Gostudymock3

Individual Behavioral Biases by Investor Type



We've previously covered how biases get tested on the CFA Level 3 exam, as well as emotional errors and the two types of cognitive biases--belief perseverance and information processing errors.

We've continually stressed that a key part of how this material is tested involves identifying the type of bias from a passage describing an investor.

To that end, it can be helpful to know which types of investors tend to suffer from which types of biases. Basically, it helps narrow the pool of likely correct answers before you even read anything else. 

We can group participants into 4 main categories:

  • Those who own significant company stock
  • Defined contribution plan investors
  • Retail investors
  • Professional investors

Let's cover the errors each tend to make one at a time.

Owning Company Stock & Behavioral Biases

There's a lot of errors that come up when you own company stock. The main issue here is that employees tend to over-concentrate in the stock of their employer because it's familiar or because they think they can influence the outcome etc (illusion of control).

The main risk of this is that if you over-concentrate in the place that you work, you're not treating both your financial capital and your human capital in a holistic portfolio way (human capital here is defined as the sum of your current earnings and future earnings potential).

Why do Employees over-concentrate in employer stock?

  • Familiarity and overconfidence
  • Framing - Stock compensation is seen as recommendation of the quality of the stock
  • Representativeness - Past performance as an indicator of future performance)
  • Loyalty
  • Financial or tax incentives

Biases of Defined Contribution Plan Participants

One of the things DC plan participants do is make a decision once and then stick with it, i.e. they suffer from status quo bias.

The other thing that they might suffer from is this concept of naive diversification. And naive diversification is really dividing your contributions equally amongst all your investment options, and you don't really think about what's inside of those investment options. So if your 401() or whaterver has five options, you might put 20% in each of those five. So this is sort of a 1/n strategy, where n is the # of investment options you have. So an equal amount of money into each available option. And that's "diversifying." But naïve diversification is a sort of rough, instinctive division of a portfolio. It has nothing to do with sophisticated mathematical models or considering correlation and standard deviation of risk and just thinking about it in sort of modern portfolio theory terms.

Behavioral Biases of Retail Clients

Retail clients are individual investors. This is most of us, at least in our nonprofessional lives.

One mistake retail investors are guilty of is over-trading, either as a result of overconfidence or because of loss aversion and the disposition effect of selling winners too soon and holding losers too long.

As individuals we also often suffer from home bias, which is a geographic bias towards our country. So we might hold too much of our assets in the economy or stocks of our particular country. 

Common Biases Displayed by Analysts and Professionals

The material on the CFA Level III exam about being a portfolio manager and operating as an investment professional. So if you were an analyst, you need to be really conscious of biases that you might have.

Groupthink

The first one as an individual is falling into groupthink. Groupthink is about being part of a committee or group that thinks the same way. This has traditionally led to poor, poor decisions by investment committees, because there's no feedback or disagreement to hone the thesis.

To solve for it, obviously, seek diversity, make sure that the people in the room are willing and able to talk to one another and disagree and actively solicit opinions. We've all had meetings where we know someone has good ideas but they don't speak up. So you need to actively ensure that their voice is heard.

Overconfidence

Another one that we've covered ad nauseam is overconfidence. For analysts this is often a result of "Hey, I've studied Google for 20 years. I know everything there is to know about this stock, its earnings, its momentum, its trends, its business.” And as a result, this analyst might create these narrow confidence intervals to estimate earnings. This false confidence around an elaborate model might mean they have pretty defined ideas about where the stock is going to go. 

Framing Bias

Analysts can also be guilty of processing information differently depending on how they receive it. So the most common example cited by the CFA L3 material is an earnings call scenario in which management presents good information first and really drills down into this set of information and only then turn to the more negative pieces of the company’s businesses.[1] This can frame the way an analyst thinks about a company because of the availability of that information, etc. 

To mitigate this framing bias an analyst should try, at least to the best of their ability, to rely strictly on the quantitative data in the reporting rather than the tone of voice or the way of presentation or order of the information and so on. 

A Hodgepodge of other Testable Behavioral Biases on CFA L3

One behavioral phenomenon that L3 has tested before is gambler's fallacy. This is all about thinking that there's going to be a reversal to a long-term average more than that reversal actually happens. The classic example of gamblers fallacy is if you flip a coin 10, 20, 30 times and it's all heads, you're probably somehow, in a way, going to think that the odds of the next toss coming up tails are increasing. But that's not true, right? It's independent. So it goes back to the probability and the quantitative section of Level I. But that's gambler's fallacy in a nutshell.
 
So analysts' errors and how do we get rid of them or mitigate them in general. We wanna incorporate frameworks that we know work, so probability and a structured process around that. Analysts definitely should seek out prompt feedback on their estimates, on their performance. As organizations, we wanna reward accuracy for those analysts, not sensationalism or anything like that. We as analysts have a responsibility to record our rationale, understand our trades, know what we're doing, and go back and look at that, right, so that we can overcome some of the things that lead us to be overconfident or whatever is affecting our ability to be real pros.

Summary
Okay, so wrapping it all up, we've got emotional errors, and cognitive errors. They're all important. Then we've got these classifications broken down into the investor types most likely to exhibit them.

For the CFA level 3 exam all of this boils down to can you read a passage? Can you see what's going on? Can you identify the particular bias at play? Do you understand which bucket it falls into? Can you talk about its significance? One, two sentences, right? We're not talking huge essays here. So you're gonna circle or write in, okay, this investor is exhibiting overconfidence because of the fact that they're over-trading. They think x, y and z, and the impact is y.
 

[1] One thing to note, right, the reason management presents information that way can be related to the fact that their compensation's tied to the operating results that they're actually reporting on.