Chapter 17: Behavioural Finance in Practice

Table of Contents

Table of Contents

Role of Emotions in goal setting-

Bias Explanation Solution
Role of Emotions in Goal Setting People react differently to the stress and strain of modern life. Adviser’s role lies in understanding these impulses and providing ways to make sure that such behaviours are self-limiting. Make the client conscious that the behaviour is induced by stress. Have a specific budget for indulging in such behaviour.
Retail Therapy A person goes on a shopping or buying binge in order to reduce stress. Make the client conscious that the behaviour is induced by stress. Have a specific budget for indulging in such behaviour. In extreme cases, a separate account can be opened by the client where the budgeted amount is kept and money is spent only from there.
Too many and too frequent transactions The need to do something whereas investing requires long term consistency and patience. The action bias combined with other biases induces clients to have too frequent and too many transactions which has the impact of turning an investment activity into a trading activity. Prime the client in advance with the benefits of patience and long term investing.
Chasing Past Performance Investors invest in last year’s winners. Investing based on past performance is like driving a car by looking in the rear view mirror. A pre-decided asset allocation policy that has upper limits for each asset class makes sure that overexposure to a specific asset class is avoided.
Home Country Bias Most Investors prefer to invest in the securities available in their home countries due to familiarity with the markets and the companies involved as well as the regulatory environment. Get educated on the benefits and opportunities in global investing and, in turn, educate their clients about the same.
Buying Insurance for Tax Saving At least 3 generations of Indians have grown up on a diet of buying insurance for tax saving alone. Appropriate and adequate insurance is the first step of any good financial plan. Highlight the need for adequate pure insurance products and the poor returns from investment cum insurance products as compared to equivalent investments combined with pure insurance products.

Nudging Investors for Better Behavior

Overview:

  • Nudging refers to subtly influencing behavior through positive reinforcement and guidance
  • Investment advisers can use nudges to encourage clients to make better financial decisions

Approach:

  • Lay down advance ground rules that the client buys into
  • Use ground rules as built-in nudges for client behavior
  • Example: set rules for asset re-balancing to encourage profit booking and buying low-priced assets

Role of Investment Adviser in Management of Client Emotions:

Investment advisers have a critical role in managing client emotions and helping them make rational decisions. This involves:

  • Understanding client behavior: Advisers need to have a good understanding of how clients react to market cycles and changes in their financial situation.
  • Setting realistic expectations: Advisers must ensure that clients have realistic expectations about their investments and the returns they can expect to earn.
  • Providing a calming influence: During times of market volatility, advisers need to provide clients with a calming influence and help them avoid making rash decisions.
  • Prioritizing goals: Advisers should help clients prioritize their financial goals and make decisions based on what is most important to them.
  • Providing objective advice: Advisers must provide objective advice to clients, even if it means suggesting alternatives that may be emotionally difficult to accept.

To better understand the client’s priorities and emotions, an investment adviser should conduct regular reviews of their financial situation and goals. This will help the adviser to provide customized advice that is tailored to the client’s needs.

Mock Tests-

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NISM-Series-X-B: Investment Adviser (Level 2) Certification

Chapter 17: Behavioural Finance in Practice

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1. A person who prepares the Will is called a/an

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2. How many parties are required to form a trust?

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3. Which category of biases does mental accounting bias fall under?

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4. Stereotyping Bias in investing is based on

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5. Which is the most basic legal instrument of all estate plans?

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6. According to Prospect Theory, people are risk-averse about gains and risk-seeking about losses.

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7. Overconfidence Bias is characterized by

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8. Choice paralysis is caused by

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9. Framing bias refers to

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10. Prospect theory is related to which bias?

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11. Bounded rationality is a concept introduced by Nobel laureate Herbert Simon.

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12. What is a Probate?

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13. Prospect Theory, introduced by Daniel Kahneman and Amos Tversky, describes how individuals make choices in situations involving risk and evaluate potential losses and gains.

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14. Which bias involves the preference for maintaining the current situation?

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15. Which bias is associated with the Disposition Effect?

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16. Loss Aversion Bias refers to

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17. Which of the following is a characteristic of behavioral finance?

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18. What is the key characteristic of Loss Aversion Bias?

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19. Which bias involves treating money differently based on mental accounts?

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20. Endowment Bias is an emotional bias in which

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21. In standard finance, decision making is rule-driven and consistent under different scenarios.

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22. Which of the following is a key assumption in standard finance theories?

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23. Which category of biases does cognitive errors fall under?

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24. Bounded rationality refers to the cognitive limitation of the mind, where decision making favors an optimal solution.

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25. Monetary losses hurt more than monetary gains according to Prospect Theory.

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26. What is mental accounting bias?

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27. Status Quo Bias is closely linked to

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28. Anchoring bias occurs when

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29. Which bias involves basing decisions on representative characteristics and general perceptions?

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30. A will can be revoked or altered by the testator any number of times. The instrument through which a Will can be altered is known as

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31. What is the common characteristic of emotional biases?

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32. Which bias involves relying on pre-existing information when making decisions?

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33. Choice paralysis is primarily caused by

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34. The real-life behavior demonstrated by investors is far from what is assumed in traditional finance models. Which of the following examples is observed in daily life?

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