Behavioral Finance�Unit-2�History of Behavioral Finance & incorporating Investor Behavior into the Asset Allocation process

• The history of behavioral finance as a particular case of the extensive history of behavioral economics is usually told from the perspective of finance and covers only a recent period. This simplified account starts with the discoveries of market anomalies (empirical findings in contradiction with theories of standard finance) in the 1980s and continues with attempts to explain these anomalies with the foundational ideas of behavioral economics proposed by Daniel Kahneman and Amos Tversky

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History of Behavioral Finance

• Behavioral finance has informal origins dating back to Selden's 1912 Psychology of the Stock Market, as well as Fessinger's 1956 study of cognitive dissonance and Pratt's 1964 discussion of risk aversion and the utility function. However, the official start of behavioral finance is arguably 1979, which marks the release of Daniel Kahneman's and Amos Tversky's Prospect Theory: A Study of Decision Making Under Risk.

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• Kahneman and Tversky were shortly thereafter joined by a third so-called founding father, Richard Thaler. In 1980, Thaler published a paper about investors' propensity towards mental accounting, a phenomenon wherein they tended to view their money as being in separate and disparate pools depending on function (retirement fund, vs. emergency fund vs. college fund, etc.). Together, Thaler, Kahneman, and Tversky began a robust body of literature on how people make financial decisions, using psychology to bridge the gap between real life and classic economic theory.

• The work of the three "founding fathers" is frequently referred to as the "biases literature," the study of all the behavioral biases that trip up average and professional investors alike. However, their work is just the tip of the behavioral finance iceberg. An equally important aspect of the field involves identifying and explaining inefficiencies and mispricing such as asset pricing bubbles.

Link between Psychology and Economics

• Economics is a science which is constantly progressing and interacting with other sciences. Studies in the economics literature discuss how people display a behavior in the economic decision- making progress.
• Psychology is a science which explains behavior of people and it cannot be ignored that psychology has a profound effect on economics.
• Human psychology and behaviors show complex structures, stereotyping people as indicating homogeneous behavior is criticized by many academics and researchers.

Link between Psychology and Economics

• Psychology relates the study of the mind and soul. The word is derived from Psycho- meaning mind, soul, or breathe
• Economics is the study of household management, how humans go about in managing their daily lives. Thus, economics implies the study of human behaviors.
• The similarities between psychology and economics is that they both study human beings. The difference between psychology and economics is that economics study how humans behave in markets. Whether it be the computer market, technology market, cosmetic product market. It focuses more on people’s preferences, utility, opportunity costs, etc. given the circumstances.

Modern Behavioral Finance

• By the early twentieth century, neoclassical economics had largely displaced psychology as an influence in economic discourse. In the 1930s and 1950s, however, a number of important events laid the groundwork for the renaissance of behavioral economics. First, the growing field of experimental economics examined theories of individual choice, questioning the theoretical underpinnings of Homo economicus. Some very useful early experiments generated insights that would later inspire key elements of contemporary behavioral finance.

PSYCHOGRAPHIC MODELS USED IN

BEHAVIORAL FINANCE

• Psychographic models are designed to classify individuals according to certain characteristics, tendencies, or behaviors.
• Psychographic classifications are particularly relevant with regard to individual strategy and risk tolerance. An investor’s background and past experiences can play a significant role in decisions made during the asset allocation process.
• If investors fitting specific psychographic profiles are more likely to exhibit specific investor biases, then practitioners can attempt to recognize the relevant telltale behavioral tendencies before investment decisions are made. Hopefully, resulting considerations would yield better investment outcomes.

PSYCHOGRAPHIC MODELS

• Two studies—Barnewall (1987) and Bailard, Biehl, and Kaiser (1986) apply useful models of investor psychographics.
• One of the oldest and most prevalent psychographic investor models,based on the work of Marilyn MacGruder Barnewall, was intended to help investment advisors interface with clients. Barnewall distinguished between two relatively simple investor types: passive investors and active investors.

PSYCHOGRAPHIC MODELS

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• The Bailard, Biehl, and Kaiser (BB&K) model features some principles of the Barnewall model; but by classifying investor personalities along two axes—level of confidence and method of action—it introduces an additional dimension of analysis. Thomas Bailard, David Biehl, and Ronald Kaiser provided a graphic representation of their model

BB&K Five way Model

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PSYCHOGRAPHIC MODELS

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• The Adventurer—People who are willing to put it all on one bet and go for it because they have confidence. They are difficult to advise, because they have their own ideas about investing. They are willing to take risks, and they are volatile clients from an investment counsel

point of view.

• The Celebrity—These people like to be where the action is. They are afraid of being left out. They really do not have their own ideas about investments. They may have their own ideas about other things in life, but not investing. As a result they are the best prey for maximum broker turn

PSYCHOGRAPHIC MODELS

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• The Individualist—These people tend to go their own way and are typified by the small business person or an independent professional, such as a lawyer, CPA, or engineer. These are people who are trying to make their own decisions in life, carefully going about things, having a certain degree of confidence about them, but also being careful, methodical, and analytical.
• The Guardian—Typically as people get older and begin considering retirement, they approach this personality profile. They are careful and a little bit worried about their money. They recognize that they face a limited earning time span and have to preserve their assets.

Incorporating Investor Behavior

into the Asset Allocation Process

• Practical applications for investors and advisors. This establishes a basic framework for integrating behavioral finance insights into portfolio structure.
• Many private-client advisors, as well as sophisticated investors, have an incentive to learn coping mechanisms that might curb such systematic miscalculations.
• The overview of behavioral finance research suggests that this grow ing field is ideally positioned to assist these real-world economic actors.

Incorporating Investor Behavior

into the Asset Allocation Process

• A few of the biases identified in behavioral finance research today are common considerations impacting asset allocation. Why does behavioral finance remain underutilized in the mainstream of wealth management?
• Practitioners are often vexed by their clients’ decision-making processes when it comes to structuring investment portfolios.

Incorporating Investor Behavior

into the Asset Allocation Process

• Many advisors, when designing a standard asset allocation program with a client, first administer a risk tolerance questionnaire, then discuss the client’s financial goals and constraints, and finally recommend the output of a mean-variance optimization. Less than- optimal outcomes are often a result of this process because the client’s interests and objectives may not be fully accounted for.
• According to Kahneman and Riepe, financial advising is “a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interest.

QUANTITATIVE GUIDELINES FOR INCORPORATING

• To override the mean-variance optimizer is to depart from the strictly rational portfolio. The following is a recommended method for calculating the magnitude of an acceptable discretionary deviation from default of the mean-variance output allocation. Barring extensive client consultation, a behaviorally adjusted allocation should not stray more than 20 percent from the mean-variance-optimized allocation.

QUANTITATIVE GUIDELINES FOR INCORPORATING

• For example, if a prototype “balanced” portfolio comprises 60 percent equities and 40 percent fixed-income instruments, a practitioner could make routine discretionary adjustments resulting in a 50 to 70 percent equities composition and a 30 to 50 percent fixed-income composition.

Method for Determining Appropriate Deviations from the Rational Portfolio

1. Subtract each bias-adjusted allocation from the mean-variance output.

2. Divide each mean-variance output by the difference obtained in Step 1.Take the absolute value.

3. Weight each percentage change by the mean-variance output base. Sum to determine bias adjustment factor.

Thank You