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CHAPTER 18 ASSIGNMENT: Deconstructing Client Bias Questions
Daniel Kahneman and Mark Riepe (Kahneman, D., and M. Riepe, 1998, “Aspects
of investor psychology,” Journal of Portfolio Management 24, (Summer), 52-65)
argue that behavioral finance can make a substantial contribution to client
management:
To advise effectively, advisors must be guided by an accurate picture of the
cognitive and emotional weaknesses of investors that relate to making
investment decisions: their occasional faulty assessment of their own
interests and true wishes, the relevant facts that they tend to ignore, and
the limits of their ability to accept advice and to live with the decisions
that they make.
They go on to propose that a questionnaire be administered whose purpose is to
ascertain individual-specific “cognitive and emotional weaknesses.” One of the
questions was briefly discussed in the chapter. Based on how clients answer
these questions, a number of recommendations to improve the client
management process are made. In this exercise, students are presented with
several questions from their questionnaire and are asked to consider which
behavioral biases are being addressed. Some guidance on these four sample
questions follows.
PERSPECTIVE
1. The point of this question is to see if there is a pronounced tendency
towards hindsight bias, with a high probability leading the advisor to
suspect this bias. A discussion of the dangers of such a bias and the errors
that it leads to is appropriate. It exacerbates overconfidence. Moreover it
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“often turns reasonable gambles into foolish mistakes in the minds of
investors.” The appearance of inevitability may lead to the client being
unfairly blamed.
2. This question gets at non-linear weighting of probabilities, with a
tendency to say that these probability changes do not have equal impact
suggesting non-linear preferences. In particular, most people will that the
first and last have most impact. Since it has been suggested that nonlinear weighting of probabilities may be emotion-driven, this is a potential
problem to keep in mind.
3. This question gets at reference point preferences and integration vs.
segregation. Let’s assume integration. Since A is in the domain of gains,
because of concavity a $10 loss will not hurt much. This is the house
money effect. Little losses after big gains do not risk hitting the lossaversion drop-off. On the other hand, B is in the domain of losses and
because of convexity, a further loss will hurt relatively more. Reference
point preferences may be a driver of the disposition effect. Because of the
power of the disposition effect it may be helpful to discuss the conditions
under which a sale would be made. A process of this type can mitigate
bias.
4. This question gets at how difficult it is for someone to get past a narrow
frame – in other words, to take a long view. The ratio of the average loss
to the average gain is 97%/63% when the horizon is one month/five
years. Did the client realize that there was such a large difference? A key
job of the advisor is to persuade clients that they should take the long
view. As Kahneman and Riepe say, “many clients like to talk long-term
and act short-term.” Again, process is key. It would be wise to agree on a
set of procedures to follow as events (especially market declines) unfold.
©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly available website, in whole or in part.
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STUDENT EXERCISE: QUESTIONS
BEHAVIORAL BIASES of CLIENTS
DESIGNED
to
EXPLORE
the
Suppose you are a financial planner. In a questionnaire you ask among others
the following questions.
1. Recall the latest action of the Fed about which there was speculation in the
press.
On the day before the event, what was your estimate of the
probability that the Fed would act as it did?
2. You are facing a chance for a gain of $20,000. You do not know the exact
probability. Consider the following three pairs of probabilities:
a. The probability is either 0% or 1%.
b. The probability is either 41% or 42%.
c. The probability is either 99% or 100%.
Are the three differences, a, b and c, equally significant to a decisionmaker? Could you order them by their impact on preferences?
3. Investor A owns a block of a stock, which he originally bought at $100 per
share. Investor B owns a block of the same stock for which she paid $200
per share. The value of the stock was $160 per share yesterday, and today
it dropped to $150 per share. Who is more upset?
4. In what percentage of months during the last 71 years did stocks make
money? What was the ratio of the average loss to the average gain? Also
answer the same questions for the percentage of consecutive five-year
periods (starting at the beginning of a month)?
DISCUSSION QUESTIONS
For each question, what bias or suboptimal tendency is being
investigated? What recommendations might be appropriate?
©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or
duplicated, or posted to a publicly available website, in whole or in part.