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Level III

Behavioral Finance and Investment Processes
Summary
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Uses and Limitations of Classifying Investors into Types
Investors can be classified by their psychographic profile i.e. behavior, personality, attitudes and interests.

BB&K (Bailard, Biehl and Kieser) model classifies investors into five types based on two axes of “investor psychology”.
Hint: selfemployed

Confident
Individualist
• make decisions after careful analysis
• listen to advice
• process information in a rational
manner

• high risk tolerance
• prefer to maintain control over
investments
• reluctant to take advice
• hold highly undiversified portfolios

Straight
Arrow

Careful

Guardian
Hint: Retired
or near to
retire people

Adventurer

• prefer to seek advice
• avoid volatility
• seek preservation of wealth

Impetuous
Celebrity

• prefer following popular investments
• willing to take investment advice

rational, balanced,
secure and sensible

Anxious
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Behavioral Alpha Process
A top-down approach to bias-identification
1. Interview client to identify active or passive traits
and risk tolerance

2. Plot investor on active/passive scale and risk
tolerance scale
 Active investors: medium to high risk
 Passive investors: low risk

•
•
•
•
•
•
•

3. Test for behavioral biases to identify behavioral
biases in a client

Active Investor Traits
Earned wealth by risking own money (e.g.
entrepreneur)
Maintain control over investment decisions
Have faith in own abilities
Prefer risky asset allocation
Aim for maximization of wealth by foregoing
current lifestyle
Take initiative
Not reluctant to borrow money

Opposite will be true for passive investor

4. Classify investor into a behavioral investment type

(BIT) to identify biases

If an investor is classified as active investor in Step 1
but he exhibits low risk tolerance in Step 2, then
assume he/she is a passive investor.

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Behavioral Investor Type Diagnostic Process

How Behavioral Factors Affect Client-Adviser Relations
Understanding client’s behavioral tendencies allows
advisors to:
• better formulate financial goals.
• better understand the client before delivering any
investment advice.
• formulate an appropriate asset allocation for the
client.
• develop a stronger bond by satisfying clients.
Limitations of Classifying Investors
An individual may:
• exhibit both cognitive and emotional biases at the
same time.
• reflect characteristics of multiple investor types.
• exhibit changing behavior over time.
• need unique treatment.
• act irrationally and in an unpredictable manner.

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Biases Associated with Each Behavioral Investor Type (BIT)
Basic type

Passive

Passive

Active

Active

Low

Low to medium

Medium to high

High

Conservative

Moderate

Growth

Aggressive

Emotional

Cognitive

Cognitive

Emotional

BIT

Passive Preserver
• dislike losses
• dislike change
• uneasy during times of stress
• probably became wealthy
passively (through inheritance)
• under-react to new
information

Friendly Follower
• follow others
• invest in popular investments
• believe that their forecasts about
future events were more
accurate than they actually were
• respond differently based how
questions are framed
• overestimate risk tolerance

Independent Individualist
• overestimate ability to predict
• maintain views on market
• under-react to new information
• do not get corroboration from other
sources
• place higher weight to information which is
readily available
• make decisions based on personal
classification

Emotional
biases

•
•
•
•

• regret aversion

• overconfidence & self-attribution

Cognitive
biases

• mental accounting
• anchoring and adjustment

• availability
• hindsight
• framing

•
•
•
•

Investment
advice

• difficult to advise
• explain effects of investment
decisions on various
investment goals

• may listen to advice
• advisors should provide
quantitative measures

• may listen to advice
• advisors should provide quantitative
measures

Risk tolerance
Investment style
Primary bias

loss aversion

status-quo
endowment
regret aversion

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conservatism
confirmation
availability
representativeness

Active Accumulator
• entrepreneurial
• exhibit over-confidence in
their ability to predict or
succeed
• do not save for future
• actively involved in
decision-making  trade
excessively

• overconfidence
• self-control
• illusion of control

• most difficult to advise
• explain effects of
investment decisions on
various investment goals
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Impact of Behavioral Factors on Portfolio Construction
Behavioral Factors/Biases

Impact on Portfolio Construction

Status quo bias

Sticking with default portfolio allocation despite changes in
risk tolerance level or other circumstances.

Regret aversion and framing biases

Naïve diversification or 1/n strategy: allocating an equal
amount of money to available investment options regardless
of the different risk profiles of these options.

Overconfidence, representativeness
& availability, status-quo, framing,
endowment biases

Investing in the familiar: a classic example is being
overweight in own-company stock.

Regret aversion, overconfidence, and
disposition effect (loss aversion)
biases

Excessive trading which results in high transaction costs and

poor portfolio performance.

Availability, illusion of control,
endowment, familiarity, and status
quo biases

Investors invest a relatively high portion of their funds in
domestic stocks. Home bias.

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Impact of Behavioral Factors on Analysts
Behavioral Factors Biases

Remedial Actions

Overconfidence in
forecasting skills

Overconfidence (encouraged by complex
models), representativeness, availability,
hindsight

Prompt and accurate
feedback, structure that
rewards accuracy, learn to use
Bayes’ formula

Influence of
company’s
management on
analysis

Faming, anchoring and adjustment (analysis
Disciplined and systematic
influenced by initial default position or anchor), approach
availability (greater importance to more easily
available information)

Analyst biases in
conducting
research

Excessive unstructured information  illusion
of knowledge  overconfidence
Excessive information feeds representativeness
bias (classify new information based on past
experiences)
Confirmation bias
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Focus on objective data,
systematic and structured
approach, follow Standard V,
seek contrary facts and
opinions

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Behavioral Factors and Investment Committees
Social proof bias: Following the view points/decisions of a group.
Implications:
• Group members become overconfident among themselves leading to excessive risk exposure.
• Group decisions are more vulnerable to confirmation bias.
• Group member avoids divergent opinions to avoid unpleasant tensions within a group.
Remedial Actions
• Individual views should be collected before the meeting.
• Committee composition should have diversity in culture, knowledge, skills, experience and
thought processes.
• Chair of the committee should be impartial.
• Committee members should respect opinions of each other.
• At least one member of a group should play a role of “devil’s advocate”.

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Investor Behavior and Markets
Observed Market Behavior Behavioral Explanation
Momentum or trending
effect

Herding behavior
Availability bias: more recent events easily recalled and given relatively
high weight (recency effect)

Hindsight bias  regret  trend-chasing effect

Bubbles

Overconfidence bias (illusion of knowledge and self attribution) leads
to underestimation of risk and over-trading

Crashes

Disposition effect in the context of loss aversion bias: tendency to sell
winners quickly and hold on to losers too long

Value stocks outperform
growth stocks in the longrun

Halo effect: tendency of people to generalize positive views/beliefs
about one characteristic of a product/person to another characteristic;
related to representativeness bias refers to classifying new information
based on past experiences
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