The goal of the report is to identify and explore the emotional biases that an investor can display in a hypothetical scenario, in order to better understand the client’s investment behavior and make an appropriate asset allocation choice. The report detects and examines three emotional biases revealed by the client’s responses to the questionnaire. The paper discusses the influence of the biases on the client’s investing decisions and asset allocation preferences. The study goes on to recommend the best course of action for the client to take in order to reduce the impact of biases. Based on the biases, the report’s concluding section indicates the best appropriate asset allocation decision for the client.
Emotional biases can be explained as the change in cognitive and rational decision-making ability because of the influence of certain emotional factors (Lekovi? 2020). Based on the analysis of the responses registered by Mr. Jackson to the questionnaire it can be concluded that the client exhibits Regret aversion bias, Overconfidence bias and Self-control bias. The following sections explains the biases and links the explanations with the observed responses of the client:
To the first question, the customer stated that he wants to retain the stock in his portfolio because he is afraid of regret if the stock price continues to rise after he has sold it. This response confirms the presence of regret aversion bias in the behaviour of the client.
Investors are also compelled to follow the herd and make judgments based on popular investing ideas due to regret aversion bias. The customer does not want to go against the widespread opinion of the superannuation fund that invests in Lion Ltd, which validates the regret aversion bias.
When asked if the global financial crisis could have been foreseen, the customer displayed overconfidence bias by claiming that he could have predicted it. The client’s overconfidence bias is evident in his belief in the past performance of the Australian stock index and his expectation for his portfolio to gain more than 10%. On being asked about his ability to outperform markets the investor overestimated his ability confirming overconfidence bias.
According to the answer to the seventh question, the client chooses to spend most of the money now rather than saving in the superannuation fund, demonstrating indications of self-control bias. Furthermore, the client’s preference to live in the present and purchase a top-of-the-line automobile shows self-control bias.
The following section highlights the impact of above discussed biases on investor’s investment decision making and asset allocation process:
Regret aversion bias – Regret aversion bias leads to an overly conservative portfolio without a little to no exposure to assets which are optimal for the portfolio. Underperformance of risky assets at times are most visible, hence an investor hesitates in buying riskier assets so that when the value of the asset declines, the investor would not feel any regret (Shah and Malik 2021). Avoiding riskier assets and an overly conservative portfolio carries the risk for investor of not meeting long-term goals and an asset liability mismatch. Another element of regret aversion is herd behaviour, which is demonstrated by a client who invests in a stock based on popular opinion (Gupta and Ahmed 2016). Following the herd would provide him with gratification and allow him to convince himself that he is not to fault if others make mistakes.
Overconfidence bias – The client with this bias would be completely confident in his ability to beat the markets on his own, and would take unjustified and harmful risks. The investor would make an investment choice by underestimating the investment’s risk and overestimating the asset’s return potential (Qasim et al 2019). If an investment choice goes well, self-attribution bias, a type of overconfidence bias, would leads the investor to take credit for it while blaming others if the venture fails. The asset allocation of the client would be undiversified or too concentrated as a result. Excessive churning of the portfolio occurs when an overconfident investor buys and sells assets often, resulting in high turnover and trading costs. Even if the client earns profit in his attempt to beat the markets during a bullish market, he would overestimate his ability and start taking unnecessary risks (Bouteska and Regaieg 2018).
Self-control bias – Self control bias can lead the portfolio of the client to be insufficient in meeting the savings needs and long-term goals due to the client favoring current spending over saving for long-term. In case, the portfolio is unable to meet the goals as desired by the investor, the client would resort to taking excessive risks to meet the goals resulting in a volatile portfolio (Ladeira et al 2018). The asset allocation for client would be more focused towards income generating assets like short-term bonds and dividend paying stocks to meet the short-term income needs irrespective of the suitability of those investments (Delaney and Lades 2015).
There are two types of behavioral biases namely Cognitive biases and Emotional biases. Errors arising from cognitive biases involves faulty information processing methods, memory errors, and basic statistical errors and are easier to correct. Emotional biases emerge from an investor’s intuition and impulsive decision-making tendency and are immensely harder to correct as they are based on feelings. The following section lays out few actions that could be taken to mitigate the risks involve with the identified biases:
Regret aversion bias – In order to mitigate this bias, the client needs to be educated to about the benefits of diversification with effective communication regarding the disadvantages of an ultra-conservative portfolio (Ávila et al 2016). The client needs to be made aware of the fact that losing capital in investment is a normal phenomenon and can happen to anyone. The portfolio of the client should be constructed applying the modern portfolio theory concepts of risk and return keeping aside the aspect of gains and losses as suggested by Ms Hart. The client needs to be made aware the of the consequences of not being able to meet the long-term retirement goals.
Overconfidence bias – Ms Hart should advise the client to keep a complete record of trades, including the motive for each trade, to minimize the influence of these biases on the investment portfolio. The customer must compare trading techniques against one another, including both wins and losses, in order to find profitable patterns in the decision-making process. Every two years, the trading records should be evaluated to identify winners and losers, allowing the customer to spot losing investments and track the amount of trading. Ms Hart has to educate the client on the fact that his investing successes were mostly attributable to luck rather than talent.
Self-control bias – Ms Hart should lay out a complete and comprehensive structure of goals and strategies which are clearly defined and explained in an unambiguous manner. This would allow the client to exercise prudence and oversight over his actions and bring discipline. Ms Hart should also prepare a budget for the client to help deter the propensity of the client to overconsume. The advisor should work closely with the client to execute the strategies and plans put in place for optimum results.
The current allocation of Mr. Jackson includes 80 percent of the capital invested in equities, 15 percent of assets invested in bonds and the remaining 5 percent is invested in cash and cash equivalents. The current allocation seems to be concentrated in equities and given the age of the client is overly risky due to a high allocation to equity. Despite the fact that the client often struggles to meet his annual expenses with the current annual income, he tends to invest more capital into risky asset classes like equity.
Emotional biases exhibited by the client in the form of self-control, herd mentality and regret aversion are the major cause of such an asset allocation. Regret aversion bias of the client has compelled him to invest in securities due to the fear of missing out and hold on to investment due to the fear of regret if the price of the security moves up after selling. The overconfidence bias seems to have influenced the investor for such a low investment in bonds as the investors thinks himself of being superior in terms of cognitive abilities, stock selection and market timing. Due to low liquidity needs of the client, investment in cash and cash equivalent securities is less.
In order to achieve an optimal portfolio, the client should follow the advice of Ms Hart who has suggested an asset allocation structure based upon mean-variance optimization portfolio. According, to Ms Hart, the client should reduce his allocation to equity by 25 percent (from 80% to 55%) to avoid the risk of concentration. The bond portfolio allocation should be increased from 15% to 35% to have a stable and regular stream of income in the form of coupon payments. Allocation to cash should also be increased by 5% to a total allocation of 10%.
Out of the total capital allocated in equity, 60% of the capital should be invested in large cap blue chip stocks to avoid risk and the remaining 40% should be divided equally following the Growth at Reasonable Price (GARP) principle (Priyanto 2021). The bond allocation should be divided equally between investment grade corporate bonds and Treasury Inflation Protected Securities (TIPS) to tackle inflation. Cash allocation should be divided between short term treasury bills and fixed deposits.
Conclusion
The primary purpose of these report was to identify, interpret and analyze the behavioral biases present in the conduct of a client based on a hypothetical case study. The client, Mr. Jackson, displayed several emotional biases in his conduct regarding the management of his investment portfolio and decision-making capacity. Emotional biases are defined as a shift in cognitive and rational decision-making capacity caused by emotional circumstances. The biases that were identified, exhibited by the client were regret aversion bias, self-control bias and overconfidence bias. The report examines the impact and consequences of these biases on the investment portfolio and asset allocation decisions undertaken by the client. The regret aversion bias was established on the analysis of the response of the client recorded for the first and second question. The overconfidence bias was judged by analyzing the responses to third, fourth and fifth question where the client displayed over estimation of capabilities in beating the market comprehensively. Self-control bias of the client was evident by his responses to sixth and seventh question which indicated that the client prefers to live in the moment instead of planning for the future and saving. The next section of the report identified issues like concentration of portfolio, disregard of riskiness of assets, incapability of the current portfolio to meet the long-term goals of the client and several others, which cropped up due to the emotional biases displayed by the client. The concluding section of the report suggests an asset allocation which is distinct from the current allocation and is deemed to be appropriate for the client based on the risk tolerance capacity and financial conditions of the client.
References
Ávila, L.A.C.D., Oliveira, A.S.D., Ávila, J.R.D.M.S. and Malaquias, R.F., 2016. Behavioral biases in investors’ decision: studies review from 2006-2015.
Bouteska, A. and Regaieg, B., 2018. Loss aversion, overconfidence of investors and their impact on market performance evidence from the US stock markets. Journal of Economics, Finance and Administrative Science.
Delaney, L. and Lades, L., 2015. Present bias and everyday self-control failures.
Gazel, S., 2015. The regret aversion as an investor bias. International Journal of Business and Management Studies, 4(02), pp.419-424.
Gupta, Y. and Ahmed, S., 2016. The impact of psychological factors on investment decision making of investors: an empirical analysis. EPRA International Journal of Economic and Business Review, 4(11).
Kansal, P. and Singh, S., 2018. Determinants of overconfidence bias in Indian stock market. Qualitative Research in Financial Markets.
Ladeira, W.J., Santini, F.O., Pinto, D.C., Araujo, C.F. and Fleury, F.A., 2018. Self-control today, indulgence tomorrow? How judgment bias and temporal distance influence self-control decisions. Journal of Consumer Marketing.
Lekovi?, M., 2020. Cognitive biases as an integral part of behavioral finance. Economic Themes, 58(1), pp.75-96.
Priyanto, P., 2021. The Value of GARP Investing: Evidence from the Indonesian Stock Exchange. JABE (
Journal Of Accounting And Business Education), 5(2), pp.9-20.
Qasim, M., Hussain, R., Mehboob, I. and Arshad, M., 2019. Impact of herding behavior and overconfidence bias on investors’ decision-making in Pakistan. Accounting, 5(2), pp.81-90.
Riaz, T. and Iqbal, H., 2015. Impact of overconfidence, illusion of control, self control and optimism bias on investors decision making; evidence from developing markets. Research Journal of Finance and Accounting, 6(11), pp.110-116.
Shah, I. and Malik, I.R., 2021. The Impact of Over Confidence, Loss Aversion and Regret Aversion on Investors Trading Frequency: Empirical Evidence of Pakistan Stock Exchange.
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