familiarity with matters relating to the management of money, not just prudence.
Prudent Investor rule: This is a modified version of Prudent Man Rule in that it views asset allocation
from a portfolio context. An asset (like derivatives) may be too risky to invest if considered on a stand-
alone basis but can provide diversification benefits if viewed in a portfolio context.
Life insurance companies' RETURN objective : APEG
(Actuarial + Positive interest rate spread + Enhance Margin + Growth Surplus)
An investor whose decisions are impacted by mental accounting will look at investments as separate,
focusing on the risk of investments in isolation.
According to behavioral finance, expert forecasters are overconfident in their forecasting ability due to
cognitive dissonance.
Cognitive dissonance states that individuals will avoid information (reflecting what has been actually
experienced) that is in disagreement (dissonance) with the individual’s perceived ability of himself or
herself. As a result, experts will have limited recollection of their failures.
Frame dependence refers to investors' tendency to frame their tolerance on the current direction of
the market or in the context of the information received rather than on its own merits.
Anchoring refers to the inability to fully incorporate (adjust) the impact of new information on
projections.
Representativeness can cause investors’ perceptions to be based upon current or historical information
rather than unbiased expectations resulting in overpriced “winners” underperforming and underpriced
“losers” outperforming as prices return to their intrinsic values.
If someone developed her investment style through trial and error, learning from her own mistakes.
This is a sign of heuristic-driven bias.
Behavioral finance assumes that:
1.investors are loss averse, which means they prefer uncertain losses to certain losses.
2.investors exhibit biased expectations, due to overconfidence in their ability to forecast the future.
3.investors construct portfolios via asset segregation, meaning that they tend to focus on an asset’s
individual investment features versus its impact on the overall portfolio position
By admitting his mistake but reiterating other projections, one used the "single predictor" defense.
Feeling that they should spread out their risk, but not knowing how leads to the 1/n diversification
heuristic. Often times, participants will only have a rough understanding of the effects of correlation
and diversification and will simply divide their assets equally over the investment options in the plan in
an attempt diversify their portfolio.
DC participants tend to hold excess stock of the company they work for due to familiarity and a
perceived endorsement by management.
The endorsement effect refers to the misconception that by offering an investment as an alternative,
the sponsor is implicitly endorsing it as a good investment.
Note that the status quo bias refers to a lack of action on the part of the participant. Also note that
putting too much in company stock would be an example of an investor being “boundedly selfish” in
that there does not seem to be a determination if the investment would be in the investor’s best
interests.
Trial and error and experimentation are heuristic learning processes. Heuristic learners pick up
information simply, through their own efforts or from sources simple to access. They don't do research.
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