18 RELATE TO BEHAVIORAL FINANCE. KRISTA DUCHENE, CFA, IS...

Questions 13-18 relate to Behavioral Finance.

Krista Duchene, CFA, is an investment advisor for U.S. clients. Below, she summarizes some

recent conversations with her clients.

Jonathan: Jonathan faces mandatory retirement from his unionized job in five years. He has a

relatively small portfolio and will be highly dependent on it in retirement. His only other

asset will be a modest pension. He wants to avoid all international equities in his portfolio

because he read in a few online news stories that many of them have performed poorly in the

past year, despite having performed well for many years before that. Jonathan's portfolio

consists primarily of investment grade bonds that he inherited from his father. He feels that

his father was a knowledgeable investor, so it will be good to hold the bonds. Duchene plans

to apply behaviorally modified asset allocation (BMAA) to Jonathan's situation.

Seth: Seth attended his bachelor party in Las Vegas last week where he gambled and lost

$5,000. Afraid to come home and share the news with his future spouse, he accepted a

proposal with a 50% chance of losing another $5,100 (therefore, losing $10,100 in total) or a

50% chance of winning $5,000 (therefore, losing $0 in total). Being sure his luck would turn,

he won and ended up breaking even overall.

Leah: Leah played a coin tossing game with her son. They tossed a quarter 10 times and it

came up heads every time. Given that the long-term mean must be 50% heads and 50% tails,

Leah said that the probability of tails turning up on the 11th loss is much more likely than

heads.

Micah: After careful analysis, Micah purchased 200 shares of Ruby Corp. (Ruby) several

months ago at $25 per share. The share price fell shortly thereafter due to an unexpected anti-

trust court ruling that increased competition in Ruby's industry. The current share price is $20

and reliable analyst reports suggest that price properly reflects the new situation. Micah says

he may consider selling his shares when the price rises above $25.

Stacey: Stacey owns 6% of the outstanding voting common stock of a private company. She

has no involvement in the company and has considered selling the shares in the past but has

not found the time to do so. Also, because Stacey is independently wealthy, she would have

no need for the funds anyways.

...

In applying BMAA to Jonathan's situation and his desire to avoid international equity and

hold the bonds, the most appropriate action would be to:

A) mitigate both his requests and have him invest in international equity and sell the investment

grade bonds.

B) accommodate his request to hold the investment grade bonds.

C) accommodate his request not to invest in international equities.

Jonathan has relatively low wealth and high standard of living risk (SLR), suggesting we

mitigate (change his behavior). But he is also emotional and we will likely have to

accommodate some of his biases. The desire to hold the investment grade bonds his father

bought is an emotional (endowment) bias, but it makes sense that he retains significant fixed

income, given his lower overall risk tolerance and the fact that he is approaching retirement.

We can more reasonably accommodate that bias and retain the bonds. Totally avoiding

international equity ignores the potential to lower his portfolio risk through diversification as

well as potentially improve his return. Both are important given his significant SLR. It makes

more sense to work with him and mitigate that bias.

For Further Reference:

Study Session 3, LOS 6.a, b, c, d

SchweserNotes: Book 1 p.108, 109

CFA Program Curriculum: Vol.2 p.51, 52, 81

Question #14 of 60

Seth's behavior in accepting the 50/50 proposal is best described as:

A) risk averse.

B) risk neutral.

C) risk seeking.

The loss that has already occurred, cannot be changed, and should not rationally affect his

next decision. The proposal has an expected payoff of losing $50 (50% chance of making

$5,000 and 50% chance of losing $5,100) but the payoff is clearly uncertain. A risk averse

investor would not accept the proposal. A risk averse investor would not even accept a fair

wager with an expected 0 payoff. Accepting a negative payoff event is risk seeking. Seth is so

averse to emotionally accepting he has already lost 5,000, he will take a proposal with a

negative payoff.

Study Session 3, LOS 5.a

SchweserNotes: Book 1 p.79

CFA Program Curriculum: Vol.2 p.7

Question #15 of 60

Leah's description of the coin toss is best described by which of the following cognitive

errors?

A) Anchoring and adjustment bias.

B) Confirmation bias.

C) Gambler's fallacy.

Leah's description of the coin toss is an example of gambler's fallacy; in this case a mistaken

belief that reversal to the mean dictates that the previous coin flips affect the next outcome.

With a coin, the next and every flip is independent of all other flips and a 50/50 proposition.

Anchoring and adjustment refers to being "anchored" to a previous data point. Being

influenced by (anchored to) the previous forecast, the individual is not able to fully

incorporate or make an appropriate adjustment in her forecast to fully incorporate the effect

of new information. It is not the same as inaccurately extrapolating past data into the future.

Confirmation bias refers to the tendency to view new information as confirmation of an

original forecast.

Study Session 3, LOS 7.f

SchweserNotes: Book 1 p.139

CFA Program Curriculum: Vol.2 p.137

Question #16 of 60

Which bias best describes Micah's actions with regard to his holdings of Ruby shares?

C) Conservatism bias.

Micah is clearly anchored to the original purchase price of 25, so the behavior is most like

anchoring and adjustment. There are also elements of conservatism, forming an initial

rational view and then not updating it; as well as confirmation, ignoring new analyst reports

that the current price is fair. However, Micah's situation is more specific in that he is

"anchored" to his $25 initial purchase price.

Study Session 3, LOS 6.a, b

CFA Program Curriculum: Vol.2 p.51, 52

Question #17 of 60

Which bias is Stacey most likely exhibiting?

A) Endowment bias.

B) Regret aversion bias.

C) Status quo bias.

Status quo bias, endowment bias, and regret aversion bias are very closely related. However,

status quo is maintaining a choice out of inertia, which is exactly what Stacey is doing.

In contrast, endowment bias arises when some intangible emotional value is assigned to a

holding, perhaps because it was inherited. That may well be true, but the facts do not

specifically tell us that. Regret aversion bias is the fear of making a change and having it go

badly, so the thought is that by doing nothing, one will never be responsible.

Question #18 of 60

Which of the following models least likely assumes that investors satisfice rather than

maximize utility?

A) Behavioral asset pricing.

B) Behavioral portfolio theory.

C) Adaptive markets hypothesis.

The behavioral asset pricing model adds a sentiment premium to the discount rate of the

traditional capital asset pricing model; the required return on an asset is the risk-free rate, plus

a fundamental risk premium, plus a sentiment premium. There is nothing in the behavioral

asset pricing model that mentions satisficing.

The adaptive markets hypothesis (AMH) assumes successful market participants apply

heuristics until they no longer work and then adjust them accordingly. In other words, success

in the market is an evolutionary process. Those who do not or cannot adapt do not survive.

AMH specifically assumes that investors satisfice rather than maximize utility.

Holding a well-diversified portfolio as prescribed by traditional finance will maximize utility

in theory. With behavioral portfolio theory, individuals construct a portfolio by layers. Each

layer reflects a different expected return and risk. The end result does not maximize utility in

theory, so there is an element of satisficing occurring. Satisfice is described as investors

gathering what they consider to be an adequate amount of information and apply heuristics to

arrive at an acceptable decision (i.e., behavioral portfolio theory). The investor does not

necessarily make the theoretically optimal decision from a traditional finance perspective.

Question #19 of 60