1.12 Incorporating Investor Behaviour.pptx

Chapter 2 Behavioural FInance

1. DISCOVER . LEARN . EMPOWER UNIT-1 – Chapter Name INSTITUTE –University School of Business DEPARTMENT -Management Program Name Course Name: Behavioral Finance and Analytics Course Code: 23BAT756 Chandigarh University, Mohali Incorporating Investor Behaviour into Asset Allocation 1

2. Learning Objectives Foundations of Finance CO Number Title Level CO1 To gain an understanding of the concepts of behavioral finance. Remember   CO2 Analyze psychographic models used in behavioral finance by retail investors for investment decisions Understand   CO3 To analyze the effect of different Behavioural influences on various investment decisions Understand CO 4 Differentiating the different investors' behaviour in Indian Financial Markets using segmentation Analyze CO 5 To evaluate investment decisions by retail investors using emerging trends in financial markets Application Foundations of Finance – Standard and Behavioural

3. Principle I: Moderate Biases in Less-Wealthy Clients; Adapt to Biases in Wealthier Clients A client outliving his or her assets constitutes a far graver investment failure than a client’s inability to amass the greatest possible fortune. If an allocation performs poorly because it conforms, or adapts, too willingly to a client’s biases, then a less-wealthy investor’s standard of living could be seriously jeopardized. The most financially secure clients, however, would likely continue to reside in the 99.9th socioeconomic percentile. In other words, if a biased allocation could put a client’s way of life at risk, moderating the bias is the best response. If only a highly unlikely event such as a market crash could threaten the client’s day-to-day security, then overcoming the potentially suboptimal impact of behavioral bias on portfolio returns becomes a lesser consideration. Adapting is, then, the appropriate course of action.

4. Principle II: Moderate Cognitive Biases; Adapt to Emotional Biases Behavioral biases fall into two broad categories, cognitive and emotional, with both varieties yielding irrational judgments. Because cognitive biases stem from faulty reasoning, better information and advice can often correct them. Conversely, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to rectify. Cognitive biases include heuristics (such as anchoring and adjustment), availability, and representativeness biases. Other cognitive biases include ambiguity aversion, self-attribution, and conservatism. Emotional biases include endowment, loss aversion, and self-control. These will be investigated as well as others in much more detail later on. In some cases, heeding Principles I and II simultaneously yields a blended recommendation.

5. QUANTITATIVE GUIDELINES FOR INCORPORATING BEHAVIORAL FINANCE IN ASSET ALLOCATION 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. The rationale for the 20 percent figure is that most investment policy statements permit discretionary asset class ranges of 10 percent in either direction.

6. QUANTITATIVE GUIDELINES FOR INCORPORATING BEHAVIORAL FINANCE IN ASSET ALLOCATION 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. Given here is a basic algorithm for determining how sizable an adjustment could be implemented by an advisor without departing too drastically from the pertinent mean-variance-optimized allocation.

7. 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.

8. 11 Assessment Pattern 11 Components HT-1 HT-2 Assignment Surprise Test Business Quiz GD Forum Attendance Scaled Marks Max. Marks 10 10 6 4 4 4 2 40

9. References Textbooks / Reference Books T1 Pompian , M. 2106. Behavioral Finance and Wealth Management.Ist Ed. Wiley: New Jersey. ISBN: 0-471-74517-0. T2 Ackert , L. and Deaves , R. (2115). Behavioral Finance.Ist Ed. Mason, OH: South-Western Cengage Learning. ISBN: 978-0-324-66117-0. R1 Belsky , G. and Gilovich , T. 1999. Why Smart People Make Big Money Mistakes—And How to Correct Them: Lessons from the New Science of Behavioral Economics. 2 nd Ed. Simon & Schuster: New York. ISBN: 0-684-84493-1.