BEHAVIORAL FIANCNE AND WEALTH MANAGEMENT AUTHOR : MICHAEL M. POMPiaN BEHAVIORAL FIANCNE AND WEALTH MANAGEMENT AUTHOR : MICHAEL M. POMPiaN
BOOK REVIEW OF :

BOOK REVIEW OF :

PREPARED BY : ASHISH SHARMA
PREPARED BY : ASHISH SHARMA
2014
2014

Behavioral Finance and Wealth Management

Author Information

“Michael M. Pompian, CFA, CFP, is a partner at Mercer Investment Consulting, a firm serving institutional and private wealth clients. Prior to joining Mercer, he was a wealth management advisor with Merrill Lynch and PNC Private Bank, and served on the investment staff of a family office. Pompian is a Chartered Financial Analyst (CFA), a Certified Financial Planner (CFP), and a Certified Trust Financial Advisor (CTFA). He is also a member of the CFA Institute (formerly AIMR) and the New York Society of Security Analysts (NYSSA). He holds a BS in management from the University of New Hampshire and an MBA in finance from Tulane University. Pompian is a regular speaker on the subject of behavioral finance and has published several articles on the subject. He is married with three sons and can be reached at michael.pompian@mercer.com. “
Michael M. Pompian describes various biases which we can see in human beings , also tells about various experiments on human beings in his book “ BEHAVIOURAL FINANCE AND WEALTH MANAGEMENT “ and tells “HOW TO BUILD OPTIMAL PORTFOLIOS THAT ACCOUNTS FOR INVESTOR BIASES “
The book is published by John wiley and sons, inc. ,Hoboken , New jersey. Published simultaneously in Canada. The book was published in the year 2006 .

SUMMARY :
Understanding the use of behavioral finance theory in investing is a important topic these days. Nobel laureate Daniel Kahneman has described financial advising as a prescriptive activity whose main objective should be to guide investors to make decisions that serve their best interests. In this Edition of Behavioral Finance and Wealth Management, Michael Pompian has taken practical approach towards the growing science of behavioral finance, and puts it to use for real investors. He has provided the knowledge of 20 of the most prominent individual investor biases into behaviorally-modified asset allocation decisions. Offering investors and financial advisors a self-help book, Pompian shows how to create investment strategies that leverage the latest cutting edge research into behavioral biases of individual investors. This book Shows investors and financial advisors how to either moderate or adapt to behavioral biases, in order to improve investment results and identifies the best practical allocation for investment portfolios. Using these two sound approaches for guiding investment decision-making, behavioral biases are incorporated into the portfolio management process. “The book uses updated cases studies to show investors and financial advisors how an investor's behavior can be modified to improve investment decision-making . It provides useable methods for creating modified investment portfolios, which may help investors to reach their long term financial goals. “ Book has Increased awareness of biases so that financial decisions and resulting economic outcomes are improved and Offers advice on managing the effects of each bias in order to improve investment results. The author provides a brief history of behavioral finance, through a thorough catalog of noteworthy investor biases, advice on how to deal with these biases, provided various examples and the directions of future research in the field and highly recommends his book because of its straightforward language, which makes it widely accessible and easy to understand.
The book also tells about the implications of each biases , their effects and tells about how to overcome these biases.

VARIOUS BIASES DISCUSSED IN THE BOOK :-
1. OVERCONFIDENCE BIAS : In the basic term Overconfidence means unwarranted faith in one’s reasoning, judgement and cognitive feelings. Overconfidence develops from a cognitive psychological experiments and surveys in which subject’s overestimates their own predictive abilities and the precision of the information which they know. Overconfidence has been called the most “pervasive and potentially catastrophic” of all the cognitive biases to which human beings fall victim. In short we can say that when people think they are smart and have better information than others that’s the point when you can see overconfidence bias in them which normally results in loses.
Overconfident investors overestimate their ability to evaluate a company as a potential investment. As a result, they can become blind to any negative information that might normally indicate a warning sign that either a stock purchase should not take place or a stock that was already purchased should be sold out. Such investors with overconfidence bias can trade excessively believing that they have special knowledge than others. Overconfident investors generally holds undiversified portfolios resulting in more risks
Example : A person who thinks he is a great boxer and who challenges someone who is an amazing fighter to a boxing match. The person who was overconfident and who was mistaken about his actual boxing abilities could end up getting badly defeated in the fight as a result of his overconfidence.

2. Representativeness Bias :
Representativeness bias is a bias used when people makes judgments about the probability of an event under uncertainty. When they come across a new phenomenon which is not consistent with any of their preconstructed classification , they subject it to those classifications anyway, relying on a rough best-fit approximation to determine which category and, thereafter, form the basis for their understanding of the new element. It is the degree to which an event is similar in essential characteristics to its parent population, and reflects the salient features of the process by which it is generated. When people rely on representativeness to make judgments, they are likely to judge wrongly because the fact that something is more representative does not make it more likely.
Example : * 1. Believing that all blondes are dumb * 2. Looking at someone who is wearing glasses and is dressed business-like or formally, then concluding that they are intelligent.

3. Anchoring and Adjustment Bias :
Anchoring is a cognitive bias. It is a term used in psychology to describe the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions. During normal decision making, individuals anchor, or overly rely on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Generally if the anchor is set then there is bias towards that value. Investors tend to make a forecast of the percentage that a particular asset class might rise or fall based on the current level of returns. They tend to stick too closely to their original estimates when new information is learned about a company.
Example : A person looking to buy a used car - they may focus excessively on the odometer reading and the year of the car, and use those criteria as a basis for evaluating the value of the car, rather than considering how well the engine or the transmission is maintained.

4. Cognitive Dissonance Bias :
When newly acquired information conflicts with pre-existing understandings, people often experience mental discomfort which is a psychological phenomenon known as cognitive dissonance. It is the mental stress & discomfort experienced by individual who holds two or more contradictory ideas at the same time. It helps in taking fast decisions when the is more valuable than accuracy. Cognitive dissonance can cause investors to hold loss making securities which they otherwise would have sold because they want to avoid the mental pain associated with admitting that they made a bad decision. The first step in overcoming the negative effects of cognitive dissonance is to recognize and try to abandon such counterproductive coping techniques. . People who can recognize this behavior become much better investors than others. There are three common responses to cognitive dissonance that have negative implications for personal finance and which should be avoided:
1. Modifying beliefs
2. Modifying actions
3. Modifying perceptions of relevant information
Example : An investor decides in advance that he is going to purchase shares of a firm when the price drops to $78 a share. The price is currently at $80 a share. All of a sudden, the company's stock price starts going up. The investor's belief that the stock would be a good buy at $78 seems to be contradicted by the stock's current behavior. The investor decides to buy at $85 instead of $78 to reconcile the cognitive dissonance he is experiencing. This may not be as good of an investment decision, but the investor will rationalize himself into thinking it is, mainly to get rid of his feeling of cognitive dissonance.

5. AVAILABILITY BIAS :
The availability bias is a shortcut method, that allows people to estimate the probability of an outcome based on how familiar that outcome appears in their lives. people not only consider what they recall in making a judgment but also use the ease or difficulty with which that content comes to mind as an additional source of information. Sometimes this bias is beneficial, but the frequencies that events come to mind are usually not accurate reflections of their actual probability in real life . The tendency to overestimate the likelihood of events with greater "availability" in memory, which can be influenced by how recent the memories are or how unusual or emotionally charged they may be.
Example : suppose you were in a car accident later on today. It would be a natural for you to drive more carefully for the next couple of weeks or months; as time passes, however, your driving would return to normal.

6. SELF ATTRIBUTION BIAS :
Attribution bias is a type of cognitive bias. Self-attribution bias occurs when people attribute successful outcomes to their own skill but blame unsuccessful outcomes on bad luck. Self-attribution investors can, after a period of successful investing believe that their success is due to their judgement as investors rather than the factors out of their control. This behaviour can lead to taking on too much risk, as the investors become too confident in their behaviour. Self attribution leads invertors to hear what they want to hear. It can lead investors to keep undiversified portfolios and can make them over confident leading them to loses. Mindful awareness , self compassion is very useful in removing this bias from investors. This bias often leads the investors to invest more than what is wise.
Example : You get an A grade for an essay and you give its credit to your own intelligence and when You get a C grade on an essay you attribute it to your professor for not having explained well what they wanted.

7. ILLUSION OF CONTROL BIAS :
It is a type of cognitive bias. It refers to the tendency of human beings to believe that they can control or influence outcomes which they cannot. for example, various research has demonstrated that people actually cast the dice more vigorously when they are trying to attain a higher number. Here they believe that by throwing dice on their own will give them good/high number on dice. It occurs due to a need to protect self-esteem from the negative consequences of the loss of control. It is a defense mechanism that makes us all feel in control and maintain our self-esteem when we face events that we cannot control. Illusions of control can lead investors to maintain underdiversified portfolios. It adds overconfidence to the investors. Illusion of control bias can cause investors to use limit orders and other such techniques in order to experience a false sense of control over their investments.
Example : you enter the lottery and win millions. You assume that this is a result of how good your lucky numbers are.

8. CONSERVATISM BIAS :
Conservatism bias is a bias in human information processing . Conservatism bias is a mental process in which people cling to their prior views or forecasts at the expense of acknowledging new information. For example, suppose that an investor receives some bad news regarding a company’s earnings and that this news negatively contradicts another earnings estimate issued the previous month. Conservatism bias may cause the investor to underreact to the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information. When conservatism-biased investors react to new information, they often do it so slowly. Investors too often give more attention to forecast outcomes than to new data that actually describes emerging outcomes. Many wealth management practitioners have observed clients who are unable to rationally act on updated information regarding their investments because the clients are stuck on prior beliefs. It is important to note that the conservatism bias may appear to conflict with representativeness bias, but the latter refers to over-reacting to new information, while conservatism bias refers to under-reacting to new information.
Example : suppose that an investor receives some bad news regarding a company’s earnings and that this news negatively contradicts another earnings estimate issued the previous month. Conservatism bias may cause the investor to underreact to the new information, maintaining impressions derived from the previous estimate rather than acting on the updated information.

9. AMBIGUITY AVERSION BIAS :
People don’t like to gamble when there is uncertainty in probability distribution. People prefer the familiar to the unfamiliar. It is increasingly recognized that decision making under uncertainty depends not only on probabilities, but also on psychological factors such as ambiguity. Ambiguous events have a much greater degree of uncertainty. The distinction between ambiguity aversion and risk aversion is important but subtle. Risk aversion comes from a situation where a probability can be assigned to each possible outcome of a situation. Ambiguity aversion applies to a situation when the probabilities of outcomes are unknown. Ambiguity aversion may cause investors to demand high compensation for the risks taken of investing in certain assets.
Example : Suppose that subjects are presented with two boxes, referred to here as Box 1 and Box 2. The subjects are advised that Box 2 contains a total of 100 balls, exactly half of which are white, and half of which are black. Box 1 likewise contains 100 balls, again a mix of white and black, but the proportion of white to black balls in Box 1 is kept secret. Subjects are asked to choose one of the following two options, each of which offers a possible payoff of $100, depending on the colour of the ball drawn at random from the relevant box.
1A. A ball is drawn from Box 1. The subject receives $100 if the ball is white, $0 if the ball is black.
1B. A ball is drawn from Box 2. The subject receives $100 if the ball is white, $0 if the ball is black.
2A. A ball is drawn from Box 1. The subject receives $0 if the ball is white, $100 if the ball is black.
2B. A ball is drawn from Box 2. The subject receives $0 if the ball is white, $100 if the ball is black.

10. ENDOWMENT BIAS :
People who have endowment bias, value an asset more when they hold property rights to it than when they don’t. people give order value to the things whose owner they are. Endowment bias is the phenomenon in which most people would demand a considerably higher price for a product that they own than they would be prepared to pay for it. It is a emotional type of bias. “Endowment bias is described as a mental process in which a differential weight is placed on the value of an object. That value depends on whether one possesses the object and is faced with its loss or whether one does not possess the object and has the potential to gain it. If one loses an object that is part of one’s endowment, then the magnitude of this loss is perceived to be greater than the magnitude of the corresponding gain if the object is newly added to one’s endowment.” Endowment bias influences investors to hold on the securities which they have inherited, apart from the fact whether retaining those securities is financially wise or not.
Example : Participants were given a mug and then offered the chance to sell it or trade it for an equally priced alternative good pens. It was found that participants willingness to accept compensation for the mug once their ownership of the mug had been established was approximately twice as high as their willingness to pay for it.

11. SELF-CONTROL BIAS :
It is a emotional type of bias. It refers to the tendency of human beings to consume today at the expense of saving for tomorrow. Most of this chapter focuses on the savings behaviors of investors and how best to promote self-control in this problematic realm. Self-control bias can cause investors to spend more today at the expense of saving for tomorrow. This behaviour can be problematic for them in respect of there wealth because retirement can come too early for investors before saving enough. This bias can cause failure to there retirement plans and can cause asset allocation imbalance problems. It may cause investors to forget the basic financial principles. It may arise due to lack of planning, lack of spending habits , lack of discipline etc.
Example : A student desiring an “A” grade in history class might forgo a lively party to study at the library. A person who is overweight may forgo ice creams, or products of cheese in order to control his/her weight.

12. OPTIMISM BIAS :
This kind of bias also falls in the category of emotional type of bias. Optimism bias is a kind of bias that causes a person to believe that they are at less risk of experiencing a negative event as compared to others. Many optimistic investors believe that bad investments will not happen to them and this kind of behaviour leads them to losses and problems. Being optimistic is good upto a limit but after that limit is crossed it turns on to the person with negative effect. Optimism bias can cause investors to think they are above average investors maybe because of their social skills or maybe other factors. Optimism bias can cause investors to invest near their geographic region as they believe maybe they know there locality much well than others. Optimism bias can cause investors to overload themselves with company stock because optimism biases can make them think that other companies will give less returns than their own.
Example : people hugely underestimate their chances of losing their job or being diagnosed with cancer.

13. MENTAL ACCOUNTING BIAS :
Mental accounting bias is a cognitive type of bias. Mental accounting refers to the coding, categorization, and evaluation of financial decisions. It refers to the tendency of people to code, categorize, and evaluate economic outcomes by grouping their assets into non interchangeable mental accounts. Mental accounting refers to the tendency for people to separate their money into separate accounts based on a variety of subjective criteria, like the source of the money and intent for each account. Mental accounting bias can cause investors to irrationally distinguish between returns derived from income and those derived from capital appreciation. Mental accounting bias can cause investors to hesitate to sell investments that once generated significant gains but, over time, have fallen in price. It can cause people to imagine that their investments occupy separate accounts which have no logical impact . It is important to note that mental accounting is very common and that nearly everyone is susceptible to this bias in some way or another. Mental accounting can sometimes serve as a benefit rather than as a harmful cognitive mechanism for investors.
Example : people often have a special jar for money or fund set aside for a vacation or a new home, new mobile etc while still carrying substantial credit card debt.

14. CONFIRMATION BIAS :
Confirmation bias is a cognitive type of bias. Confirmation bias is a tendency to search for information in a way which confirms one's preconceptions and leads to statistical errors. In finance, the effects of confirmation bias can be observed almost daily. Investors often fail to see anything negative about investments they have made, even when there are substantial evidence against these investments. Confirmation bias can cause investors to seek out information that confirms their beliefs about an investment that they have made and ignore the information that may contradict their beliefs. This behaviour can leave investors to losses. This bias can cause investors to continue to hold under diversified portfolio which can turn out to be risky later on. In order to overcome this bias investors should first find out whether this bias exist in them or not and then they should look to all the information even if it contradict their information or its against their beliefs.
Example : suppose an investor hears a rumor that a company is on the verge of declaring bankruptcy. Based on that information, the investor is considering selling the stock. When he goes online to read the latest news about the company, he tends to read only the stories that confirm the likely bankruptcy scenario and he misses a story about the new product the company just launched that is expected to perform extremely well. Instead of holding the stock, he sells it at a substantial loss just before it turns around and climbs to an all-time high.

15. HINDSIGHT BIAS :
Hindsight Bias is a type of cognitive bias . it is a kind of bias in which the people who are suffering from this bias tend to believe that they knew the result from the starting even though the result wasn’t predictable at all. Hindsight bias affects future forecasting. The biggest implication which this bias gives investors is that it gives investors a false sense of security when making investment decisions which develops excessive risk taking behaviour, and place people’s portfolios at risk. Hindsight biased investors can unduly fault their money managers when funds perform poorly and vice versa.
So in order to overcome this the advisors should advice their client after finding out this bias in clients.
Example : An individual notices that outside, it’s beginning to look a little bit gray. He says to himself, I bet that it’s going to rain this afternoon. When it actually does rain, the individual tells himself that he was certain that it would when he saw the clouds rolling in earlier.

16. LOSS AVERSION BIAS :
Loss Aversion Bias is a emotional type of bias. People with this kind of bias develops a mentality to avoid the loses as much as possible even if there is a sure shot profits on the other hand. Loss aversion can prevent people from unloading there unprofitable investments, even if there Is very little or no chance for turnaround. Loss aversion causes investors to hold losing investments too long. Loss aversion can cause investors to sell profitable securities too early, in the fear that their profit will start goin down unless they sell them.
Educating clients about an investments risk profile can help them overcoming this bias.
Example : Suppose you make a plan to invest $50,000. You are presented with two alternatives. Which scenario would you rather have?
a. Be assured that I’ll get back my $50,000, at the very least—even if I don’t make any more money.
b. Have a 50 percent chance of getting $70,000 and a 50 percent chance of getting $35,000.

17. RECENCY BIAS :
Recency Bias is a type of cognitive bias. It is a type of bias which causes people to remember or recall the recent events than those which occurred in near past. Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves. Recency bias can cause investors to ignore proper asset allocation. Recency bias can cause investors to ignore fundamental value and leads them to focus only on recent upward price performance which can be disastrous later on.
Example : If a person is asked to recall the names of 30 people that they have just met, they will usually remember the names of the people that they most recently met first. And if we plot the result in a graph paper it wil give us a U shaped curve.

18. REGRET AVERSION BIAS :
Regret Aversion Bias is a emotional type of bias. Regret Aversion Bias can simply be put as the tendency to avoid making decisions due to the fear of experiencing the pain of regrets. Regret aversion leads investors to prefer stocks of good companies, even when an alternative stock has an equal or a higher expected return. Regret aversion can cause investors to hold on to good winning stocks for too long but here is a saying in finance whatever goes up , it comes down too. It causes investors to be too conservative in their investment choices.
Example : suppose that an investor buys stock in a small growth company based only on a friend's recommendation. After six months, the stock falls to 50% of the purchase price, so the investor sells the stock at a loss. To avoid this regret in the future, the investor will ask questions and research any stocks that his friend recommends.

Conversely, say the investor didn't take the friend's recommendation to buy the stock, but the price increased by 50% rather than decreasing. Thus, to avoid the regret of missing out, the investor will be less risk averse and buy any stocks that his friend recommends in the future.

19. FRAMING BIAS :
Framing Bias is a cognitive type of bias. It refers to the tendency of decision makers to respond to various situations differently based on the context in which a choice is presented to them. This bias tells that people react to a particular choice in different ways depending on whether it is presented as a loss or as a gain. Depending on how questions are asked, framing bias can cause investors to communicate responses to questions about risk tolerance that are either conservative or aggressive.
Example : Participants were asked to choose between two treatments for 600 people affected by a deadly disease. Treatment A was predicted to result in 400 deaths, whereas treatment B had a 33% chance that no one would die but a 66% chance that everyone would die. This choice was then presented to participants either with positive framing, i.e. how many people would live, or with negative framing, i.e. how many people would die.
Treatment A was chosen by 72% of participants when it was presented with positive framing ("saves 200 lives") dropping to only 22% when the same choice was presented with negative framing ("400 people will die").

20. STATUS QUO BIAS :
Status Quo Bias is a emotional type of bias. “People with this bias tend to be biased towards doing nothing or maintaining their current or previous decision.” Status quo bias causes investors to hold securities with which they feel familiar or of which they are emotionally fond. Status quo bias can cause investors to hold securities which are inherited or purchased.
Example: Your investment portfolio contains a certain high-quality corporate bond. The bond has been providing income for you, and you are happy with it. Your financial advisor analyzes your bond holdings and recommends that you replace the corporate bond with a municipal bond of comparable quality, estimating that you will ob- tain a better return after capital gains taxes and fees.
Now if you will still hold on to the corporate bond then means you are suffering from status quo bias.

CRITICS
This book Behavioral Finance and Wealth Management tells about how to build optimal portfolios that account for Investor biases. The book is written with easy language although it can be much better if some simple terms are used as that is more easy to understand. Overall it’s a great book to read which helps to understand various biases which are prevailing in investors these days which are causing them loses, and tells about how to overcome these biases and have safe investments. The best thing is that the author has included several examples with real world applications and examples of daily life which makes the understanding of these biases more easy. Its hard to find any problem in the book but still some more simple wordings would be great. Through this book i have came to know about the biases prevailing in me and with the help of this book hopefully i will overcome them soon.
This book is just a reference for overcoming the biases but doesnot guarantee complete eradication of them as every human being is having different thinking and that’s why it becomes little difficult to apply these solutions on all.
The book can turn up to be a magical book for young entrepreneurs and new investors who will start investing as they can take help from this book for lowering the risk of loses by removing the biases they are having and have good and safe investment leading them to profits and gains.