Behavioral Finance and Investment Processes

1. Introduction

In economic and financial theory is based on the assumptions that

individuals act rationally and consider all available information in the
decision-making process.

Behavioral finance challenges these assumptions. The relaxing of these

assumptions has implications at both the individual and market levels.

An individual investors or experienced money managers, may act

irrationally.
2. The Uses and Limitations of Classifying Investors into Types

In recent decades, financial service professionals and researchers have

been attempting to classify investors by their psychographic
characteristics: personality, values, attitudes, and interests

We will now review two models of investor psychographics:

• One model was proposed in Barnewall (1987) and

• the other in Bailard, Biehl, and Kaiser (1986).

2.1.1. Barnewall Two-Way Model

distinguishes two relatively simple investor types:

1. Passive.
2. Active.

1. “passive investors” are defined as those investors who have become

wealthy passively—for example, by inheritance or by risking the capital
of others rather than risking their own capital

2. “Active investors” are individuals who have been actively involved

in wealth creation through investment, and they have risked their own
capital in achieving their wealth objectives. Active investors have a
higher tolerance for risk than they have need for security.
2.1.2. Bailard, Biehl, and Kaiser Five-Way Model

• The first (aspect of personality) deals with aspects about how confident
the investor is about some things or how much he tends to worry about
them.

• The second element deals with whether the investor is methodical,

careful, and analytical in his approach to life or whether he is
emotional, intuitive, and impetuous.

These two elements can be thought of as two “axes” of individual

psychology:

one axis is called the “confident–anxious” and .

the other is called the “careful–impetuous”.
The Adventurer:
• They are confident and willing to take chances.
• Their confidence leads them to make their own decisions.
• They are reluctant to take advice.

The Celebrity:
• They may hold opinions about some things.
• but to a certain extent recognize their limitations.
• May be willing to seek and take advice about investing.

The Individualist:
• Individualists are independent and confident,
• They like to make their own decisions
• but only after careful analysis. They are pleasant to advise
because they will listen and process information rationally.

The Guardian:
• Guardians are cautious and concerned about the future.
• They are concerned about protecting their assets
• and may seek advice from those they perceive as being more
knowledgeable than themselves.

The Straight Arrow:

• Straight arrows are sensible and secure.
• They are willing to take on some risk in the expectation of earning
a commensurate return.
2.1.3. New Developments in Psychographic Modeling: Behavioral Investor Types

Pompian (2008)

• introduces a behavioral alpha (BA) approach.

• It is a “top-down” approach to bias identification that may be simpler and more
efficient than a bottom-up approach.
• The BA approach is more efficiently identify biases for the purpose of determining
which type of bias dominates.
The Behavioral Alpha Process: A Top-Down Approach

Step 1: Interview the client and identify active or passive traits and risk
tolerance.
In this part showing Questionnaire in CFA book (Behavioral Finance)

Step 2: Plot the investor on the active/passive and risk tolerance scale.
Step 3: Test for behavioral biases
Step 4: Classify investor into a behavioral investor type.

Passive Preserver (PP)

•Basic type: Passive
•Risk tolerance level: Low
•Primary biases: Emotional

Friendly Follower (FF)

•Basic type: Passive
•Risk tolerance level: Low to medium
•Primary biases: Cognitive

Independent Individualist (II)

•Basic type: Active
•Risk tolerance: Medium to high
•Primary Biases: Cognitive
Active Accumulator
•Basic type: Active
•Risk tolerance: High
•Primary Biases: Emotional
 2.2. Limitations of Classifying Investors into Various Types

The limitations of behavioral models include the following:

1. Individuals may exhibit both cognitive errors and emotional biases.

Unfortunately, it may not be appropriate in most cases to classify a person as
either an emotionally biased person or a cognitively biased person.

2. Individuals may exhibit characteristics of multiple investor types. Therefore,

users of investor classification models should not look for people to fit neatly
into one “box” or type.

3. Individuals will likely go through behavioral changes as they age. As people

age their behaviors may change. The most widely recognized example is that
as people age their tolerance for risk (i.e., losses) generally decreases.

4. Individuals are likely to require unique treatment even if they are classified
as the same investor type because human behavior is so complex. For
example, one Passive Preserver may be more emotional or less risk tolerant
than another. The classifications should not be taken as absolutes.
5. Individuals act irrationally at different times and without predictability. Life
would be easier if we knew exactly when we or our clients would act irrationally.
Because we do not, it is important to recognize that placing people into
classifications may be more challenging at certain points, for example, during
periods of market or personal stress compared with times of relative calm or even
personal exuberance.
3. How Behavioral Factors Affect Adviser–Client Relations

As behavioral finance gains credibility and acceptance by the investment

community, advisers and investors are increasingly likely to include behavioral
considerations in a client’s investment policy statement (IPS). By adding behavioral
factors to the IPS, a number of benefits can be realized.

We show every successful relationship shares a few fundamental characteristics,

including the following as outlined by Pompian (2006):

1. The adviser understands the client’s financial goals and characteristics. These
are considered when developing the investment policy statement.

2. The adviser invests as the client expects. Results are communicated on a regular
basis and in an effective manner that takes into account the client’s
characteristics.

3. The relationship benefits both client and adviser.

Behavioral finance can enhance these areas as shown in the following sections.

3.1. Formulating Financial Goals

Experienced financial advisers know that defining financial goals is critical to
creating an investment program appropriate for the client. Behavioral finance
helps advisers discern why investors set the goals they do.

3.2. Maintaining a Consistent Approach

Most successful advisers maintain a consistent approach to delivering wealth
management services.

3.3. Investing as the Client Expects

Addressing client expectations is essential to a successful relationship; in many
unfortunate instances, the adviser does not deliver on the client’s expectations
because the adviser does not understand them.
• In bubbles, investors often exhibit symptoms of overconfidence; overtrading,
underestimation of risks, failure to diversify, and rejection of contradictory
information.

• The overconfidence and excessive trading that contribute to a bubble are

linked to confirmation bias and self-attribution bias. In a rising market, sales of
stocks from a portfolio will typically be profitable, even if winners are being sold
too soon.

• Investors can have faulty learning models that bias their understanding of this
profit to take personal credit for success. This behavior is also related to
hindsight bias, in which individuals can reconstruct prior beliefs and deceive
themselves that they are correct more often than they truly are.