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2022 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

Behavioral Finance and Investment Processes

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Introduction

Much of current economic and financial theory is based on the assumptions that individuals act rationally and consider all available information in the decision-making process. Behavioral finance challenges these assumptions. The relaxing of these assumptions has implications at both the individual and market levels. It is important to note that, at the individual level, all market participants, whether they are less knowledgeable individual investors or experienced money managers, may act irrationally; in other words, all market participants may deviate from the behavior that is assumed in traditional financial theory. Some of these deviations have been identified and categorized as behavioral biases. In addition, individual behavioral biases may be reinforced in a group setting, which further complicates rational investment processes.

This reading focuses on understanding individual investor behavior and how it affects adviser–client relationships and portfolio construction, as well as on the analyst-, committee-, and market-level impact of behavioral biases. Section 2 discusses how investors may be classified by type based on the biases and other behaviors they display and explains the uses and limitations of classifying investors into types. Section 3 discusses how behavioral factors affect adviser–client relationships. Section 4 examines the potential effects of behavioral biases on portfolio construction. Section 5 discusses how behavioral biases affect the work of analysts, looking specifically at their forecasts, and explores remedial actions for analyst biases. Section 6 examines committee decision making and how behavioral biases may be amplified or mitigated in a group setting, and discusses steps to make committees more effective. Section 7 discusses how behavioral finance influences market behavior by examining market anomalies and observed market behavior. A summary and practice problems conclude the reading.

Learning Outcomes

The member should be able to:

  1. explain the uses and limitations of classifying investors into personality types;

  2. discuss how behavioral factors affect adviser–client interactions;

  3. discuss how behavioral factors influence portfolio construction;

  4. explain how behavioral finance can be applied to the process of portfolio construction;

  5. discuss how behavioral factors affect analyst forecasts and recommend remedial actions for analyst biases;

  6. discuss how behavioral factors affect investment committee decision making and recommend techniques for mitigating their effects;

  7. describe how behavioral biases of investors can lead to market characteristics that may not be explained by traditional finance.

Summary

This reading includes suggestions on how to include behavioral considerations in financial decision making. The effects of including behavioral considerations in adviser–client relationships and portfolio construction are discussed. Finally, the reading considers the effect of behavioral factors on analyst forecasts, committee decision making, and market behavior. It is important to remember that all market participants, regardless of expertise, may exhibit behavior that differs from that assumed in traditional finance. Among the points made in this reading are the following:

  • Classifying investors into investor types based on their characteristics, including level of risk tolerance, preferred approach to investing, and behavioral characteristics and biases, is useful for providing insight and financial decision making but should be used with some caution.

  • Adviser–client relations and financial decisions will be more effective and satisfying if behavioral factors are taken into account.

  • Including behavioral factors in portfolio construction may result in a portfolio that is closer to the efficient portfolio of traditional finance, while being easier for the client to understand and accept as suitable. By considering behavioral biases, it is possible to moderate their effects.

  • All market participants, even those with significant knowledge of and experience in finance, may exhibit behavioral biases. Analysts are not immune. Analysts, in general, are prone to overconfidence, representativeness, availability, illusion of control, and hindsight biases. Awareness of their biases and their potential influences can help analysts put in place measures to help moderate the effect of these biases.

  • Analysts interpreting information provided by management should consider and adjust for the biases that analysts and management teams are typically susceptible to, including framing, anchoring and adjustment, availability, and overconfidence. Management biases can affect both the choice of information presented and how it is presented. These may have an effect on the analysis.

  • Committees often have the responsibility for making investment decisions and are subject to behavioral biases. It is important to implement procedures to alleviate the effect of behavioral biases and improve committee decision making.

  • Behavioral finance has the potential to explain some apparent deviations from market efficiency (market anomalies).