Behavioural Finance

• Cognitive Error 可以被correct

  • Based on Faulty cognitive reasoning

  • Stem from basic statistical, information or memory error

  • Better education and advice can correct for the cognitive error

• Emotional Bias 只能适应它

  • based on feelings or emotions

  • stem from impulse or intuition

  • "Adapt to it"

Cognitive Error

• Belief Perseverance: RICCH

• Information Processing: FAMA

Belief Perseverance

• Representativeness Bias: overweight new info, overweights small sample that is less representative

  • Base-rate neglect; Sample-size neglect

• Illusion of Control: people tend to believe that they can control outcomes, but in fact they can not.

  • Believe they can control outcomes / Overstate their influence

  • Overconfidence in trading, fail to adequately diversify

• Conservatism Bias: Slowly update to new info, overweight past info

  • Maintain or slowly update views

  • holding securities too long

• Confirmation Bias (Selection Bias): notice what support their beliefs, ignore what contradict their beliefs 选择看支持他们观点的，忽略反对他们观点的

  • look for positive info, ignore negative info

  • Under diversified / Over-concentrated

• Hindsight Bias (I knew it all along): see past events as having been predicted 觉得自己预测到了未来，但是实际中没有

  • overestimate the degree they predicted an outcome

  • unfairly assess performance and risks

Information Processing

• Framing Bias: people answer questions based on how they are asked (make decision based on description)

  • choose suboptimal investments

  • forcus on short-term price fluctuation and result in excessive trading

  • misidentify risks tolerances

• Anchoring and Adjustment Bias: oversight the anchor / overweight the default information

  • stick too closely to the original estimate

• Mental Accounting: treat one sum of money differently, 把来源不同的钱，在自己脑子里划分不同意义。但实际上都是钱

  • group assets into non-fungible (non-interchangeable) mental accounts

  • neglect opportunities to reduce risk

  • chase income stream

• Availability Bias: based on how easily the outcome comes to mind, to make a decision

  • make decision based on advertising

  • limited investment opportunity set and under-diversity

  • Source 产生availability bias 的原因: retrievability, categorisation, resonance, narrow range of experience

Emotional Bias

• LOSSER

• Loss Aversion Bias: realise gains early and delay recognising losses

  • house money effects: engage in increasingly risky gambles with previous winning

  • disposition effect: hold losers too long and sell winners too quickly

  • Limited upside potential

  • trade excessively and hold riskier portfolio 因为好的都卖了，留着的都是垃圾

  • Initialised by Kahnesman and Tversky (1979) about prospect theory

• Overconfidence Bias: Unwarranted faith in their abilities

  • underestimate risks

  • Trade Excessively

  • Hold poorly diversified portfolio

  • experience lower return than the peers in the market

  • Illusion of Knowledge bias / Self-attribution bias

• Self-Control Bias: deviate from their long term goals to short-term goals 由于不够自律而追求短期目标，而不是长期 (have a strong desire to consume today)

  • save inefficiently for the future

  • accept too much risk to generate higher return

  • cauaw asset allocation imbalanced

• Status Quo Bias: People do nothing instead of making changes 不动，不改变。观念很陈旧，不愿意更新

  • unknowingly maintain portfolios that are inappropriate for their circumstances

  • fail to explore other opportunities

• Endowment Bias: value an asset more when they hold rights to it 对于已有的东西，有感情的东西，看的更重，不愿意卖

  • Fail to sell off certain assets or replace them

  • continue to hold classes that are familiar

  • maintain an inappropriate asset allocation

• Regret-Aversion Bias: Avoid making decisions out of fear that turns out poorly 害怕可能会让人后悔的决定。害怕后悔

  • Error of commission 害怕做错

  • Error of Omission 害怕错过

  • Too Conservative

  • Engage in herding behaviour

Behavioural Finance & Investment Process

Classification of Investors into Types

• Barnewall Two-way Model

  • Passive Investor: accumulate wealth passively

    • Lower risk tolerance

    • the small the economic source, the more passive the investor is

  • Active Investors: actively involved in wealth creation

    • high RT

    • prefer to control own investments

    • if loss of control, RT reduce quickly

• Bilard, Biehl, and Kaiser Five-way Model

  最下面 是 Anxious

  

• Pompian Model (Four-way Model)

  

• The more emotional bias a person is, tell them more emotional things, "big picture", not statistical data.

• For cognitive error exposed investors, tell them reasons

Limitations of Classifying investors into BITs

• Individuals may simultaneously display both emotional biases and cognitive errors.

• Individual might display traits more than one behavioral investor type.

• As investors age(ing), they will most likely go through behavioral changes. 会随年龄增长变

• Even in the same type, individuals should not be treated the same due to their unique circumstances and psychological traits. 每个人都不一样

• Individuals act irrationally at different times and without predictability.

Adviser–Client Relations

• RT (risk tolerance) questionnaires

  • 对 institutional investor 更有效，比 individual

  • 对 cognitive bias 对投资者更有效，对比 emotional 。emotional的都是sb

Portfolio Construction

• Inertia and Default: Status quo

• Naïve Diversification: Regret aversion

• Company Stock: Familiar, overconfidence, Framing, Loyalty effects and status quo

• Excessive Trading: Many biases. (e.g. overconfidence, regret of aversion etc)

• Home Bias: Availability, illusion of control, endowment, and status quo, confirmation.

• Behavioral Portfolio Theory: Mental account bias

Others

• Gamblers’ fallacy: a misunderstanding of probabilities in which people wrongly project reversal to a long-term mean, is a related cognitive bias.

• Hot hand fallacy: people affected by this fallacy wrongly project continuation of a recent trend.

• Social proof: individuals are biased to follow the beliefs of a group.

• Halo effect: extends a favorable evaluation of some characteristics to other characteristics.

• Home bias: portfolios exhibit a strong bias in favor of domestic securities.