Behavioral Finance &

Investment Processes

Classifying Investors into Behavioral

Types
1. Barnwell two-way model
2. Bailard, Biehl and Kaiser five way model
3. the Pompain model

1.Barnwell two-way model

Developed in 1987, Classifies investors into two types Passive
and Active
(i)Passive investors
who have not had to risk their own capital to gain wealth
Wealth attained through steady employment or inheritance or saving
More risk averse and have a great need for security

(i)Active investors

Risk their own capital to gain wealth

Take an active role in investing their own money
Less risk averse than passive investors
Willing to give up security for control over wealth creation

2. Bailard, Biehl and Kaiser five way

model
Developed in 1986, classifies investors along two dimensions
according to how they approach life.
Confidence and method of action

2. Bailard, Biehl and Kaiser five way

model
i.

The Adventurer

Might hold highly concentrated portfolios

Willing to take chances
Likes to make own decisions, unwilling to take advice.
Advisors find them difficult to work with

ii. The Celebrity

Might have opinions but understands limitations
Seeks and takes advice about investing

iii. The individualist

Likes to make own decisions after careful analysis
Good to work with because they listen and process info rationally

2. Bailard, Biehl and Kaiser five way

model
iv. The Guardian
Concerned with the future and protecting assets
May seek the advice of someone they perceive as more knowledgeable
than themselves

v. The Straight Arrow

Average investors
Willing to take increased risk for increased expected return

3. The Pompain behavioral model

Developed in 2008, identifies four behavioral investor
types(BIT)s
Pompain suggests that the advisor go through a 4-step
process to determine investors BIT
1. Interview the investor to determine if he is active / passive
as an indication of risk tolerance
2. Plot the investor on a risk tolerance scale
3. Test for behavioral biases
4. Classify the investor into one of the BITs

3. The Pompain behavioral model

4 BITs ranging from conservative to aggressive investing
i. Passive Preserver
- Low risk tolerance - Emotional bias
- Not willing to risk own capital - Not financially sophisticated
- Hard to advise

ii. Friendly Follower

-

Low to moderate risk tolerance - Cognitive errors

Overestimates risk tolerance
Wants popular investments
For advising more quantitative methods should be used to educate her
on benefits of diversification

3. The Pompain behavioral model

iii. Independent Individualist
-

Active investor
- Cognitive Bias
Willing to risk own capital - Moderate to high risk tolerance
Strong willed - Own research and likes to invest himself
Difficult to advise but willing to listen to sound advice
Best approach to advising is regular education on relevant investment concepts

iv. Active Accumulator

-

Active Investor - Emotional Bias

High tolerance for risk - Likely entrepreneurial background
Deeply involved in investing - Strong willed & Confident
Likes to control the investing process Most difficult BIT to work with
Best course of action is to take control of investment process and not let the investor
control the situation

Limitations on Classifying Investors

into Behavioral Types
Many individuals may exhibit both cognitive and
emotional errors
An individual may display traits of more than one BIT
As investors age they most likely go through behavioral
changes (decreased risk tolerance and more emotional)
Although individuals are of on BIT but have unique
circumstances and psychological traits cant be treated
the same
Individuals tend to act irrationally at unpredictable times

Analyst Forecast & Behavioral

Finance
Research indicates that experts in various fields make
forecasting errors as a result of behavioral biases
It is analysts superior skills at analyzing companies that
makes them vulnerable to forecasting errors.
Understanding weaknesses can help limit the degree of
forecasting inaccuracies

Analyst Forecast & Behavioral

Finance
Three primary behavioral biases that can affect
analysts forecasts:
i.

Overconfidence

ii. The way management presents Info

iii. Biased research

Analyst Behavioral Biases

i. Overconfidence
Analysts subject to:
- Illusion of knowledge bias
- Makes them think their forecasts are more accurate than they
think
- fueled by access to large amounts of data forecast better as
info is more and better than others

- Illusion of control bias

- Can lead analysts to feel that they have all available data
- Analysts feel they have eliminated all risk in the forecasting
model

Analyst Behavioral Biases

i. Overconfidence
Analysts subject to:
- Representativeness
- An analyst judges the probability of a forecast being correct on how
well the available data represent the outcome
- Incorrectly combines 2 probabilities
- Probability that info fits a certain information category
- Probability that the category of info fits the conclusion

- Availability
- An analyst gives undue weight to more recent , readily recalled data
- Being able to quickly recall info, makes the analyst more likely to fit it
with new info and conclusions

Analyst Behavioral Biases

i. Overconfidence
To subconsciously protect their overconfidence, analysts utilize ego
defense mechanisms
- Self-attribution bias
- Analysts take credit for their successes and blame others or external factors for
failures
- Analysts use it to avoid cognitive dissonance associated with having to admit a
mistake

- Hindsight Bias
- Analysts selectively recalls details of the forecast or reshapes it in such a way that
it fits the outcome
- The forecast even though it can be off-target , serves to fuel the analysts
overconfidence
- Leads to future failures

Analyst Behavioral Biases

i. Overconfidence how to avoid it
To mitigate overconfidence, analysts can :
1. Self-calibration :
process of remembering previous forecast more accurately in relation to
how close the forecast was to the actual outcome
Forecasts should be unambiguous and detailed reduces hindsight bias

2. Prompt & Immediate Feedback

Through self evaluation, colleagues and superiors
A structure that awards accuracy

3. Counterargument
Analysts should seek atleast one counterargument supported by evidence
4. Consider sample size

Analyst Behavioral Biases

ii. Influence by Company
Management

The way a companys management frames info can influence how

the analysts interpret and include it in forecasts
Company managers susceptible to behavioral biases themselves
Three cognitive biases usually seen when management reports
company results:
1. Framing
2. Anchoring & Adjustment
3. Availability

Analyst Behavioral Biases

ii. Influence by Company
Management

1. Framing
Refers to a persons inclination to interpret the same info
differently depending on how it is presented

Simply changing the order in which info is presented can

change the recipients interpretation

A typical management report for a company presents

accomplishments first

Analyst Behavioral Biases

ii. Influence by Company
Management
2. Anchoring & Adjustment
-. Being anchored to a previous data point

-. Being influenced by a prior forecast, the analysts are not able

make an appropriate adjustment in their forecast to fully
incorporate new info
-. The way the info is framed combined with anchoring can lead
to over emphasis of positive outcomes in forecast

Analyst Behavioral Biases

ii. Influence by Company
Management
3.
Availability

Refers to the ease with which info is attained or recalled

The enthusiasm with which managers report operating
results and accomplishments makes the info very easily
recalled and thus prominent in analysts mind
Self-attribution bias in management reports result of
compensation structures of management

Management typically receives salary increases and bonuses based

on operating results
Inclined to overstate results as well as the extent to which their
personal actions influenced them

Recalculated earnings , which dont necessarily incorporate

accepted accounting methods

Analyst Behavioral Biases

ii. Influence by Company
Management
Ways of avoiding
Analysts should:

- Focus on quantitative data verifiable and

comparable
- Put less focus on subjective info
- Be certain that info is framed properly
- Recognize appropriate base rates so that data is
properly calibrated

Analyst Behavioral Biases

iii. Analyst Biases in Research
Confirmation Bias
Tendency to view new info as confirmation of an
original forecast
Helps analyst resolve cognitive dissonance by focusing
on confirmation info
Ignores contradictory info
Gamblers Fallacy
Thinking that there will be reversal to the long term
mean more frequently than actually happens

Analyst Behavioral Biases

iii. Analyst Biases in Research
Ways to avoid:
Analysts should:

Use metrics and ratios that allow for comparability to

previous forecasts
Use systematic approach with prepared qs and gather
data before forming any opinions or conclusions
Use a structured process by incorporating new info
sequentially
Seek contrary evidence

Behavioral Finance & market

Behavior
Momentum Effect
A pattern of returns that is correlated with the recent
past
Effect can last up to two years, after which it generally
reverses itself with returns reverting to the mean.
Caused by investors following the lead of others, which
at first is not considered to be irrational
The collective sum of those investors trading in the
same direction results in irrational behavior

Behavioral Finance & market

Behavior
Momentum Effect: Several forms of momentum effect:
Herding:
Investors trade in the same direction or in the same securities
Possibly trade contrary to the info they have available
Herding makes investors comfortable as they are trading with
the consensus of a group
Behavioural biases of
Availability (recent trend is extrapolated into forecast)
Fear of Regret (investor looks back thinking they should have
bought or sold a particular investment fuels a trend-chasing
effect excessive trading short term trends

Behavioral Finance & market

Behavior
Financial bubbles & Crashes
Periods of unusual positive and negative returns caused by panic buying
and selling, neither of which is based on economic fundamentals
(investors believe price wil go up or down)
A bubble or crash is defined as an extended period of prices that are
two standard deviatons from the mean
A crash can also be characterized as fall in asset prices of 30% or more
over a period of several months, whereas bubbles take longer to form
Typically, in a bubble the initial behavior is thought to be rational as investors
trade according to economic changes or expectations
Later investors start to doubt the fundamental value of underlying asset at
which point the behavior becomes irrational

Behavioral Finance & market

Behavior
Financial bubbles & Crashes
Typically, in a bubble the initial behavior is thought to be rational
as investors trade according to economic changes or expectation
Later investors start to doubt the fundamental value of underlying asset at
which point the behavior becomes irrational

In bubbles, investors sometimes exhibit rational behavior

They know theyre in it but dont know where the peak of the bubble is
There are no alternative investments to get into
For investment managers, there could be performance or career incentives
encouraging them to stay invested in the inflated asset class

Behavioral Finance & market

Behavior
Financial bubbles & Crashes
Self-attribution bias
Hindsight bias
Regret aversion
Disposition effect

As the bubble unwinds in the early stages, investors are

anchored to their beliefs causing them to under react
because they are unwilling to accept losses
As the unwinding continues, the disposition effect dominates
as investors hold on to losing stocks in effort to postpone
regret

Examples of market bubbles

The Dutch Tulip Mania (aka Tulipomania) of 1634-1637
Tulip Mania or Tulipomaniawas a speculative bubble in tulip bulbs that took place in the
Netherlands from 1634 to 1637. Tulipomania occurred shortly after the tulip plant was introduced to
Europe from the Ottoman Empire, in present-day Turkey.
The tulip plants rarity and exotic beauty (as compared to plants that were common in Europe at the
time) helped it to find immediate favor within Dutch high society, who cultivated and displayed tulips
as a status symbol.
As tulip prices rose to new heights, speculators began to buy tulip bulbs to flip later on for higher
prices. Very soon, almost all classes of Dutch society were involved in tulip bulb speculation, with
many trading all of their worldly possessions for a single tulip bulb.
When tulip bulb prices became worth the equivalent of tens of thousands of dollars (in current
values), many Dutch tulip speculators became fantastically wealthy.
Alas, tulip bulb prices eventually peaked and soon imploded, bankrupting scores of speculators and
throwing the Netherlands into a mild economic depression that lasted for many years.

Examples of market bubbles

The Dot-com Bubble (Late 1990s)
TheDot-com Bubblewas a speculative bubble in the shares of early internet companies called
Dot-coms.
From the mid to late-1990s, technology company stocks in the Nasdaq stock index soared to
incredible heights,making scores of investors and technology company founders extremely
wealthy. At this time, many people began to believe that technology had led to the creation of a
New Economy where the traditional business cycle and recessions were a thing of the past. These
New Economy beliefs led to excessive risk-taking in business and investments as Dot-com
companies went public (such as the infamous Pets.com and Webvan) even though they had
negative earnings or astronomically high business valuations.
In early 2000, the technology stock bubble crashed spectacularly as the Nasdaq plunged from
5,000 to nearly 1,000 by 2002 and the U.S. economy was hurled into a recession.

Behavioral Finance & market

Behavior
Halo effect:
Investor transfers favourable company attributes into thinking
that the stock is a good buy.
A company with a good record of growth and share price
performance is seen as a good investment with continued high
expected returns
Form of representativeness in which investors extrapolate past
performance into future expected returns

Behavioral Finance & market

Behavior
Home Bias Anomaly:
Investors favor investing in their domestic country as
compared to foreign countries
Also pertains to companies closer to the investor
Bias can be related to a perceived information
advantage or the comfort one feels from being
closer to home office or executives of the company
Investors have a desire to invest in their own
community