CFA Level III Review, Behavioral Finance

The material in behavioral finance is historically tested in the morning essay portion. Within the vignette, often within one of the first two portfolio management cases, there will be some information on the advisor or investor that displays a concept or bias. You will then have to identify the bias from a list and justify it with a reason.
Question #4 in last year’s morning section was worth 17 points for 4.7% of your total exam score (click here for the complete morning section and guideline answers).
Question #4A
Most of the points on behavioral questions in past exams have revolved around identifying a bias/error given a client interview. Reading through the curriculum and doing enough practice problems, you will begin to pick up on keywords associated with the terms. These will be the words that tip you the answer on the exam.
Regret aversion, loss aversion and status quo bias are often and easily confused. For status quo, the idea revolves around the lack of action so look for words or ideas like “inactivity” or “no change.” Regret aversion is often signaled with a bad trade or loss in the past leading to fear of more loss, so look for this historical precedent. Loss aversion is focused more on preferences and the utility behind gains and losses.
Question #4B
Mental accounting is one that comes up often in the essays. Look for words like “separate accounts” or “layered-pyramids” and “buckets” to convey the idea that the investor has the bias. Remember, the portfolio should be viewed on a holistic basis or all-together. Keeping your net worth in “separate” accounts does not really change anything.
Anytime you hear someone talk about the ability to control, or influence the performance of their investments directly, it is a tipoff for illusion of control. Consequences are excessive trading and inadequately diversified portfolios.
Question #4C
The answer here is basically two reasons from the list of differences between cognitive errors and emotional biases. Lists of procedures, strengths/weaknesses, differences between methods and applicable situations are the prime material for concept questions across the CFA exams.
Behavioral Finance
This always seemed to me like the lead-in reading to the biases and not that important other than the general idea. Understand the difference between traditional finance and behavioral finance (in traditional finance, individuals are assumed to be rational, risk-averse) as well as the difference between the expected utility and prospect theories. I wouldn’t worry too much about detail here, just get the concepts and move on.
Behavioral Biases
This is almost entirely a list reading which lends itself well to an outline format of notes or flashcards. If you look through old essay exams released by the Institute, you will see that this is the reading that gets questioned the most (many times, it is the only reading questioned).  Focus on the definition of each bias, consequences for a portfolio and how an investor/advisor might overcome it.
Behavioral Finance and Investment Process
Know the limitations of classifying investors into types and the main idea behind how to advise each type. A big part of the behavioral material revolves around how the investor’s type affects their risk tolerance so pay attention to that.
The material on passive and active investors has been around a while. Remember that passive investors are usually the more risk-averse while active investors usually want more control/interaction in the decision-making process.
Understand how naïve diversification and home bias affect portfolio construction. Naïve diversification, often in DC plans is simply allocating an equal sum to each option.
The biases on analyst forecasts and behavioral finance is also important so make sure you study them along with the investor biases.
**We will try to go over as many of the essay questions from previous years as possible during our 21-week plan. You absolutely must work through these essays and study the guideline answers! Practicing with the actual exams from years past is the best way to get ready for the CFA level 3 exam. Posted here are more details on the CFA Level III format and how to study for the essay portion.
‘til next time, happy studyin’
Joseph Hogue, CFA

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