CFA Level 3

长线班视频课程
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Behavioral Finance
CFA三级基础班

讲师：Alan

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Reading 7
The Behavioral
Finance Perspective

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With its simplifying assumption of rational investors and efficient markets,
traditional finance has gained wide acceptance among academics and
investment professionals as a guide to financial decision making. Over time,
however, the limitations of traditional finance have become increasingly
apparent. Individual decision making is not nearly as objective and intellectually
rigorous, and financial markets are not always as rational and efficiently priced
as traditional finance assumes. To bridge this gap between theory and practice,
behavioral finance approaches decision making from an empirical perspective. It
identifies patterns of individual behavior without trying to justify or rationalize
them. A practical integration of behavioral and traditional finance may lead to a
better outcome than either approach used in isolation.

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 Behavioral finance VS Traditional finance

Ø Traditional finance: individuals are assumed to be risk-averse, self interested

utility-maximizers who process available information in an unbiased way.(rational)
Traditional finance further hypothesizes that, at the market level, prices
incorporate and reflect all available and relevant information .

Ø Behavioral finance: includes behavioral economics, investor psychology,

behavioral science, experimental economics, and cognitive psychology (normal)

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Behavioral finance VS Traditional finance

Behavioral finance micro（BFMI） Behavioral finance macro（BFMA）

• Examines behaviors or biases that • considers market anomalies that

distinguish individual investors from distinguish markets from the
the rational actors. efficient markets of traditional
• BFMI questions the perfect finance.
rationality and decision-making • BFMA questions the efficiency of
process of individual investors markets

考试重点 与一级equity investment中的知

识点有部分重合
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 Decision-making process

Framework for understanding the implications of the decision-making process

for financial market practitioners:

Normative analysis （traditional finance）

• Normative analysis is concerned with the rational solution to the problem at hand. It
defines an ideal that actual decisions should strive to approximate.

Descriptive analysis（behavioral finance）

• Descriptive analysis is concerned with the manner in which real people actually make
decisions.

Prescriptive analysis（effort to use behavioral finance in practice）

• Prescriptive analysis is concerned with practical advice and tools that might help people
achieve results more closely approximating those of normative analysis
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 Utility theory and Bayes`s formula

Utility theory and Bayes`s formula

To maximize utility, a rational investor will make decisions conforming to the four
axioms of utility: completeness, transitivity, independence, and continuity.

Completeness: Choices and preferences are known.

• The individual is aware of all available choices and can value and assign preferences to
each, such that between any two choices, the individual prefers one over the other or is
indifferent between them.

Transitivity: Rankings are applied consistently.

• If the investor prefers choice X to choice Y and prefers choice Y to Z, the investor will
prefer choice X to choice Z.
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 Utility theory and Bayes`s formula

Independence: Utilities are additive and divisible.

• Adding choice Z to both X and Y will not affect the preference ranking of X and Y. If, for
example, the investor prefers X to Y and we add Z to both choices, the investor will prefer
(X + Z) over (Y + Z).
• Also, assuming the investor prefers X to Y, if any portion, p, of Z is added to X and Y, the
investor's preference ranking does not change. The investor will prefer (X + pZ) to (Y + pZ).

Continuity: Indifference curves are smooth and unbroken.

• Assume there are three choices, L, M, and N, such that the investor prefers L to M and M
to N. There must be a combination of L and N (portions a and b) that makes the investor
indifferent between (aL + bN) and M.
• This ensures that indifference curves are unbroken (i.e., continuous).

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Utility theory and Bayes`s formula

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 Rational economic man

Rational economic man

Homo economics or rational man (REM)

• REM will try to obtain the highest possible economic well-being or utility given budget
constraints and the available information about opportunities.

4 ways for REM to make decisions in a perfect world and under uncertainty

• Adhere to the axioms of utility theory

• Behave in such a way as to assign a probability measure to possible events
• Incorporate new information by conditioning probability measures according to
Bayes' formula
• Choose an action that maximizes the utility function.
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 Rational economic man

Assumptions of REM

• Perfect rationality: assumes that REM has the ability to reason and make
beneficial judgments at all times

• Self-interest: humans are perfectly selfish.

• Perfect information: people may possess perfect or near-perfect information on

certain subjects

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 Risk averse

Risk averse
• Expected utility theory(traditional finance) generally assumes that individuals are risk-
averse. This means that an individual may refuse a fair wager. (a wager with an
expected value of zero), and also implies that his utility functions are concave and
show diminishing marginal utility of wealth;

To receive a certain expected value

Investors are given two

choices
Investing in an uncertain
alternative that give the same
expected value
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Risk averse

• Someone who is indifferent between the two investments is called

risk-neutral;

• Someone who prefers to invest in the uncertain alternative is called

risk-seeking;

• In traditional finance, individuals are assumed to be risk-averse.

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Utility Function of Wealth

Utility Function of Wealth

Concave utility function

• A concave utility function means that utility increases at a decreasing

rate with increases in wealth; the risk-averse individual has a
diminishing marginal utility of wealth.

Convex utility function

• A convex utility function means that utility increases at an increasing rate

with increases in wealth; the risk-seeking individual has an increasing
marginal utility of wealth. The degree of risk aversion can be measured
by the curvature of the utility function.
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Utility Function of Wealth

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Challenges to Traditional Finance and the REM

Challenges to Traditional Finance and the REM

The assumption of REM is that perfect information, perfect rationality and perfect
self-interest. However there are 3 challenges against those assumptions.

• Bounded rationality assumes that individuals’ choices are rational but are subject
to limitations of knowledge and cognitive capacity, and do not behave with perfect
rationality; （ The clients may not have time themselves to examine the
investment universe and arrive at optimal solutions, but they rely on their adviser
to do this for them. Thus, they exhibit bounded rationality. ）

• People have difficulty prioritizing short-term (spending) goals over long-term

(spending versus saving) goals and do not behave with perfect self-interest;

• It is intuitively obvious that many economic decisions are made in the absence of
perfect information and do not behave with perfect information 17
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 Challenge to risk aversion

Challenge to risk aversion

1. Observed behaviors are not 2. Observed behaviors also
3. Risk evaluation is reference-
show dependent, meaning risk
always consistent with the differences between individuals evaluation depends in part on
assumption of an individual who at different income level: the wealth level and
is constantly risk-averse. · Those with less income prefer circumstances of the decision
· Such as buying lottery tickets either certainty or a risk that maker. It is not necessarily true
and buying insurance, in which offers a small chance of a large that an individual's utility
expected utility is low but people gain to a risk that is moderate; function has the same curvature
(even with low incomes) · Middle-income people are consistently
participate in the purchase; more likely to be attracted by
· If an investment offers a few small, fair gambles.
extremely large prizes, its
attractiveness is increased far
beyond the aggregate value of
the prizes.
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 Challenge to utility maximization

A useful way to assess the validity of rational economic theory is to use indifference curves. The aim of indifference
curve analysis is to demonstrate, mathematically and graphically, the basis on which a rational consumer substitutes
certain quantities of one good for another.
Indifference curve analysis may incorporate budget lines or constraints, which represent restrictions on consumption
that stem from resource scarcity. In the work-versus-leisure model, for example, workers may not allocate any sum
exceeding 24 hours per day. The number of hours available for work and leisure may be lower than 24 hours
depending on other demands on their time.
An indifference curve, as shown in the next ppt slide, depicts all of the possible combinations of two goods amongst
which an individual is indifferent

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Trade off between work and leisure

Challenge to utility maximization

1. Not everyone can calculate mathematical equations
2. Fail to consider exogenous factors in rational Utility analysis

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Prospect Theory

Prospect Theory

• Prospect theory has been proposed as an alternative to expected utility theory;

(behavioral finance)

• Prospect theory assigns value to gains and losses (changes in wealth), rather
than to final wealth, and probabilities are replaced by decision weights;

• The value function is defined by the deviations from a reference point and is
normally concave for gains (implying risk aversion), convex for losses (risk-
seeking), and steeper for losses than for gains (loss aversion).(导出来人们其
实是loss aversion的）

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 Prospect Theory

Loss aversion（from perspective of

prospect theory）

• Investors are assumed to place a greater value on

a loss than on a gain of the same amount;

• Given a potential loss and gain of equal sizes, the

increase in utility associated with the potential gain
is smaller than the decrease in utility (i.e., disutility)
associated with the potential loss;

• Investors tend to fear losses and can become risk

seeking (assume riskier positions) in an attempt to
avoid them. (越怕损失，就越会持有，这里更强调的是一
直持有该股票，而非持有很久后才把它卖掉，注意区分
behavioral portfolio theory)
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 prospect theory

prospect theory
In prospect theory, based on descriptive analysis of how choices are made, there are two
phases to making a choice: an early phase in which prospects are framed (or edited) and a
subsequent phase in which prospects are evaluated and chosen.

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 prospect theory

Editing process:

Codification: People perceive outcomes as gains and losses rather than final states
of wealth or welfare. A gain or loss is, of course, defined with respect to some
reference point.

Combination: Prospects are simplified by combining the probabilities associated

with identical gains or losses.

Segregation: The riskless component of any prospect is separated from its risky
component.
For example, a prospect initially coded as (300, 0.8; 200, 0.2) is decomposed into a
sure gain of (200, 1.0) and a risky prospect of (100, 0.8; 0, 0.20). The same process
is applied for losses.

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prospect theory

Cancellation: Cancellation involves discarding common outcome probability pairs

between choices.
For example, the pairs (200, 0.2; 100, 0.5; 20, 0.3) and (200, 0.2; 300, 0.4; –50, 0.4)
are reduced to (100, 0.5; 20, 0.3) and (300, 0.4; –50, 0.4).

Simplification: Prospects are likely to be rounded off. A prospect of (0.51, 0.49) is

likely to be seen as an even chance to win 50. Also, extremely unlikely outcomes
are likely to be discarded or assigned a probability of zero.

Detection of dominance: Outcomes that are strictly dominated are scanned and
rejected out further evaluation.

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 prospect theory

evaluation phase

In the evaluation phase of prospect theory, people behave as if they compute a value
(utility) function based on the potential outcomes and their respective probabilities and
then choose the alternative that has a higher utility.
Thus, the subjective probability weighting can be incorporated into an individual`s expected
utility expression:

“w” means the weighting of subjective probability

“u” means the utility
“p” means the probability

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 Relations between different theories

Relations between different theories

Traditional finance includes expected utility theory, risk aversion and perfect information.

Expected utility and decision theories are normative, describing how people should behave
and make decisions

Behavior finance includes prospect theory and bounded rationality

1. Prospect theory: relaxes the assumptions of expected utility theory and risk aversion
2. bounded rationality :Relaxes the assumption that all available information is used to arrive at a
wealth-maximizing decision

prospect theory and bounded rationality are descriptive , showing how people do behave
and make decisions
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 Bounded rationality

Bounded rationality
Bounded rationality: recognizing that people are not fully rational when making
decisions and do not necessarily optimize but rather satisfice (defined below) when
arriving at their decisions;

Satisficing is finding an acceptable solution as opposed to optimizing, which is

finding the best (optimal) solution;
The optimal solution is the one that maximizes the utility realizable from the
situation.

Decision makers may choose to satisfice rather than optimize because the cost and
time of finding the optimal solution can be very high;

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 Decision theory

Decision theory

Decision theory is concerned with identifying values, probabilities, and other uncertainties relevant to
a given decision and using that information to arrive at a theoretically optimal decision.
It assumes that decision maker is fully informed, is able to make quantitative calculations with
accuracy and is perfectly rational.

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Summary of traditional finance vs. behavioral finance

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 Traditional Perspectives on Market Behavior

Traditional Perspectives on Market Behavior

Markets fully, accurately, and instantaneously incorporate all available information into market
prices;
Underlying market efficiency is the assumption that market participants are rational economic
beings, always acting in their own self-interest and making optimal decisions by trading off costs
and benefits weighted by statistically correct probabilities and marginal utilities.
The efficient market hypothesis requires that agents have rational expectations.

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 Studies Challenging the Anomalies

Studies Challenging the Anomalies

Fundamental Anomalies
Size effect: This test indicates that stocks of small-sized firms tend to outperform stocks of
large-sized firms;
Value effect: refers to the finding that value stocks those with lower price-to-earnings
(P/E), lower market-to-book (M/B), and higher dividend yields] have outperformed growth
stocks (those with higher P/E, higher M/B, and lower dividend yields).

Technical Anomalies
Moving Averages(移动平均线)
Trading Range Break (Support and Resistance).

Calendar Anomalies
January effect.

Conclusions: market efficiency is not black or white, but rather gray. 32

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 Perspectives on portfolio construction

Perspectives on portfolio construction

Traditional finance perspective:

A rational portfolio is one that is mean-
variance efficient.
（只要题目中提到variance和mean，则可以
立即判断是从TF的角度去考虑，而非BF）

Behavioral finance perspective: there are 4 models that try to explain the behavior of
individuals and markets
And their implications for portfolio construction:
1.consumption and savings. 2.behavioral asset pricing
3.behavioral portfolio theory. 4.adaptive markets hypothesis.
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Perspectives on portfolio construction

Consumption and Savings

Traditional finance assumes investors make conscious decisions to save and consume in
a pattern that meets both their short- and long-term goals.

An alternative theory incorporating behavioral finance assumptions.

1.Framing refers to the way a question is asked or the way information is presented
and can affect the way individuals perceive a choice and view its alternatives;

Framing : individuals classify their wealth as current income, currently owned

assets, or present value of future

If wealth is classified as current income, the individual is more likely to use it to

meet current spending needs and desires;

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 Perspectives on portfolio construction

2. Self-control bias refers to an individual's tendency to place a much greater value on current
consumption than on future goals;

3.mental accounting refers to individuals‘ tendencies to mentally place goals into different “files”.
This ignores the fact that wealth is interchangeable.

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 Perspectives on portfolio construction

Behavioral Asset Pricing

Traditional perspective assumes that perfectly rational investors make wealth-maximizing

decisions at all times using all available information (e.g., CAPM).

The behavioral asset pricing model: The discount rate on security is the sum of the risk-
free rate and fundamental premiums (corresponding to efficient prices) and a sentiment
premium (reflecting sentiment-based risk)

The discount rate on security = risk-free rate + fundamental risk premium + sentiment
premium.

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 Perspectives on portfolio construction

Behavioral Portfolio Theory (BPT)

Traditional finance: hold a well-diversified portfolio.

Behavioral finance: construct their portfolios in layers(like mental accounting) and

expectations of returns and attitudes toward risk vary between the layers(layers are
independent). And the layers are depends on:

First, the allocation to different layers depends on investor goals and the importance
assigned to each goal. For example, if high importance is assigned to an upside
potential goal, then the allocation of funds to the layer with the highest upside
potential will be greater than if high importance is attached to minimizing potential
downside losses. （如果目标是追求高收益，那么就应该多投资一些高收益产品）

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 Perspectives on portfolio construction

Second, the allocation of funds within a layer to specific assets will depend on the goal set for
the layer. If a higher goal is set, then the assets selected for the layer are likely to be riskier or
more speculative in nature. （similar to the first one, BUT more focus on sell a inappropriate
stock and hold a appropriate stock, do not confuse with loss aversion in prospect theory）

Third, the number of assets chosen for a layer depends on the shape of the investor’s utility
function. Thus, the greater the concavity of the utility curve, the greater the number of
securities included in a layer. (越风险厌恶，则需要分散化要更好，资产的数量就需要更
多)

Fourth, concentrated positions in some securities may occur if investors believe they have an
informational advantage with respect to the securities.

Fifth, investors reluctant to realize losses (loss-averse) may hold higher amounts of cash position
so that they do not have to meet liquidity needs by selling assets that may be in a loss position.

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 Perspectives on portfolio construction

Adaptive Markets Hypothesis(AMH)

Traditional finance: Try to maximize expected utility, which leads to EMH

Behavioral finance: Success is defined as survival rather than as having maximized expected
utility.

The adaptive markets hypothesis, based on some principles of evolutionary biology, suggests that
the degree of market efficiency is related to environmental factors characterizing market ecology.
These factors include the number of competitors in the market, the magnitude of profit
opportunities available, and the adaptability of the market participants.

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 Perspectives on portfolio construction

Five implications of the AMH are:

1.The relationship between risk and reward varies over time (risk premiums change over time) because
of changes in risk preferences and such other factors as changes in the competitive environment;

2.Active management can add value by exploiting arbitrage opportunities;

（只有不断的调整才能获取超额收益，所以活下来的主动投资策略都是可以获取超额收益的）

3.Any particular investment strategy will not consistently do well but will have periods of superior and
inferior performance;

4.The ability to adapt and innovate is critical for survival;

5.Survival is the essential objective. In other words, recognizing that things change, the survivors will be
those who successfully learn and adapt to changes.

EMH说的是市场有效就做被动投资，无效就做主动投资。而AMH说的是市场是不断改变的，
所以要不断改变交易策略，能存活下来就好。注意，这里我们不强调一直有用，而是强调当前有用就行。
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Reading 8
The Behavioral
Biases of Individuals

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 Categorizations of behavioral biases

Categorizations of behavioral biases

Cognitive error Emotional biases

Individual try to process information into rational Emotional biases are caused by individuals`
decisions, but they simply lack the capacity or psychological predispositions and can affect how
sufficient information to do so. individuals see information and make decisions.
Cognitive errors are more easily corrected Think of emotional bias as the way individuals
because they stem from faulty reasoning rather frame the information and the decision rather
than an emotional predisposition. than analyze and interpret it.
Emotional biases stem from impulse or intuition;
emotional biases tend to result from reasoning
influenced by feelings.
Emotional bias is not deliberate, it is more of a
spontaneous reaction.
MORE FOCUS ON BIG PICTURES, DO NOT SETTLE WITH
DETAILS
Behavioral biases, cognitive or emotional, may cause decisions to deviate from the rational decisions of traditional finance.
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Cognitive errors can be divided into two classifications:
1. belief perseverance biases
2. Processing biases.

Belief perseverance errors reflect an inclination to maintain beliefs. The belief is maintained by
committing statistical, information-processing, or memory errors. Belief perseverance biases are closely
related to the psychological concept of cognitive dissonance.
Belief perseverance biases include conservatism, confirmation, representativeness, illusion of control,
and hindsight.

Information-processing biases result in information being processed and used illogically or irrationally.
Information-processing biases include anchoring and adjustment, mental accounting, framing, and
availability.

Emotional biases include loss aversion, overconfidence, self-control, status quo, endowment, and
regret aversion.

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 Cognitive Errors

Cognitive Errors: Belief Perseverance

Belief perseverance is the tendency to cling to one's previously held beliefs irrationally or
illogically.

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 Cognitive Errors

Conservatism bias：people maintain their prior views or forecasts by inadequately incorporating new
information ;（强调不能很好接受新信息）

The result of conservatism bias

As a result of conservatism bias, FMPs(financial market participants) may do the following:
Maintain or be slow to update a view or a forecast, even when presented with new information.
opt to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex
data.

比如题目说A基金经理投资了A公司，但目前出现一个对A公司新的消息，可是A基金经理视而不
见，不予充分考虑该新消息

The effect of conservatism bias may be corrected for or reduced by properly analyzing and weighting
new information.

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 Cognitive Errors

Confirmation bias

Confirmation bias：Individuals tend to notice only information that agrees with their perceptions or beliefs.
They look for confirming evidence while discounting or even ignoring evidence that contradicts their beliefs
or their perceptions;

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As a result of confirmation bias, FMPs may do the following:
Consider only the positive information about an existing investment and ignore any negative information
about the investment.（区别conservatism bias，后者更强调new information，但有时，两者会同时
体现在同一行为中，如A基金经理投资A公司，但目前出现一个对A公司新的不利的消息，可是A基
金经理视而不见，不充分考虑该新的不利的消息）

Develop screening criteria and then ignore information that either refuses the validity of the screening
criteria or supports other screening criteria.

Under-diversify portfolio , leading to excessive exposure to risk. （你觉得你投资的都是对的，那就不

分散了）FMPs may become convinced of the value of a single company and its stock. For example, Hold
a disproportionate amount of their investment assets in their employing company’s stock because they
believe in their company and are convinced of its favorable prospects.

The effect of confirmation bias may be corrected for or reduced by actively seeking out information that
challenges your beliefs.

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 Cognitive Errors

Representativeness bias.
Representativeness bias：people tend to classify new information based on past experiences and
classifications. This bias occurs because people attempting to derive meaning from their experiences tend to
classify objects and thoughts into personalized categories which are not necessarily fit;
Two forms: base rate neglect, sample-size neglect.

Base rate neglect

The base rate or probability of the categorization is not adequately considered.
For example, an investor determine the potential success of an investment in company ABC might categorize
company ABC as a growth stock, but it ignores the base probability that a company is a growth company.

Sample-size neglect
Investors incorrectly assume that small sample sizes are representative of populations.
Individuals are quick to treat properties reflected in small samples as properties that accurately describe
large pools of data. They overweight the information in the small sample

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As a result of representativeness bias FRMs may do the following:

Adopt a view or a forecast based almost exclusively on new information or a small sample .
This situation may also result in high investment manager turnover as the investor changes investment
managers based on short-term results.（暂时低回报率并不会持续发生）

Update beliefs using simple classifications rather than deal with the mental stress of updating beliefs given
complex data.

The effect of representativeness bias may be corrected for or reduced by asking FMPs if they are failing to
consider the base rate or neglecting the law of small numbers.

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 Cognitive Errors

Illusion of control

Illusion of control: people tend to believe that they can control or influence outcomes when, in fact, they
cannot. Expectancy of a personal success probability inappropriately higher than the objective probability
would warrant;

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As a result of illusion of control bias, FMPs may do the following:

Traders especially online traders, believe that they have “control” over the outcomes of their investments,
which leads to excessive trading.

Lead investors to inadequately diversify portfolios.

The collection of too much information, even those information may not add accuracy of the forecast.
（认为只要信息多，哪怕是没用的信息，自己也可以利用这些信息去控制结果）

The effect of representativeness bias may be corrected for or reduced by keeping the record.

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 Cognitive Errors

Hindsight bias

Hindsight bias：A bias with selective perception and retention aspects. People may see past events as
having been predictable and reasonable to expect.

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As a result of hindsight bias, FMPs may do the following:

Overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of
confidence.

Cause FMPs to unfairly assess money manager or security performance.

The effect of hindsight bias may be corrected for or reduced by keeping the record and examine their
investment decisions.

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 Cognitive Errors

Cognitive Errors: Information Processing

Describing how information may be processed and used illogically or irrationally in financial
decision making.

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 Cognitive Errors

Anchoring and adjustment

Anchoring and adjustment: the use of a psychological heuristic influences the way people estimate
probabilities. When required to estimate a value with unknown magnitude, people generally begin
by envisioning some initial default number an "anchor“ which they then adjust up or down to reflect
subsequent information and analysis;

它和之前讲的conservation bias很类似，但是区别在与conservation说的是自己就不想去调整，而anchor说的是想调，
但是不知道怎样去调或者调的不够。区别两者的方法是主观能动性，如果是的话那么就是anchor，如果是
长期都不愿意调整，则是conservation。

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As a result of anchoring and adjustment bias,

FMPs may stick too closely to their original estimates when new information is learned.

The effect of anchoring and adjustment bias may be corrected for or reduced by remembering that the
past prices, market level and reputation provide little information about an investment`s future potential
and thus should not influence buy-and-sell decisions.

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 Cognitive Errors

Mental accounting bias

Mental accounting bias: people treat one sum of money differently from another equal-sized sum
based on which mental account the money is assigned to;

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As a result of mental accounting bias, FMPs may do the following:

In mental accounting, people do not care about optimal diversification, so Neglect opportunities to reduce
risk by combining assets with low correlations.

Irrationally distinguish between returns derived from income and those derived from capital appreciation.

The effect of mental accounting bias may be corrected for or reduced by focus on total return and risk.

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 Cognitive Errors

Framing bias

Framing bias：a person answers a question differently based on the way in which it is asked (framed);

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As a result of framing bias, FMPs may do the following:
Misidentify risk tolerances because of how questions about risk tolerance were framed; may
become more risk-averse when presented with a gain frame of reference and more risk-seeking
when presented with a loss frame of reference. This may result in suboptimal portfolios.

Choose suboptimal investments, based on how information about the specific investments is
framed.

Focus on short-term price fluctuations, which may result in excessive trading. （看见有价格浮动就
会相应的买卖，因为你只看见了它的表现形式，而不看它的本质）

The effect of framing bias may be corrected for or reduced by being neural and open-minded
as possible when interpreting investment-related situations.

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 Cognitive Errors

Availability bias

Availability bias：people take a heuristic (sometimes called a rule of thumb or a mental shortcut)
approach to estimating the probability of an outcome based on how easily the outcome comes to mind .

There are 4 sources of availability bias：

Retrievability: If an answer or idea comes to mind more quickly and easily than another answer or idea,
the first answer or idea will likely be chosen as correct even if it is not the reality;（Do not confuse with
representative, which does not focus on “comes to mind more quickly and easily “）
比如原本认为投资A项目的资金过高，但由于回想过去后，认为过去有投资类似A公司的成功经验，
所以目前投资A公司的资金量不算高。

Categorization: When solving problems, people gather information from what they perceive as relevant
search sets. Different problems require different search sets, which are often based on familiar
categorizations. If it is difficult to come up with a search set, the estimated probability of an event may be
biased.（简单归类，比如说直接认为开好车的都是好人）
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Narrow range of experience: This bias occurs when a person with a narrow range of experience uses too
narrow a frame of reference based upon that experience when making an estimate.（井底之蛙）

Resonance: People are often biased by how closely a situation parallels their own personal situation.
（你喜欢爵士乐，就会觉得周围都是爵士乐爱好者）

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As a result of availability bias, FMPs may do the following:
Choose an investment, investment adviser, or mutual fund based on advertising or past experience
that comes to mind firstly rather than on a thorough analysis of the options. Limit their investment
opportunity set. This may be because they use familiar classification schemes.

Fail to diversify.

Fail to achieve an appropriate asset allocation.

The effect of availability bias may be corrected for or reduced by realizing that human generally
disregard or forget about events that happened more than a few year ago.

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 Emotional biases

Emotional biases are harder to correct for than cognitive errors because they originate from impulse or
intuition rather than conscious calculations. In the case of emotional biases, it may only be possible to
recognize the bias and adapt to it rather than correct for it.

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 Emotional biases

Loss aversion bias

Loss aversion bias: people tend to strongly prefe r avoiding losses as opposed to achieving gains .A
number of studies suggest that, psychologically, losses are significantly more powerful than gains;
Loss-aversion bias, executed in practice as the disposition effect

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As a result of loss-aversion bias, FMPs may do the following:
Hold investments in a loss position longer than justified by fundamental analysis. FMPs hold losing
investments in the hope that they will return to break even.

Sell investments in a gain position earlier than justified by fundamental analysis. FMPs sell winning
investments because they fear that their profit will erode.

Limit the upside potential of a portfolio by selling winners and holding losers.

Trade excessively as a result of selling winners. Excessive trading has been shown to lower investment
returns.

Hold riskier portfolios than is acceptable based on the risk/return objectives of the FMP. This is caused by
the sale of investments that are winners and the retention of investments that are losers. FMPs may
accept more risk in their portfolios than they would if they had based their decision on risk/return
objectives and fundamental analysis.
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The effect of loss aversion bias may be corrected for or reduced by a disciplined approach to investment
based on fundamental analysis.

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 Emotional biases

原版书例题

Effect of Loss-Aversion Bias

Loss-aversion bias, executed in practice as the disposition effect, is observed often by wealth management
practitioners. The classic case of this bias is when an investor opens the monthly account statement and
scans the individual investments for winners and losers. Seeing that some investments have lost money and
others have gained, discuss how the investor is likely to respond given a loss-aversion bias.

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Sample Solution:

The investor is likely to respond by continuing to hold the losing investments. The idea of actually losing
money is so painful that the first reaction is to hold the investment until it breaks even. The investor is
acting based on emotions, not cognitive reasoning. In this case, if the investor did some research, he or she
might learn that the company in question is experiencing difficulty and that holding the investment actually
adds to the risk in the portfolio (hence the term risk-seeking in the domain of losses).
Conversely, the winners are making money. Loss-averse FMPs have a tendency to sell these investments and
realize their gains to avoid any further risk. In this case, if the investor did some research, he or she might
learn that the company in question actually improves the risk/return profile of the portfolio. By selling the
investment, not only is the potential for future losses eliminated, but the potential for future gains is also
eliminated. Combining the added risk of holding the losers with the elimination of potential gains from
selling the winners may make investors’ portfolios less efficient than portfolios based on fundamental
analysis.

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 Emotional biases

Overconfidence bias

Overconfidence bias: people demonstrate unwarranted faith in their own intuitive reasoning ,
judgments, and/or cognitive abilities. This overconfidence may be the result of overestimating
knowledge levels, abilities, and access to information.（Do not confuse with illusion of control which
focus more on “outcome”）

Illusion of knowledge and self-attribution biases contribute to the overconfidence bias.

Illusion of knowledge bias: overestimating knowledge levels, abilities, and access to information
（比如题目说A基金经理自称在某个行业具有超常的或丰富的经验，肯定能够使其在该行业投资获利）

Prediction overconfidence leads to underestimating risk and setting confidence intervals too narrow.

Certainty overconfidence relates to over-stated probabilities of success;

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Self-attribution bias, the combination of self-enhancing bias and self-protecting bias, contributes to
overconfidence.

By self-enhancing , individuals take all the credit for their successes. （成功都是自己的功劳）

By self-protecting ,they place the blame for failure on someone or something else.（失败都是别人的过错）

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As a result of overconfidence bias, FMPs may do the following:

Underestimate risks and overestimate expected returns.

Hold poorly diversified portfolios.

Trade excessively.

Experience lower returns than those of the market.（比如太多的交易成本）

The effect of overconfidence bias may be corrected for or reduced by being objective when making
investment decisions.

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 Emotional biases

Self-control bias

Self-control bias：people fail to act in pursuit of their long-term, overarching goals because of a lack of
self-discipline. There is an inherent conflict between short-term satisfaction and achievement of some
long- term goals.

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As a result of self-control bias, FMPs may do the following:

Save insufficiently for the future.

Accept too much risk in their portfolios in an attempt to generate higher returns. In this attempt to
make up for less than adequate savings, the capital base is put at risk.（因为你把本来该去投资的钱花
掉了，所以你只能去追求一个更大的收益，那么就会有更大的风险）

Cause asset allocation imbalance problems. For example, some FMPs prefer income-producing assets in
order to have income to spend. This behavior can be hazardous to long-term wealth because income-
producing assets may offer less total return potential.

The effect of self-control bias may be corrected for or reduced by writing down the plan, so that they can
be reviewed regularly.

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 Emotional biases

Status quo bias

Status quo bias: an emotional bias in which people do nothing (i.e.,maintain the “status quo”) instead of
making a change .

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As a result of status quo bias, FMPs may do the following:

Unknowingly maintain portfolios with risk characteristics that are inappropriate for their
circumstances.

Fail to explore other opportunities.

The effect of status quo bias may be corrected for or reduced by education, but it is hard to correct.

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 Emotional biases

Endowment bias

Endowment bias：people value an asset more when they hold rights to it than when they do not.

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As is the case with Endowment bias, endowment bias may lead FMPs to do the following:

Fail to sell off certain assets and replace them with other assets.

Maintain an inappropriate asset allocation . The portfolio may be inappropriate for investors’ levels
tolerance and financial goals.

Continue to hold classes of assets with which they are familiar. FMPs may believe they understand the
characteristics of the investments they already own and may be reluctant to purchase assets with which
they have less experience. Familiarity adds to owners’ perceived value of a security.

The effect of Endowment bias may be corrected for or reduced by education, but it is hard to correct.

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 Emotional biases

Regret-aversion bias

Regret-aversion bias: people tend to avoid making decisions that will result in action out of fear that
the decision will turn out poorly. Simply put, people try to avoid the pain of regret associated with bad
decisions.(Do not confuse with status quo bias)

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As a result of regret-aversion bias, FMPs may do the following:
Be too conservative in their investment choices as a result of poor outcomes on risky investments in
the past. This behavior can lead to long-term underperformance and potential failure to reach
investment goals.

Engage in herding behavior. FMPs may feel safer in popular investments in order to limit potential
future regret. It seems safe to be with the crowd, and a reduction in potential emotional pain is
perceived.（所以只是说避免去做一些和他人不一样的行为，而不是说不做行为）

The effect of regret-aversion bias may be corrected for or reduced by education, but it is hard to correct.

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Summary

Cognitive Errors Emotional Biases

• Representativeness bias • Loss aversion bias

• Illusion of control bias • Overconfidence bias
• Conservatism bias • Self-control bias
• Confirmation bias • Status quo bias
• Hindsight bias • Endowment bias
• Framing bias • Regret-aversion bias
• Anchoring and adjustment
• Mental accounting bias
• Availability bias

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 Implication for investment policy development

Implication for investment policy development

Attempts are made to either mitigate behavior biases or accommodate them. Goals-based investing,
for example, recognizes that individuals are subject to loss aversion and mental accounting.

Goals-based investing approach

The bottom layer of the pyramid(portfolio) is constructed first and is comprised of assets designed to
meet investor`s most important goals.
Once this foundation layer is constructed, the investor moves to the next layer.
Each successive layer as you move up the pyramid consists of increasingly risky assets used to meet less
and less important goals.

Typically, investors will end up having a diversified portfolio using this approach, but the resulting
portfolio may not be efficient from a traditional finance perspective.

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 Behaviorally Modified Asset Allocation

Behaviorally Modified Asset Allocation

Behaviorally modifying a portfolio simply means constructing is according to the investor‘s behavioral risk
and return preferences. The construction of the modified portfolio considers the investor’s emotional and
cognitive behavioral biases and current wealth;

As a general rule, the wealthier the client, the more her behavioral biases can be accommodated
(adapted to); the less wealthy, the more mitigated (moderated).

Another general rule is that cognitive errors should be mitigated(moderated) and emotional biases should
be accommodated (adapted to);

The client's wealth should be determined by considering total wealth relative to lifestyle.
The lower the client's standard of living risk, the greater the client's effective wealth and the greater the
ability to accommodate behavioral biases.

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Reading 9
Behavioral finance
and investment
processes

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 Introduction

Introduction

All market participants may deviate from the behavior that is assumed in traditional financial
theory. Some of these deviations have been identified and categorized as behavioral biases.

Adviser-client relationships

Portfolio construction
Behavioral biases
may affect The work of analyst

Committee decision making

Market behavior
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 General discussion of investor types

General discussion of investor types

When the psychology of investing is recognized in creating the client`s investment policy statement
and subsequent implementation, the outcome is likely to be favorable.
We will discuss three behavioral models:

Barnewall Two-Way Behavioral Model

Ballard, Biehl, and BB&K Five-Way Model

Pompian Behavioral Model

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 Barnewall Two-Way Behavioral Model

Barnewall Two-Way Behavioral Model

Barnewall distinguishes two relatively simple investor types: passive and active.

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 (managers who benefit when their companies do well are examples of the latter category).
Passive investors have a greater need for security.

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.

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 Ballard, Biehl, and BB&K Five-Way Model

Ballard, Biehl, and BB&K Five-Way Model

(BB&K) model classifies investor personalities along two axes:

One axis is called the “confident–anxious” axis, which deals with how confidently the investor
approaches life, regardless of whether it is his approach to his career, his health, or his money.

The other is called the “careful–impetuous” axis, which deals with whether the investor is
methodical, careful, and analytical in his approach to life or whether he is emotional, intuitive,
and impetuous.
Confident
individualist adventurer

Careful Straight arrow Impetuous

Guardian Celebrity

Anxious
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Individualist: Independent and confident, Like to make their own decisions but only after careful
analysis. Pleasant to advise because they will listen and process information rationally.

Adventurer: May hold highly undiversified portfolios. Confident and willing to take chances.
Makes their own decisions. Makes them reluctant to take advice. Challenge for an investment
adviser.

Straight Arrow: Sensible and secure. Willing to take on some risk in the expectation of earning a
commensurate return.

Guardian: Cautious and concerned about the future. May seek advice from those they perceive
as being more knowledgeable than themselves

Celebrity: Like to be the center of attention. May hold opinions about some things but to a certain
extent recognize their limitations. May be willing to seek and take advice about investing.

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 Pompian Behavioral Model

Pompian Behavioral Model

In recent years, there have been additional developments in the practical application of behavioral
finance. In pompian behavioral model, there are four types investors:

Passive Preserver
Friendly Follower
Independent Individualist
Active Accumulator

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The Passive Preserver, place a great deal of emphasis on financial security and preserving wealth
rather than taking risks to grow wealth.
May not be financially sophisticated.
May be difficult to advise because they are driven mainly by emotion.

The Friendly Follower are passive investors with a low to medium risk tolerance who tend to
follow leads from their friends, colleagues, or advisers when making investment decisions, even
those leads are not suitable for Friendly followers.
May be difficult to advise because they often overestimate their risk tolerance.

The Independent Individualist is an active investor with medium to high risk tolerance who is
strong-willed and an independent thinker.
Independent Individualists may be difficult clients to advise because of their independent mindset,
but they are usually willing to listen to sound advice when it is presented in a way that respects
their intelligence.
The Active Accumulator The Active Accumulator is the most aggressive behavioral investor type.
These clients are usually entrepreneurial and want to be heavily involved in the investment decision-
making process. 92
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 93
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Limitations of Classifying Investors into types

Limitations of Classifying Investors into types

Individuals may exhibit both cognitive errors and emotional biases;

Individuals may exhibit characteristics of multiple investor types;

Individuals will likely go through behavioral changes as they age;

Individuals are likely to require unique treatment even if they are classified
as the same investor type because human behavior is so complex;

Individuals act irrationally at different times and without predictability.

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 The Client/Adviser Relationship

The Client/Adviser Relationship

Every successful relationship shares a few fundamental characteristics, including the following as
outlined by Pompian (2006). Behavioral finance can enhance these areas.

The adviser understands the client’s financial goals and characteristics.

The adviser maintains a systematic (consistent) approach to advising the client.
The adviser invests as the client expects.
The relationship benefits both client and adviser.

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limitations of risk tolerance questionnaires.

Risk tolerance questionnaires can also generate dramatically different results when
administered repeatedly to the same individual, but with slight variations. Such
imprecision arises primarily from variations in wording.

Adviser may interpret what the client says too literally, when client statements should only
act as indicators.

Risk tolerance questionnaires may work better as a diagnostic tool for institutional
investors whose risk analysis is a cognitive process（客户越理性，则问卷调查的意义越
好，反之越感性，则越不好。 呈现出来cognitive biased的人是比较理性的，而呈现
emotional biased的都是比较感性的）

Risk tolerance questionnaires may fail emotionally biased individuals.

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 Portfolio Construction - DC plan

Portfolio Construction - DC plan

Behavioral biases may affect how investors construct portfolios from the securities available to
them. Some useful evidence on the portfolio selection decisions of individual investors comes
from defined-contribution (DC) pension plans.

Status quo bias refers that they tend not to change their asset allocations through time, even
though it might be assumed that their tolerance for risk and other circumstances would be
changing or no transaction costs.

Some companies have introduced “autopilot” strategies to counteract the inertia that plan
participants frequently exhibit. For example, target date funds automatically switch from risky
assets to fixed-income assets as the plan member nears the intended retirement date.

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 Portfolio Construction - DC plan

Naive diversification—dividing contributions equally among available funds irrespective of the

underlying composition of the funds.

In one experiment, one group of subjects is given the choice between a stock (equities) fund and
a bond fund and a second group of subjects is given a choice between a stock fund and a
balanced (50 percent stock, 50 percent bond) fund. Both group allocated 50/50.

Others suggest investors follow conditional naïve diversification. They select a smaller number of
funds(for example, three to five), and then allocate equally.

In either case this is motivated by seeking to avoid regret. Owning equal amounts of all, investors
did not miss the best performer.

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 Portfolio Construction - DC plan

Company stock: investing in the familiar

Explanations given for investment in employer’s stock include the following:

Familiarity and overconfidence effects: Employees underestimate risk because of familiarity with the
employing company and overconfidence in their estimates of the company’s performance.

Naïve extrapolation of past returns(representativeness): Plan members at companies whose stock

has done well in the past may expect this performance to continue and hence wish to hold company
stock in their account.
Framing and status quo effect of matching contributions

Loyalty effects: Employees may be willing to hold employer’s stock to assist the company, as they
perceive it.
Financial incentives : Employees might rationally invest in employer’s stock when there are financial
incentives for them to do so.
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 Portfolio Construction - DC plan

Excess Trading

The evidence of member inertia in DC plans is in contrast to evidence of individuals with retail
investment accounts. Investors with retail accounts appear to be more active traders.

Excessive trading appears to be driven by overconfidence. Overconfident investors may falsely

think that they have the knowledge and insight to make profitable trades, and trade actively to
benefit from these insights.

The frequent traders not only had higher transaction costs because of excessive trading but also
experienced opportunity losses because of the loss aversion effect that investors tend to sell
winners and hold on to losers.

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 Portfolio Construction - DC plan

Home bias

A large body of literature exists showing that many investors maintain a high proportion—often
80 percent or more—of their investments in securities listed in their own country.

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Analyst Forecasts & Behavioral Finance

Analyst Forecasts & Behavioral Finance

How behavioral factors impact security analysts, there are 3 ways to

show:

Overconfidence in forecasting skills

Influence of company’s management on analysis

Analyst biases in conducting research

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 Overconfidence in forecasting skills

Overconfidence in forecasting skills

Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own intuitive
reasoning, judgments, and/or cognitive abilities. This overconfidence may be the result of
overestimating knowledge levels, abilities, and access to information.

Analysts also tend to remember their previous forecasts as being more accurate than they really were.
(a form of hindsight bias)

1. Illusion of knowledge bias: people generally do a poor job of estimating probabilities but believe they
do it well because they believe that they are smarter and more informed than they actually are;
2. Illusion of control bias: which is a tendency of analysts to try to control what cannot be controlled;
3. Self-attribution bias: in which people take credit for successes and assign responsibility for failures;
4. Representativeness: in which analysts judge the probability of a forecast being correct by considering
how much the outcome resembles overall available data;
5. Availability bias: which involves individuals giving undue weight to more accessible, readily recalled
information.
6. Hindsight bias: ego defense mechanism;
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 Influence by Company Management

Influenceby Company Management

Analysts should remember that company management is also susceptible to behavioral biases. Framing,
anchoring and adjustment, availability and self-attribution bias are important biases. Those four biases
are most frequently seen when company management report company result.

Framing is a cognitive bias in which the same problem is assessed differently depending on how
information or a question is presented;

Anchoring means that the framework for interpreting and analyzing the available information can be
influenced disproportionately by an initial, default position or “anchor”. Adjustments from the anchor
tend to insufficiently incorporate new information;

Availability is a cognitive bias that involves individuals giving undue weight to more accessible, readily
recalled information.

self-attribution bias in company executives that arises from the impact of incentive compensation on
company reporting.
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 Analyst Biases in Conducting Research

Analyst Biases in Conducting Research

Confirmation bias, a cognitive bias, is the tendency for people to evidence as additional support for
an initial hypothesis.

The gamblers’ fallacy, is a related cognitive bias. Investment professionals, and strategists in
particular, can suffer from this cognitive bias. It reflects a faulty understanding about the behavior
of random events, expecting reversals to occur more frequently than actually happens.
The expectation of a market reversal(stock price)—a fall coming after a rising trend—could reflect
the gamblers’ fallacy.

A representative bias is one in which the analyst inaccurately extrapolates past data into the future.

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 How behavioral factors affect committee decision making

How behavioral factors affect committee decision making

Many investment decisions are made by groups or committees rather than by individuals acting alone.

Social proof is a bias in which individuals are biased to follow the beliefs of a group. Analysts may
wrongly favor the judgment or endorsement of others, often without being fully aware that they are
doing so.

Committees are often made up of individuals with similar backgrounds who are likely to approach
decisions in a similar way.

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 How behavioral factors affect committee decision making

Solutions for Structuring and Operating Committees to Address Behavioral Factors :

A committee is made up of members from diverse backgrounds;

Members are independent enough to express and support their own views rather than falling into
line with the views of others;

The chairman should actively encourage alternative opinions so that all perspectives are covered.

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 How behavioral factors affect Market Behavior

How behavioral factors affect Market Behavior

Over time, academic papers have broadened the understanding of market efficiency. However, this
understanding still does not explain some persistent market patterns. Behavioral finance does offer
some explanation of these exceptions to market efficiency, and focuses on the biases that contribute to
these anomalies.

Anomalies(apparent deviations from the efficient market hypothesis) are identified by persistent abnormal
returns that differ from zero and are predictable in direction.

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 Momentum effect

Momentum effect

Momentum or trending effects, in which future price behavior correlates with that of the recent
past. Typically in the short term, up to two years, there is a positive correlation, but for longer
periods of two to five years returns are negatively correlated and revert to the mean.

Herding occurs when a group of investors trade on the same side of the market in the same
securities, or when investors ignore their own private information and act as other investors do.

The availability bias in this context is also called the recency effect, which is the tendency to recall
recent events more vividly and give them undue weight.

Regret is the feeling that an opportunity has been missed, and is typically an expression of
hindsight bias.

The disposition effect, which includes an emotional bias to loss aversion, will encourage investors to hold on
to losers.
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 Biases in bubbles and crashes

Bubbles and Crashes

Periods of significant overvaluation or undervaluation can persist for more than one year, rather than rapidly
correcting to fair value;

Bubbles and crashes appear to be panics of buying and selling;

A more objective modern definition specifies periods when a price index for an asset class trades more than
two standard deviations outside its historic trend.

A crash would also typically be a fall of 30 percent or more in asset prices in a period of several months. Some
bubbles and crashes will reflect rapid changes in economic prospects that investors failed to anticipate.

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 Biases in bubbles and crashes

Investors often exhibit symptoms of overconfidence; overtrading, underestimation of risks,

failure to diversify, and rejection of contradictory information;

The overconfidence: lead to excessive trading and under-estimate the risk involved

Confirmation bias: investors look for evidence that confirms their beliefs and ignore evidence
that contradicts their beliefs

Hindsight bias: in which individuals can reconstruct prior beliefs and deceive themselves that
they are correct more often than they truly are. This bias creates the feeling of “I knew it all
along.”

Regret aversion: an investor does not want to regret missing out on all the gains everyone else
seems to be enjoying
The disposition effect, which includes an emotional bias to loss aversion, will encourage
investors to hold on to losers.
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As a bubble unwinds in the early stages, there can be underreaction that can be caused by
anchoring when investors do not update their beliefs sufficiently.

In crashes, the disposition effect encourages investors to hold on to losers and postpone
regret.

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 Value and Growth

Value and Growth

Value stocks are typically characterized by low price-to earnings ratios, high book-to-market equity,
and low price-to-dividend ratios. Growth stock characteristics are generally the opposite of value
stock characteristics.

There is a circumstance that:

Value stocks historically outperformed growth stocks

Small-capitalization stocks outperformed large-caps

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 Value and Growth - Bias

Value and Growth - Bias

The size and book-to-market effects are not mispricing, are associated with different risk exposures.

The halo effect extends a favorable evaluation of some characteristics to other characteristics.
A company with a good growth record and good previous share price performance might be
seen as a good investment, with higher expected returns than its risk characteristics merit.
This view is a form of representativeness that can lead investors to extrapolate recent past
performance into expected returns.

The home bias anomaly, by which portfolios exhibit a strong bias in favor of domestic securities
in the context of global portfolios.

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