Reading 9

Behavioral Finance and Investment Processes

Created for AlchemistsAcademy by MacLane Wilkison

Investor Types

Barnewall Two-Way Model

Passive investors - individuals who have become wealthy passively (e.g. inheritance, managers, etc.)

Higher need for security and lower risk tolerance

Active investors - individuals who have been actively involved in wealth creation (e.g. entrepreneurs)

Higher risk tolerance and lower need for security

Five-Way Model

(1) Adventurers may hold highly undiversified portfolios because they are confident and willing to take chances. Their confidence leads them to make their own decisions and makes them reluctant to take advice. (2) Celebrities like to be the center of attention. They may hold opinions about some things but to a certain extent recognize their limitations and may be willing to seek and take advice about investing. (3) Individualists are independent and confident. They like to make their own decisions but only after careful analysis. (4) 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 knowledgable. (5) Straight arrows are sensible and secure. They are willing to take some risk in expectation of earning a comensurate return.

Diagnostic Process

Interview the client and identify active or passive traits and risk tolerance
Plot the investor on an active/passive and risk tolerance scale
Test for behavioral biases
Classify the investor into a behavioral type

Passive preserver (PP)
Friendly follower (FF)
Independent Individualist (II)
Active Accumulator (AA)

Limitations of Behavioral Typing

Individuals may exhibit both forms of biases
Individuals may exhibit characteristics of multiple behavioral types
Individuals' behavior may change throughout the life-cycle
Individuals within behavior types may require unique treatment (no one size fits all)
Individuals may act irrationally and unpredictably regardless of type

Behavioral Factors and Portfolio Construction

Intertia - tendency to not change asset allocations throughout time despite changing risk tolerances
Naive diversification - "1/N" diversification strategy (i.e. allocating assets equally across categories)
Investing in the familiar - tendency to invest in employer's stock
Excessive trading - fees degrade returns
Home bias - overweighting of domestic asset classes

Behavioral Factors and Analyst Forecasts/Research

Overconfidence bias
Self-attribution bias
Representativeness bias
Availability bias
Illusion of control
Hindsight bias
Confirmation bias
Gamblers' fallacty - incorrect prediction of a mean reversal

Behavioral Factors and Market Behavior

Momentum

Herding - occurs when many investors take the same side of a trade
Regret aversion
Disposition effect - the tendency to hold losers and sell winners

Bubbles and crashes
Value vs. growth stocks

Halo effect - extrapolation of recent good results into the future