of the EMH: Semistrong form of the efficient market hypothesis is
supported and it is NOT possible to consistently
outperform the market using fundamental analysis.
• A common test to examine whether a market is
semi-strong efficient is event study i.e. analyzing
similar events of different companies at different
times and evaluating their effects on the stock price
(on average) of each company.
C. Support for the Strong Form of the EMH: Strong form of
the efficient market hypothesis is NOT supported,
implying that it is possible to consistently earn
abnormal returns using non-public/insider information.
4.1.3) Studies Challenging the EMH: Anomalies
Market movements that are inconsistent with the
efficient market hypothesis are called market anomalies.
Market anomalies result in the mispricing of securities.
• However, these market anomalies result in inefficient
markets only if they are persistent and consistent
over reasonably long periods; and thus, can

generate abnormal returns on a consistent basis in
the future.
• If these anomalies are not consistent, they may
occur as a result of statistical methodologies used to
detect the anomalies, for example due to use of
inaccurate statistical models, inappropriate sample
size, data mining/data snooping (it involves over
analyzing the data in an attempt to find the desired
results), and results by chance etc.
Major Types of Market Anomalies:
There are three major types of identified market
anomalies:
1) Fundamental anomalies: A fundamental anomaly is
related to the fundamental assessment of the stock’s
value. It includes:
• Size effect: According to size-effect anomaly, stocks
of small-cap companies tend to outperform stocks
of large-cap companies on a risk-adjusted basis.
• Value Effect: According to value-effect anomaly,
value stocks tend to outperform growth stocks i.e.
o The stocks with low price-to-earnings (P/E) ratios,

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low price-to-sales(P/S) ratios, and low market-tobook (M/B) ratios tend to generate more returns
and outperform the market relative to growth
stocks (i.e. with high P/E, P/S and M/B ratios).
o Stocks with high dividend yield tend to outperform
the market and generate more return.
However, it has been evidenced that value effect

anomalies do not represent actual anomalies because
they result from use of incomplete models of asset
pricing.
2) Technical anomalies: A technical anomaly is related
to past prices and volume levels. It includes:
• Moving averages: Under this strategy, a buy signal is
generated when short period averages rise above
long period averages and sell signal is generated
when short period averages fall below the long
period averages.
• Trading range break (Support and Resistance):
Under this strategy, a buy signal is generated when
the price reaches the resistance level, which is
maximum price level and a sell signal is generated
when the price reaches the support level which is
minimum price level.
o However, in practice, it is generally not possible to
earn abnormal profits based on technical
anomalies after adjusting for risk, trading costs etc.
3) Calendar anomalies: Calendar anomalies are related
to a particular time period. For example,
• January Effect: According to January effect
anomaly, stocks (particularly small cap stocks) tend
to exhibit a higher return in January than any other
month.
• Turn-of-the-month effect: According to turn-of-themonth effect, stocks tend to exhibit a higher return
on the last day and first four days of each month.
Conclusion: In reality, markets are neither perfectly
efficient nor completely anomalous.
4.1.3.5 Limits to Arbitrage

Theory of limited arbitrage: Under certain situations, it
may not be possible for rational, well-capitalized traders
to correct a mispricing or to exploit arbitrage
opportunities, at least not quickly, due to the following
reasons:
• It is often risky and/or costly to implement strategies
to eliminate mispricing.
• Constraints on short-sale may exist due to which the
arbitrageur cannot take a large short position to
correct mispricing.
• Liquidity constraints i.e. the potential for withdrawal
of money by investors may force managers to close
out positions prematurely before the irrational pricing
corrects itself.


Reading 5

The Behavioral Finance Perspective

These risks and costs create barriers, or limits, for
arbitrage. As a result, markets may remain inefficient or
in other words, the EMH does not hold.
4.2

Traditional Perspectives on Portfolio Construction

From a traditional finance perspective, a portfolio that is
mean-variance efficient is said to be a “rational
portfolio”. A rational portfolio is constructed by

considering
•
•
•
•

Investors’ risk tolerance
Investor’s investment objectives
Investor’s investment constraints
Investor’s circumstances

Limitation of Mean-variance efficient Portfolio: It may not
truly incorporate the needs of the investor because of
behavioral biases.
4.3

Alternative Models of Market Behavior and
Portfolio Construction
4.3.1) A Behavioral Approach to Consumption
and Savings

Traditional life-cycle model: The life-cycle hypothesis is
strongly based on expected utility theory and assumes
that people are rational i.e. they tend to spend and
save money in a rational manner and do not suffer from
self-control bias as they prefer to achieve long-term
goals rather than short-term goals.
Behavioral life-cycle theory: The behavioral life-cycle
theory considers self-control, mental accounting, and
framing biases and their effects on the

consumption/saving and investment decisions.
Mental accounting bias: According to the behavioral
life-cycle theory, people treat components of their
wealth as “non-fungible” or non-interchangeable i.e.
wealth is assumed to be divided into three “mental”
accounts i.e.
i. Current income
ii. Currently owned assets
iii. Present value of Future income
Marginal propensity to spend (consume)or save varies
according to the source of income e.g.
• Marginal Propensity to spend tends to be greatest for
current income and least for future income.
• Marginal propensity to save tends to be greatest for
future income and least for current income.
• With regard to spending from currently owned
assets, people consider their liquidity and maturity
i.e. short-term liquid assets (e.g. cash and checking
accounts) are spent first while long-term assets (e.g.
home, retirement savings) are less likely to be
liquidated.
• It is important to note that any current income that is

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saved is re-classified as current assets or future
income.
Framing: Framing bias refers to the tendency of
individuals to respond differently based on how
questions are asked (framed).

Self-control: It is the tendency of an individual to
consume today (i.e. focus on short-term satisfaction) at
the expense of saving for tomorrow (i.e. long-term
goals).
4.3.2) A behavioral Approach to Asset Pricing
Behavioral stochastic discount factor-based (SDF-based)
asset pricing model: It is a type of behavioral asset
pricing model.
• According to this model, asset prices reflect
investor’s sentiments relative to fundamental value.
• Sentiments refer to the erroneous beliefs or
systematic errors in judgment about future cash flows
and risks of asset.
Risk premium in the behavioral SDF-based model: In the
behavioral SDF-based model, risk premium is composed
of two components i.e.
Risk premium = Fundamental risk premium + Sentiment
risk premium
In the behavioral SDF-based model, dispersion of
analysts’ forecasts serves as a proxy for the sentiment risk
premium as it represents a source of risk (e.g. a
systematic risk factor) that is not captured by other
factors in the model.
• It has been observed that there is an inverse
relationship between the price of the security and
the dispersion among analysts’ forecasts i.e.
o The greater (lower) the dispersion
the higher
(lower) the sentiment premium
the greater

(lower) the risk premium,
the higher (lower) the
discount rate* (required rate of return) and thus
the lower (higher) the perceived value of an asset.
• A low dispersion is associated with a consensus
among the analysts and investors on firms’ future
prospects and more credible information.
• It is evidenced that dispersion of analyst’ forecast is
statistically significant in a Fama-French multi-riskfactor framework i.e. the dispersion of analysts’
forecasts is greater for value stocks; thus, return on
value stocks is higher than that of growth stocks.
*Discount rate or Required rate of return in the behavioral
SDF-based model: In the behavioral SDF-based model,
discount rate is composed of three components i.e.
Discount rate OR required rate of return =
Risk free rate (reflecting time value of money) +
Fundamental risk premium (reflecting efficient prices) +
Sentiment risk premium (reflecting sentiment-based risk)


Reading 5

The Behavioral Finance Perspective

• When the subjective beliefs of an investor about the
discount rate are the same as that of traditional
finance, the investor is said to have zero sentiment.
o When sentiment is zero
market prices will be
efficient i.e. prices will be the same as prices

determined using traditional finance approaches.
• When the subjective beliefs of an investor about the
discount rate are different from that of traditional
finance, the investor is said to have non-zero
sentiment.
o When sentiment is non-zero
market prices will be
inefficient (or mispriced) i.e. prices will deviate from
prices determined using traditional finance
approaches.
Important to Note: It must be stressed that investors can
earn abnormal profits by exploiting sentiment premiums
only if they are non-random in nature i.e. systematically
high or low relative to fundamental value; otherwise, it
may not be possible to predict them and thus, mispricing
may persist.
4.3.3) Behavioral Portfolio Theory (BPT)
BPT versus Markowitz’s portfolio theory:
• BPT uses a probability-weighting function whereas
the Markowitz’s portfolio theory uses the real
probability distribution.
• The optimal portfolio of a BPT investor is constructed
by identifying the portfolios with the highest level of
expected wealth for each probability that wealth
would fall below the aspiration level (i.e. a safety
constraint).The BPT optimal portfolio may not be
mean-variance efficient.
• In contrast, the perfectly diversified portfolio of
Markowitz is constructed by risk-averse investors by
identifying portfolios with the highest level of

expected wealth for each level of standard
deviation.
• Under BPT, investors treat their portfolios not as a
whole, as prescribed by mean-variance portfolio
theory, but rather as a distinct layered pyramid of
assets where
o Layers are associated with goals set for each layer
i.e. bottom layers are designed for downside
protection, while top layers are designed for
upside potential.
o Attitudes towards risk vary across layers i.e.
investors are more risk-averse in the downside
protection layer whereas less risk-averse in the
upside potential layer. In contrast, mean-variance
investors have single attitude toward risk.
The BPT optimal portfolio construction is composed of
following five factors:
1) The allocation of funds among layers depends on the
degree of importance assigned to each goal i.e.
• If high importance is assigned to an upside potential
goal (downside protection goal), then the allocation
of funds to the highest upside potential layer (lowest

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downside protection layer) will be greater.
2) The asset allocation within a layer depends on the
goal set for the layer i.e.
• If the goal is to earn higher returns, then risky or
speculative nature assets will be selected for the

layer.
3) The number of assets chosen for a layer depends on
the shape of the investor’s utility function or risk
attitude i.e.
• The greater (lower) the concavity or the higher
(lower) the risk-aversion, the greater (smaller) the
number of securities included in a layer, reflecting a
diversified (concentrated or non-diversified)
portfolio.
4) The optimal portfolio of a BPT investor may not
necessarily be well-diversified. For example, when
investors believe to have informational advantage
with respect to the securities, they may tend to hold a
concentrated portfolio composed of those few
securities.
5) Higher loss-averse investors may allocate higher
amount to the lowest downside protection layer (i.e.
may hold cash or invest in riskless assets) and may
tend to suffer from loss-aversion bias.

Practice: Example 3,
Volume 2, Reading 5.

4.3.4) Adaptive Markets Hypothesis (AMH)
The AMH is a revised version of the efficient market
hypothesis and it attempts to reconcile efficient market
theories with behavioral finance theories.
The Adaptive Markets Hypothesis implies that the degree
of market efficiency and financial industry evolution is
related to environmental factors that shape the market

ecology i.e. number of competitors in the market, the
magnitude of profit opportunities available, and the
adaptability of the market participants.


Reading 5

The Behavioral Finance Perspective

According to the AMH, success depends on the ability
of an individual to survive rather than to achieve highest
expected utility.
The AMH is based on the following three principles of
evolution:
1) Competition: The greater the competition for scarce
resources or the greater the number of competitors in
the market, the more difficult it is to survive.
Competition drives adaptation and innovation.
2) Adaption: Individuals make mistakes, learn and
adapt. The less adaptable the market participants
under high competition circumstances and changing
environment conditions, the lower the likelihood of
surviving.
3) Natural selection: Natural selection shapes market
ecology.
Five implications of the AMH:
1) The equity risk premium varies over time depending
on the recent stock market environment and the
demographics of investors in that environment e.g.
changes in risk preferences, competitive environment

etc.
• E.g. risk aversion may decrease with an increase in
competition among market participants.

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2) Arbitrage opportunities do arise in the financial
markets from time to time which can be exploited
(e.g. by using active management) to earn excess
returns (i.e. alpha).
3) Any particular investment strategy will not consistently
do well; this implies that any investment strategy
experiences cycles of superior and inferior
performance in response to changing business
conditions, the adaptability of investors, number of
competitors in the industry and the magnitude of
profit opportunities available.
4) The ability to adapt and innovate is critically essential
for survival.
5) Survival is ultimately the only vital objective.

Practice: End of Chapter Practice
Problems for Reading 5 & FinQuiz
Item-set ID# 16837.


The Behavioral Biases of Individuals

2.

CATEGORIZATIONS OF BEHAVIORAL BIASES

Categories of Behavioral Biases:
Behavioral finance identifies two primary reasons behind
irrational decision making of investors.
1) Cognitive errors: Cognitive errors are mental errors
including basic statistical, information-processing, or
memory errors that may result from the use of
simplified information processing strategies or from
reasoning based on faulty thinking. These biases are
related to the inability to do complicated
mathematical & statistical calculations i.e. updating
probabilities.
• If identified, cognitive errors can be relatively easily
corrected and moderated* with better information,
education and advice.

reasoning based on feelings, perceptions, or beliefs.
These biases are usually related to human behavior to
avoid pain and produce pleasure.
• Emotional biases are less easily corrected than
cognitive errors. These biases can only be “adapted
to”.
*NOTE:
• Moderating a bias refers to recognizing the bias and
taking steps to reduce or even eliminate it within the
individual.
• Adapting a bias refers to recognizing the bias and
accepting it by adjusting decisions for it.
• Some biases have aspects of both cognitive errors

and emotional biases.

2) Emotional biases: Emotional biases are mental errors
that may result from impulse or intuition and/or
3.

COGNITIVE ERRORS

Categories of Cognitive Errors:
Cognitive errors can be classified into two categories:
A. BELIEF PERSEVERANCE BIASES:
Belief perseverance is the tendency to cling to one's
initial belief even after receiving new information that
contradicts or disconfirms the basis of that belief.
• Belief perseverance bias is closely related to
Cognitive Dissonance which is the inconsistent
mental state that occurs when new information
conflicts with previously held beliefs or cognition. To
deal with it, people tend to
o Focus only on information that supports a
particular belief, known as selective exposure.
o Ignore, reject, or minimize any information that
conflicts with a particular belief, known as
selective perception.
o Remember and focus only on information that
confirms a particular belief, known as selective
retention.
Types of Belief perseverance biases: Following are five
types of Belief perseverance biases.
1) Conservatism: It is a tendency of people to maintain

their prior beliefs or forecasts by improperly
incorporating new information.
• Conservatism bias implies investor under-reaction to
new information and failure to modify beliefs and
actions based on new information.
• In other words, financial market participants (FMPs)

tend to overweight the base rates and underweight
the new information to avoid the difficulties
associated with analyzing new information.
• Cognitive Costs: It refers to the difficulty associated
with processing the new information and updating
the beliefs.
o The higher the cognitive costs (e.g. in case of
abstract and statistical information), the higher the
probability that new information is underweighted
(or base rate is overweighted).
o The lower the cognitive costs, the higher the
probability that new information is overweighted
(or base rate is underweighted).
Consequences of Conservatism Bias:
• Conservatism bias influences FMPs to maintain a
view or a forecast to avoid the difficulties associated
with analyzing new information.
• Conservatism bias makes FMPs slow to react to new
information to avoid the difficulties associated with
analyzing new information. For example, FMPs may
hold winners or losers too long.
Detection of and Guidelines for Overcoming
Conservatism Bias: To correct or reduce the impact of

Conservatism bias, FMPs should:
• Adequately analyze the impact of new information
and then respond appropriately i.e. should assign
proper weight to new information.
• Seek advice from professionals when they lack the
ability to interpret or understand the new

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FinQuiz Notes 2 0 1 7

Reading 6


Reading 6

The Behavioral Biases of Individuals

information.
2) Confirmation: It is a tendency of people to selectively
seek and focus only on information that confirms their
beliefs or hypotheses while they ignore, reject or
discount information that contradicts their beliefs. This
bias also involves interpreting information in a biased
way. It is also referred to as “selection bias”.
• Confirmation bias implies assigning greater weight to
information that supports one’s beliefs.
Consequences of Confirmation Bias:
• Confirmation bias makes FMPs to focus only on
confirmatory (or positive) information about existing

investment while ignore/reject any contradictory (or
negative) information about an existing investment.
o As a result, FMPs tend to overweight those
investments in their portfolios about which they are
optimistic, leading to under-diversified portfolios
and excessive exposure to risk.
• Confirmation bias makes FMPs to develop biased
screening criteria and prefer only those investments
that meet those criteria.
Detection of and Guidelines for Overcoming
Confirmation Bias: To correct or reduce the impact of
confirmation bias, FMPs should:
• Try to collect complete information i.e. both positive
and negative.
• Actively look for contradictory information.
• Use more than one method of analysis.
• Perform additional research.
3) Representativeness: In representativeness, people
tend to make decisions based on stereotypes i.e.
people stereotype the recent past performance
about investments as “strong” or “weak”. In this bias,
• People seek to look for similar patterns in new
information (i.e. assess probabilities of outcomes on
the basis of their similarity to the current state).
• People treat characterizations from a small sample
as “representative” of all members of a population.
Representativeness bias implies investor over-reaction to
recent/new information and negligence of base rates.
E.g. an individual may conclude too quickly that a
yellow object found on the street is gold.

FMPs suffering from representativeness bias tend to buy
stocks that represent desirable qualities e.g. a good
company is viewed as a good investment.
Types of Representativeness Bias:
a) Base-rate neglect bias: It is a bias in which people
tend to underweight the base rates and overweight
the new information. E.g. an investor views stock of a
“growth” company as a “growth stock”.

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b) Sample-size neglect bias: It is a bias in which people
incorrectly consider small sample sizes as
representative of the whole population. In this bias,
FMPs tend to overweight the information in the small
sample. For example,
• FMPs may consider the past returns to be
representative of expected future returns i.e. stocks
with strong (poor) performance during the past 3-5
years may be considered winners (losers).
Consequences of Representativeness Bias: When FMPs
suffer from representativeness bias, they tend to:
• Overweight (overreact to) new information and
small samples.
• Consider the recent past returns to be representative
of expected future returns.
• Hire investment managers based on its recent/shortterm strong performance results without considering
the sustainability of such returns.
o This attitude may result in high investment manager
turnover, excessive trading and long-term

underperformance of portfolio.
• Update beliefs using simple personal classification to
avoid difficulty associated with dealing with
complex information.
Detection of and Guidelines for Overcoming
Representativeness Bias: To correct or reduce the
impact of representativeness bias, FMPs should:
• Develop and follow an appropriate asset allocation
strategy to achieve better long-term portfolio
returns.
• Invest in a diversified portfolio to meet financial goals
rather than chasing returns.
• Use a “Periodic table of investment returns” in which
the asset classes’ returns are ranked over time. This
table facilitates investors to analyze historical
patterns of the relative returns of the asset classes to
better evaluate the recent performance of an
individual.

Practice: Example 2,
Volume 2, Reading 6.

4) Illusion of control: It is a tendency of people to
incorrectly believe that they have the ability to exert
influence over uncontrollable events (e.g. outcomes
of their investments) and thereby overestimating their
ability to succeed in uncertain or unpredictable
environmental situations.
• This bias tends to increase with choices, familiarity
with the task, competition and active involvement in

the investment.


Reading 6

The Behavioral Biases of Individuals

Consequences of Illusion of Control Bias: FMPs suffering
from illusion of control bias tend to:
• Have higher expectancy of personal success and
higher certainty or confidence about their ability to
predict. This leads to excessive trading and longterm underperformance of portfolio.
• Prefer to invest in companies over which they
perceive to have some control (e.g. employer’s
company stock), leading to under-diversified
portfolios.
Detection of and Guidelines for Overcoming Illusion of
Control Bias: To correct or reduce the impact of illusion
of control bias, FMPs should:
• Realize that it is difficult to have complete control
over the outcomes of the investments and the
success of investment depends on various uncertain
factors.
• Attempt to look for contradictory viewpoints.
• Maintain records of their transactions and should
clearly document rationale underlying each trade.
• Maintain a long-term perspective rather than
chasing returns.
5) Hindsight: It is a tendency of people to overestimate
“ex-post” the predictability of events or outcomes

that have actually happened. In hindsight bias,
people tend to believe that their forecasts /
predictions about future events (e.g. investment
outcomes) were more accurate than they actually
were and they perceive events that have already
happened as inevitable and predictable. This is simply
because in retrospect, things often appear to be
much more predictable than at the time of our
forecast.
Consequences of Hindsight Bias:
• This bias causes FMPs to overestimate their ability to
forecast and predict uncertain outcomes. This
overconfidence about the accuracy of their
forecasts:
o Makes FMPs to underestimate the risk of large
errors, leading to excessive exposure to risk.
o Hinder their ability to learn from their past
forecasting errors and to improve their forecasting
skills through experience.
• This bias causes FMPs to inadequately evaluate
money managers or security performance against
what has happened as opposed to expectations.
Detection of and Guidelines for Overcoming Hindsight
Bias: To correct or reduce the impact of hindsight bias,
FMPs should:
• Recognize and own up their investment mistakes.
• Maintain records of their investment decisions (both
good and bad) and should carefully examine them
to avoid repeating past investment mistakes.
• Always remember that markets are sensitive to

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business cycles; this implies that investors should
manage their expectations and should evaluate the
performance of investment managers relative to
appropriate benchmarks and peer groups.
B. PROCESSING ERRORS BIASES:
Processing Errors Biases result from processing information
for the purpose of financial decision-making in an
illogical and irrational way.
Types of Processing Errors Biases: Following are four types
of Processing Errors Biases.
1) Anchoring and adjustment: It is a tendency of people
to develop estimates for different categories based
on a particular and often irrelevant value, known as
“anchor” (either quantitative or qualitative in nature)
and then adjusting their final decisions up or down
based on that “anchor” value.
• For example, a target price, the purchase price of a
stock, prior beliefs on economic states of countries or
on companies etc.
• Anchoring bias implies investor under-reaction to
new information and assigning greater weight to the
anchor.
Consequences of Anchoring and Adjustment Bias:
Anchoring bias may cause FMPs to continue to focus on
(i.e. remain anchored to) their original estimates (anchor
values) rather than new pieces of information.
Detection of and Guidelines for Overcoming Anchoring

and Adjustment Bias: To correct or reduce the impact of
anchoring bias, FMPs should:
• Objectively examine new pieces of information.
• NOT base their investment decisions upon past
prices (i.e. purchase prices or target prices), market
levels, and economic states of countries and
companies.
2) Mental accounting: It is a tendency of people to
divide one sum of money into different mental
accounts based on some arbitrary categories e.g.
source of money (e.g. salary, bonus, inheritance) or
the planned use of the money (e.g. leisure,
necessities).
• People suffering from mental accounting bias tend
to treat a sum of money as “non-fungible” or “noninterchangeable”.
• Instead of making investment decisions in risk/return
context (as suggested by traditional finance theory),
mental accounting bias causes FMPs to follow a
goals-based theory in which portfolio is divided into
distinct layers addressing different investment goals.
E.g.
o Bottom layers are designed for downside
protection i.e. to preserve wealth. This layer may
be comprised of low risk investments (i.e. cash and


Reading 6

The Behavioral Biases of Individuals

money market funds).
o Middle layers are designed for generating some
income. This layer may be comprised of bonds
and stocks.
o Top layers are designed for upside potential i.e. to
increase wealth. This layer may be comprised of
risky investments (i.e. emerging market stocks and
IPOs).
Consequences of Mental Accounting Bias: This bias
causes FMPs to
• Ignore the correlations among various assets by
placing them into imaginary distinct layers
addressing particular investment goals.
• Fail to avail diversification opportunities to reduce
risk by combining assets with low correlations.
• Invest in an inefficient manner due to offsetting
positions in the various layers, resulting in suboptimal
portfolio and poor performance.
• Irrationally treat returns derived from income
differently from the returns derived from capital
appreciation.
Detection of and Guidelines for Overcoming Mental
Accounting Bias: To correct or reduce the impact of
mental accounting bias:
• FMPs should develop a portfolio strategy by
considering all the assets and their correlations.
• Rather than treating income return differently from
capital return, FMPs should focus on total return.
• FMPs should allocate sufficient assets to lower
income investments to facilitate principal to grow

and to preserve its inflation-adjusted value.
3) Framing: Framing bias refers to the tendency of
people to respond differently based on how questions
are asked (framed).
Narrow framing: It is a sub category of framing bias. It
refers to a tendency of people to focus only on a narrow
frame of reference when making decisions i.e. analyzing
a situation in isolation while neglecting the larger
context.
• This bias causes people to make their decisions
based on items grouped into narrowly defined
categories considering only few specific points.
Consequences of Framing Bias:
• Framing bias affects investors’ attitude toward risk
e.g. when an outcome is framed in terms of gains,
investors tend to exhibit risk-averse attitude and
when an outcome is framed in terms of losses,
investors tend to exhibit risk-seeking attitude (or loss
aversion).
o As a result, FMPs may misidentify their risk
tolerance, leading to suboptimal portfolios.
• Framing bias may cause FMPs to select suboptimal

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investments depending on frame of reference of
information about particular investments.
• Framing bias may cause FMPs to pay attention to
short-term price movements, which may lead to
excessive trading.

Detection of and Guidelines for Overcoming Framing
Bias: To correct or reduce the impact of framing bias:
• FMPs should try to eliminate any reference to gains
and losses already incurred; instead, they should
focus on the future prospects of an investment.
• Investors should try to be as neutral and openminded as possible when interpreting investmentrelated situations.
• Investors should focus on expected returns and risk,
rather than on gains and losses.

Practice: Example 3,
Volume 2, Reading 6.

4) Availability: It is a tendency of people to overestimate
the probability of an outcome based on the ease
with which the outcome comes to mind. In other
words, individuals tend to place too much weight on
evidence that is in front of them, readily available or
easily recalled and underemphasize information that
is harder to obtain or less easily recalled.
• For example, due to lack of data available on
alternative asset classes, investors sometimes base
their decisions on only readily available data instead
of completing the appropriate due diligence
process.
Sources of availability bias:
a) Retrievability: It is a tendency of people to incorrectly
choose the answer or idea that is easily recalled or
easily retrieved.
b) Categorization: It is a tendency of people to
categorize new information by using familiar

classifications and search sets based on their prior
experiences. This may result in biased estimates of
probability of an outcome.
c) Narrow range of experience: It is a tendency of
people to pay attention to a very narrow frame of
reference when making a decision due to their
narrow range of experience.
d) Resonance: It is a tendency of people to
overestimate the probability of an outcome that
resonate (match) with their way of thinking.
Consequences of Availability Bias:
• Due to retrievability, FMPs tend to select an
investment, investment advisor, or mutual fund
based on advertising rather than on a thorough
analysis considering investment objectives and


Reading 6

The Behavioral Biases of Individuals

risk/return profile.
• Due to categorization, FMPs may focus on a limited
set of investments.
• Due to narrow range of experience, FMPs tend to
pay attention to few specific points and
characteristics and as a result may fail to diversify.
• Due to resonance, FMPs overinvest in certain
companies that resonate with their way of thinking
without performing a thorough risk/return analysis,

leading to an inappropriate asset allocation.
• The availability bias causes FMPs to overreact to
market conditions (either positive or negative).
• The availability bias causes FMPs to overemphasize
the most recent financial events.
4.

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Detection of and Guidelines for Overcoming Availability
Bias: To correct or reduce the impact of availability bias:
• FMPs should develop and follow an appropriate
investment policy strategy.
• FMPs should construct an appropriate asset
allocation strategy based on return objectives, risk
tolerances, and constraints.
• FMPs should make investment decisions based on a
thorough analysis and research.
• FMPs should focus on long-term performance rather
than chasing short-term results.

EMOTIONAL BIASES

Following are the six types of emotional biases:
1) Loss-aversion bias: It refers to the tendency of an
individual to hold on to (do not sell) losing stocks too
long in the expectation of return to break even or
better while selling (not holding) winning stocks too
early in the fear that profit will evaporate unless they
sell. It is also known as “disposition effect”.

• Under loss aversion bias, the displeasure associated
with the loss is greater than the pleasure associated
with the same (absolute) amount of gains. As a
result,
o Individuals tend to be risk-seeking in the domain of
losses as they consider risky alternatives as a source
of opportunity.
o Individuals tend to be risk-averse in the domain of
gains as they consider risky alternatives as a threat.
Sub-categories of Loss Aversion Bias: These include
House money effect: It refers to the tendency of people
to accept too much risk (become less risk-averse) in
dealing with someone else’s money. Investors may
exhibit this bias in dealing with their investment profits i.e.
they treat their investment profit as if it belongs to
someone else and thereby take higher risk when
investing it.
Myopic Loss Aversion: Myopic loss aversion is the
combination of a greater sensitivity to losses than to
gains and a tendency of people to evaluate outcomes
more frequently even if they have long-term investment
goals. This bias causes FMPs to:
• Focus on short-term results (i.e. gains and losses). As
a result, demand a higher than theoretically justified
equity risk premium.
• Fail to plan for the relevant time horizon.
• Fail to pay attention to long-term performance.
• Become highly sensitive to short-term volatility that
makes them not to invest in assets that may have
experienced volatility in recent times.

• In addition, myopic loss-averse investor’s risk-aversion

increases over time.
Consequences of Loss Aversion: As a result of holding
losing investments longer while selling winning
investments too quickly than justified by fundamental
analysis,
• Loss-averse investors may hold a riskier portfolio with
limited upside potential.
• Loss-averse investors trade excessively which may
result in poor investment returns due to higher
transaction costs.
Detection of and Guidelines for Overcoming Loss
Aversion: To correct or reduce the impact of lossaversion bias:
• FMPs should develop and follow a disciplined
investment policy strategy.
• FMPs should make investment decisions based on a
detailed fundamental analysis.
• FMPs should rationally evaluate the probabilities of
future losses and gains.
2) Overconfidence bias: It is a tendency of people to
overestimate their knowledge levels and their ability
to process and access information. In this bias, people
tend to believe that they have superior knowledge
and they make precise and accurate forecasts than
it really is.
• Overconfidence bias may cause investors to under
react to new information.
• Overconfidence bias has aspects of both cognitive
and emotional biases but the emotional aspect

dominates.
Types of Overconfidence Bias:
Illusion of Knowledge Bias: It is a bias in which people
tend to misperceive an increase in the amount of
information available as having greater knowledge and


Reading 6

The Behavioral Biases of Individuals

misjudge their ability and skill to interpret that
information. It has two categories:
a) Prediction overconfidence: This bias refers to the
tendency of people to estimate narrow confidence
intervals (i.e. narrow range of expected payoffs and
underestimated standard-deviation) for their
investment predictions. As a result, portfolio risk is
underestimated and investors may hold poorly
diversified portfolios.
b) Certainty overconfidence: It is a bias in which people
tend to assign over-stated (high) probabilities of
success to their outcomes. As a result, portfolio risk is
underestimated and investors may hold poorly
diversified portfolios.
Self-attribution Bias: It is a bias in which people tend to
attribute successful outcomes to their own skills while
blame external factors (e.g. luck) for failures or poor
outcomes. It can be classified into two types i.e.
a) Self-enhancing: Self-enhancing refers to the tendency

of people to take too much credit for their success.
b) Self-protecting: Self-protecting refers to tendency of
people to deny any personal responsibility for failures.
Consequences of Overconfidence Bias:
• Overconfidence bias causes FMPs to trade
excessively, leading to higher transaction costs and
lower returns.
• Overconfidence bias causes FMPs to become overly
optimistic about their investment outcomes; as a
result, they may underestimate risks and
overestimate expected returns and may take
excessive exposures to risk.
• Overconfidence bias causes FMPs to hold poorly
diversified portfolios.
Detection of and Guidelines for Overcoming
Overconfidence Bias: To correct or reduce the impact of
overconfidence bias:
• FMPs should critically review their trading records,
including the frequency of trading.
• FMPs should perform post-investment analysis on
both successful and unsuccessful investments and
must acknowledge their failures.
• FMPs should calculate portfolio performance over at
least two years.
• FMPs should try to gather complete information
when making investment decisions.
• FMPs should objectively evaluate investment
outcomes.

3) Self-control bias: It is a tendency of people to

consume today (i.e. focus on short-term satisfaction)
at the expense of saving for tomorrow (i.e. long-term
goals). Due to self-control bias, people are reluctant
to sacrifice present consumption for the sake of longterm satisfaction.

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• This bias is related to “hyperbolic discounting” which
refers to human propensity to prefer small payoffs
now rather than larger payoffs in the future.
Consequences of Self-Control Bias:
• Self-control bias makes FMPs to save insufficient
amount for the future; as a result, they may
subsequently take excessive risk exposures to
generate higher returns for meeting long-term goals.
• Self-control bias makes FMPs to over-invest in
income-producing assets to generate income for
meeting present spending needs; as a result,
principal may not grow sufficiently which may
negatively affect portfolio’s ability to maintain
spending power after inflation.
Detection of and Guidelines for Overcoming Self-Control
Bias: To correct or reduce the impact of self-control bias:
• An appropriate asset allocation strategy should be
constructed based on return objectives, risk
tolerances, and constraints of an investor.
• FMPs should follow a saving plan.
4) Status-quo bias: It is the tendency of people to prefer
to “do nothing” (i.e. maintain the “status quo”)
instead of making a change. In the status-quo bias,

investors prefer to hold the existing investments in their
portfolios even if currently they are not consistent with
their risk/return objectives.
• Status-quo bias is relatively difficult to eliminate.
Consequences of Status-quo Bias:
• Status-quo bias causes FMPs to continue to hold
portfolios with inappropriate risk characteristics.
• Status-quo bias causes FMPs to ignore other
profitable investment opportunities.
Detection of and Guidelines for Overcoming Status-quo
Bias: To correct or reduce the impact of status-quo bias:
• FMPs should develop and follow an appropriate
asset allocation strategy based on return objectives,
risk tolerances, and constraints.
• FMPs should recognize and quantify the risk-reducing
and return-enhancing advantages of diversification.
5) Endowment bias: It is a bias in which people become
emotionally attached to the asset they own so they
value an asset more when they own it than when
they do not. As a result, the minimum selling price that
owners ask for an asset is almost always greater than
the maximum purchase price that they are willing to
pay for the same assets.
• This bias is also related to the “Familiarity Bias” in
which people tend to prefer assets with which they


Reading 6

The Behavioral Biases of Individuals

are familiar and view them as less risky e.g.
employer’s company stocks, domestic country’s
stocks
• In an endowment bias, people hold on to the
inherited/purchased securities due to various
reasons i.e.
o To avoid the feelings of disloyalty associated with
selling those securities.
o To avoid the uncertainty associated with making
the correct decision.
o To avoid incurring tax expense associated with
selling those securities.
Consequences of Endowment Bias:
• Endowment bias causes investors to keep the
securities/businesses that they have inherited or
purchased instead of investing in assets that are
more appropriate to meet their investment
objectives.
• Endowment bias causes investors to maintain an
inappropriate asset allocation and inappropriate
portfolio.
Detection of and Guidelines for Overcoming Endowment
Bias: To correct or reduce the impact of endowment
bias:
• FMPs should treat inherited investments as if they
have received cash and then invest that cash
appropriately based on investment goals.
• To deal with the fear of unfamiliarity, FMPs should
review the historical performance and risk of

unfamiliar securities and should initially invest a small
amount in them until they are comfortable with
them.
6) Regret aversion bias: It is the tendency of people to
avoid making decisions due to the fear of
experiencing the pain of regrets(i.e. feeling of
responsibility for loss or disappointment) associated
with unsuccessful decisions.
• Error of commission: It refers to the regret from an
action taken. In general, people tend to feel greater
pain of regret when poor outcomes are the result of
an action taken by them. Hence, people consider
“no action” as the preferred decision.
• Error of omission: It refers to the regret from not
taking an action.

5.

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Consequences of Regret Aversion Bias:
• Regret aversion bias may cause FMPs to be too
conservative in their investment choices.
• Regret aversion bias may cause FMPs to hold on to
losing positions for too long to avoid the pain
associated with selling positions at loss. This behavior
may lead to excessive risk exposure.
• Regret aversion bias may cause FMPs to hold on to
investment positions too long than justified by
fundamental analysis in the fear that they will

increase in value.
• Having suffered losses in the past, regret aversion
bias may cause FMPs to avoid risky investments and
prefer low risk assets. This behavior leads to long-term
underperformance of portfolio and may jeopardize
long-term investment goals.
• Regret aversion bias may cause investors to engage
in “HERDING BEHAVIOR” in which investors simply try
to follow the crowd (i.e. invest in a similar manner
and in the same stocks as others) to avoid the
burden of responsibility and hence the potential for
future regret.
• Regret aversion bias may influence investors to invest
in stocks of well-known companies as they
mistakenly view popular investments as less risky.
• Regret aversion bias may cause investors to maintain
positions in familiar investments to avoid the
uncertainty associated with less familiar investments.
Detection of and Guidelines for Overcoming RegretAversion Bias: To correct or reduce the impact of regretaversion bias:
• FMPs should develop and follow an appropriate
asset allocation strategy based on return objectives,
risk tolerances, and constraints.
• FMPs should recognize and quantify the risk-reducing
and return-enhancing advantages of diversification.
• Education about the investment decision-making
process and portfolio theory is highly important e.g.
FMPs may use efficient frontier research as a starting
point.
IMPORTANT TO NOTE:
• In the status-quo bias, people tend to hold original

assets/investments “unknowingly” simply due to
“inertia”; whereas in the endowment and regretaversion biases, people intentionally tend to hold
original assets/investments.

INVESTMENT POLICY AND ASSET ALLOCATION

There are two approaches to incorporate behavioral
finance considerations into an investment policy
statement and asset allocation:
1) Goals-based investing approach: This approach
involves identifying an investor’s specific investment

goals and the risk tolerance associated with each
goal and then creating an investment strategy
tailored to investor’s specific financial goals. In this
approach,


Reading 6

The Behavioral Biases of Individuals

• Each investment goal is treated separately.
• A portfolio is constructed as a distinct layered
pyramid of assets representing different investment
goals and the asset allocation within each layer
depends on the goal set for the layer.
Bottom layers are constructed first as they
represent investor’s most critical goals (e.g.
needs and obligations). They comprised of

low risk assets.
Middle and Top layers represent relatively
less important goals (e.g. priorities, desires,
and aspirational goals) and comprised of
risky assets.
• Portfolio performance is evaluated in terms of
portfolio’s ability to achieve investment goals i.e.
paying expenses for children’s education, funding
retirement or making charitable contributions etc.
• Portfolio risk is evaluated in terms of minimum wealth
level or probability of losing money instead of in
terms of annualized standard deviation.
• Investors are assumed to be loss-averse rather than
risk-averse.
• Portfolio is managed and updated based on
changes in circumstances and goals of the investor.
Important to Note: In a goals-based investing approach,
the optimal portfolio of an investor may not be meanvariance efficient from a traditional finance perspective
because portfolio is constructed without considering
correlations between assets. In addition, the optimal
portfolio of an investor may not necessarily be welldiversified from a traditional finance perspective.

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objective of achieving maximum expected return
for a given level of risk; rather, a portfolio is
constructed by selecting an asset allocation that
best serves the interest of the client i.e. satisfies
investor’s natural psychological & behavioral
preferences and to which the investor can

comfortably adhere.
Guidelines for Determining a Behaviorally Modified Asset
Allocation (Section 5.1.1):
The decision to moderate or adapt to a client’s
behavioral biases during the asset allocation process
depends on two factors:
1) Client’s level of wealth: The higher (lower) the level of
wealth, the more it is preferred to adapt to
(moderate) the client’s behavioral biases.
• In this context, client’s wealth level is measured
against his/her Standard of living risk(SLR) i.e. the risk
that client’s current or a specified acceptable
lifestyle may not be sustainable in the future. E.g.
o Clients with modest or low level of assets and
modest lifestyles tend to have low SLR and are
considered to have a moderate to high level of
wealth.
o Clients with high level of assets and extravagant
lifestyles tend to have high SLR and are considered
to have a low to moderate level of wealth.
• In other words, the higher (lower) the SLR, the more it
is preferred to moderate (adapt to) the client’s
behavioral biases.
2) Type of behavioral bias the client exhibits: Asset
allocation for clients with strong cognitive errors
(emotional biases) should be moderated (adapted
to).
See: Exhibit5, Volume 2, Reading 6.
In Summary:

Benefits of Goals-based Investing approach:
• This approach is most suitable for investors whose
primary objective is to preserve wealth (i.e. to
minimize losses) rather than to accumulate wealth
(i.e. to maximize returns).
• This approach facilitates investors to create an asset
allocation based on financial goals and risk
tolerance associated with each goal.
2) Behaviorally Modified Asset Allocation: This approach
involves constructing a portfolio by selecting an asset
allocation based on investor’s behavioral risk and
return preferences.
• In this approach, portfolio is NOT based on the

a) For clients at higher levels of wealth with strong
emotional bias, the rational asset allocation should be
adjusted (modified) and adapted to the client’s
behavioral biases rather than reducing the impact of
biases.
b) For clients at lower levels of wealth with emotional
biases, it is preferred to use a blended asset
allocation i.e. it should be both moderated and
adapted to the client’s behavioral biases.
c) For clients at higher levels of wealth with cognitive
biases, it is preferred to use a blended asset
allocation i.e. it should be both moderated and
adapted to the client’s behavioral biases.
d) For clients at lower levels of wealth with cognitive
biases, the behavioral biases should be moderated
(i.e. impact of behavioral biases should be reduced)

and the rational asset allocation should be used.


Reading 6

The Behavioral Biases of Individuals

Bias Type: Cognitive

High
Wealth
Level/Low
SLR

Modest
Change in the
Rational Asset
Allocation
Suggested Deviation
from a Rational Asset
allocation*: +/- 5 to
10% Max per Asset
class

Use the Rational or
Close to rational
Asset Allocation
Low Wealth
Level/ High
SLR

Suggested Deviation
from a Rational Asset
allocation: +/- 0 to
3% Max per Asset
Class

Bias Type:
Emotional
Significant
Change in the
Rational Asset
Allocation
Suggested
Deviation from a
Rational Asset
allocation: +/10 to 15% Max
per Asset Class
Modest
Change in the
Rational Asset
Allocation
Suggested
Deviation from a
Rational Asset
allocation:: +/- 5
to 10% Max per
Asset class

See: Exhibit 6, Volume 2, Reading 6.

*It must be stressed that the appropriate amount of
change needed to modify an asset allocation largely
depends on the number of asset classes used in the
allocation.
NOTE:
Besides individual investors, institutional investors and
money managers also have behavioral biases,
particularly overconfidence bias.
Basic Diagnostic Questions for Behavioral Bias:
Loss aversion:
• When asked to choose between disposing off one
stock in your portfolio, what would you normally do?
i.e. Whether you will choose the one that was 50%
up or the one that was 50% down in value?
• Do you prefer to take higher risk if you see higher
probability of having to accept a loss in the near
future?
Endowment: Do you feel emotional attachment to your
possessions or investment holdings?
Familiarity: Do you normally believe that buying stock in
a company whose products/services you frequently buy
represent a good investment choice?
Status quo: Do you tend to trade too little or too
frequently?
Anchoring: Suppose you purchase a share at $45. After
a few months, it goes to $50 and then falls to $40 a few
months later. In this case, will you make the decision to
sell a stock by comparing the change in value against
the price at which you purchased that stock?

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Mental accounting: Do you normally categorize your
money by different investment goals?
Regret aversion: Do you normally prefer to make
decisions with a view towards minimizing anticipated
feelings of regret?
Conservatism: Suppose you make an investment based
on your own research. Later, if you come across any
contradictory information, would you either downplay
that information or play up that information?
Availability: In general, if sufficient data is not available
on an asset class, would you prefer to make an
investment decision based on readily available data
instead of performing a complete due diligence
process?
Representativeness: In making investment judgments, do
you feel inclined to rely on stereotypes and looking for
the similarity of a new investment to a past
successful/poor investment without doing a thorough
fundamental analysis?
Overconfidence: Suppose you make a winning
investment. According to you, what is the reason behind
that success i.e. good advice, strong market/ fortunate
timing, own skill and intelligence, or luck?
Confirmation: In general, how would you describe your
willingness to accept an idea that is contradictory to
your current beliefs and does not support your expected
investment outcome?

Illusion of control: Do you believe you are more likely to
win the lottery if you have the option to pick the
numbers yourself than when the numbers are picked by
a machine?
Self-control: Do you believe in the strategy of “live in the
moment” and thereby prefer to spend your disposable
income today rather than saving it?
Framing:
• Would you feel much better buying a $80 shirt for
$65, than buying the same shirt priced at $65 as the
“normal” price?
• If given $1000, would you choose to receive another
$500 for sure or 50/50 chance of ending up with
$1000? And when given $2000, would you choose to
have a sure loss of $500 or 50/50 chance of ending
up with $2000?
Hindsight: Do you believe that investment outcomes are
generally predictable and you can accurately recollect
your beliefs of the day before the event?
Practice: End of Chapter Practice
Problems for Reading 6 & FinQuiz
Item-set ID# 17018 & 18786.


Behavioral Finance and Investment Processes

1.

INTRODUCTION

According to behavioral finance, investors, analysts and
portfolio managers are susceptible to various behavioral
biases and their investment decisions are influenced by
psychological factors. Thus, investment decision-making
process demands a better understanding of individual
investors’ behavioral biases.
2.

2.1

Behavioral finance seeks to identify and explain various
behavioral biases that lead to irrational investment
decisions and helps investors to learn about and correct
their common decision-making mistakes.

THE USES AND LIMITATIONS OF CLASSIFYING INVESTORS INTO
TYPES

General Discussion of Investor Types

Investors can be classified by their psychographic
characteristics i.e. personality, values, attitudes and
interests. These psychographic classifications provide
information about an individual’s background and past
experiences and thus help advisors to achieve better
investment outcomes by identifying individual strategy,
risk tolerance and behavioral biases before making
investment decisions.
However, it is important to note that due to
psychological factors, it is not possible to make accurate

diagnosis about any individual.
2.1.1) Barnewall Two-Way Model
The Barnwell Two-Way Model classifies investors as either
'passive' or 'active':
1) Passive investors: Passive investors are individuals who
have become wealthy passively e.g. by inheriting, by
professional career, or by risking the money of others
instead of risking their own money.
• Passive investors tend to prefer high security and
have low tolerance for risk (or high risk aversion).
• The fewer the financial resources a person has, the
lower the risk tolerance and hence the more likely
the person is to be a passive investor.
• Passive investors can be good clients as they tend to
trust their advisors and delegate decision making
control to their advisors.
• Due to low risk tolerance, passive investors prefer to
hold diversified portfolios.
• Passive investors also tend to exhibit herding
behavior with regard to stock market investment.
2) Active investors: Active investors are individuals who
have earned wealth through their active involvement
in investment or by risking their own money (e.g.
building companies, investing in speculative real
estate using leverage or working for oneself) instead
of risking money of others. As a result, active investors
tend to have high risk tolerance (low risk aversion)
and low need for security.

• However, they have high risk tolerance to the extent

they have control of their investments. This implies
that as active investors feel loss of control, their risk
tolerance reduces.
• They prefer to maintain control of their investments
because they have a strong belief in themselves and
their abilities.
2.1.2) Bailard, Biehl, and Kaiser Five-Way Model
BB&K five-way model classifies investors into five types
based on two dimensions or axes of “investor
psychology”. These two axes include:
Confident-anxious axis: It deals with how confidently the
investor approaches life (any aspect i.e. career, health
or money).
Careful-impetuous axis: It deals with whether the investor
is methodical, careful and analytical in his approach to
life or whether he is emotional, intuitive, and impetuous.
BB&K Classifications:

1. Adventurer: Adventurers are highly confident; their
high confidence makes them:
• Take greater risks.
• Prefer making own decisions and dislike taking
advice. As a result, they are difficult to advice.
• Prefer holding highly undiversified/concentrated
portfolios.
2. Celebrity:
• Celebrities like to be in the center of things and don't
like to be left out.

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FinQuiz Notes 2 0 1 7

Reading 7


Reading 7

Behavioral Finance and Investment Processes

• They may not have their own ideas about
investments and thus, prefer to follow popular
investments.
• They may recognize their limitations related to
investment decisions and therefore, may seek to
take advice about investing.
3. Individualist:
• Individualists are confident & independent
individuals who prefer to make their own decisions
but who are methodical, careful, balanced and
analytical.
• Individualists tend to make their own decisions but
after careful analysis.
• They are the best clients of advisors as they listen to
their advice and process information in a rational
manner.
4. Guardian:
• Guardians are anxious and careful investors who
primarily focus on safeguarding & preserving their
wealth.

• They tend to avoid volatility.
• They are often older individuals who are either at or
near to their retirement.
• They do not generally have confidence in their
forecasting ability and knowledge and thus prefer to
seek professional guidance.
5. Straight Arrow:
• Straight arrows represent average investors who do
not fall in any specific group presented above. Thus,
they are placed in the center of the four groups.
• Straight arrows are balanced in their investment
approach and prefer to take moderate risk
consistent with return.
• They are sensible and secure.
Limitations of BB&K Model:
• Investors may approach different aspects of their life
with different level of confidence and care e.g. an
investor may be highly confident and/or less careful
about his health but more careful and anxious about
his career.
• Instead of analyzing approaches towards other
aspects of life, it is more preferable to focus on
investors’ approach towards investing.
• In addition, it is difficult to exactly classify type of an
investor because an investor’s behavior pattern and
tendencies may not be consistent and may change
over time.

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2.1.3) New Developments in Psychographic Modeling:
Behavioral Investor Types
Behavioral finance can be applied to private clients
using two approaches:
1) Bottom-up approach to bias identification: Under this
approach, advisors attempt to diagnose and treat
behavioral biases,
• By first testing for all behavioral biases in the client to
determine which type of biases dominates.
• Then this information is used to create an
appropriate investment policy statement and a
behaviorally modified asset allocation.
Limitation of Bottom-up Approach: It is very time
consuming and complex approach.
2) Behavioral alpha (BA) approach to bias identification:
It is a “top-down” approach to bias identification and
is relatively a simpler, less time consuming and more
efficient approach than a bottom-up approach.
Instead of starting with testing for all biases, the BA
approach involves following four steps:
1. Interview the client to identify active/passive trait and
risk tolerance: This step involves question-and-answer
session intended to determine:
• Investor’s objectives, constraints, risk tolerance and
past investing practices of a client.
• Whether a client is an active or passive investor.
2. Plot the investor on active/passive and risk tolerance
scale: This step involves administering a traditional
risk-tolerance questionnaire to evaluate the risk
tolerance level of a client. In general,

• Active investors will rank medium to high on the risk
tolerance scale;
• Passive investors will rank medium to low on the risk
scale.
However, it must be stressed that this division will not
always be the case. E.g. if an investor is classified as
active investor in Step 1 but he exhibits low risk tolerance
in Step 2, then he should be assumed as a passive
investor.

3. Test for behavioral biases: This step involves identifying
behavioral biases in a client.
4. Classify investor into a BIT (Behavioral Investor Type):
This step involves identifying client's Behavioral Investor
Type (BIT) and biases associated with each BIT.