Portfolio Management

Unit – IISession No. 10

Topic: Investor Characteristics

Session Plan• Recap the Previous Session• What is Traditional Finance?• What is Behavioral Finance?• What is personality typing?• Summarizing and Q & A

• What are the fundamental factors influencing the investors characters?

• Why “Self-made” investors may have greater familiarity with risk taking?

• How an individual differentiate the size of Portfolio to meet his future needs?

• Why the investors’ ability to accept risk should gradually decline through his life time?

Recap

Psychological Profiling• Focus on psychological influences process by which an

individual establishes his or her investment preferences. • Individual brings to the investment decision making process

an objective set of – financial circumstances, – goals, and constraints

• Behavioral patterns and personality characteristics often also play an important role in setting individual risk tolerance and return objectives.

• Psychological profiling, sometimes referred to as • Personality typing, • Bridges the differences between traditional finance (economic

analysis of objective financial circumstances).

Psychological Profiling• Traditional Finance• Much of the standard history of economic and financial

theory rests on the philosophy that financial market participants are rational.

• Information-based investors • Objectives that maximize the expected utility of wealth.• In models of traditional, or standard, investment decision

making, investors are assumed to: Exhibit risk aversion - prefer the investment with the lowest volatility Hold rational expectations - forecasts will reflect all relevant

information Practice asset integration - investors choose among risky investments

Psychological Profiling• Behavioral Finance • Individuals approach/behavior in uncertain situations. • In these studies, psychological considerations appear to play an

important role • Guiding investor behavior, especially during periods of stress. • These decision-making models attempt to incorporate the

principles of behavioral finance, in which individual investors are recognized to: Exhibit loss aversion - investors evaluate opportunities in terms of gain

or loss rather than in terms of uncertainty with respect to terminal wealth

Hold biased expectations - misplaced confidence in one’s ability to assess the future

Practice asset segregation - investment choices individually

Psychological Profiling• Personality Typing • Classification of Investors by their personality

dimensions, socioeconomic background, personal experience, and current wealth status.

• Personality typing understand through survey and scenario analysis.

• It helps the investment advisers to better understand the behavioral drivers – individual’s goal-setting, asset allocation, and risk-taking

decisions, Client management

Psychological Profiling• The critical question that must be answered with respect to client

questionnaires is whether the results consistently assign respondents to risk-taking and decision-making styles that explain the respondents’ actual behavior.

• A stratified random sample involves independent sampling from subgroups that, when combined, represent a population’s overall characteristics.

• Results from the sample questions (each question addresses a specific category of investor risk tolerance and decision-making style) are tabulated and used to identify systematic differences in decision-making style and risk tolerance.

• Based on these measures, four investment personality types are established.

• Correlation analysis can be used to assess a questionnaire’s usefulness. By assigning ranks to personality types (1 = Methodical, 2 = Cautious, 3 = Individualistic, 4 = Spontaneous)

Psychological Profiling

Psychological Profiling

Psychological Profiling• Cautious Investors • Cautious investors are generally averse to potential losses.• This aversion may be a consequence of their current financial

situation or of various life experiences, but most exhibit a strong need for financial security.

• Cautious investors usually desire low-volatility investments with little potential for loss of principal.

• Although these individuals generally do not like making their own decisions

• Cautious investors dislike losing even small amounts of money. • They often miss opportunities because of over analysis or fear of

taking action. • Their investment portfolios generally exhibit low turnover and low

volatility.

Psychological Profiling• Methodical Investors • This group relies on ‘‘hard facts.’’ • Methodical investors may intently follow market analysts or

undertake research on trading strategies. • Even when their hard work is rewarded, they typically

remain on a quest for new and better information.• Their reliance on analysis and database histories generally

keeps them from developing emotional attachments to investment positions, and their discipline makes them relatively conservative investors.

Psychological Profiling• Spontaneous Investors • Spontaneous investors are constantly readjusting their

portfolio allocations and holdings. • With every new development in the marketplace, they fear

a negative consequence. • Although spontaneous investors generally acknowledge that

they are not investment experts, they doubt all investment advice and external management decisions.

• Spontaneous investors are quick to make decisions on investment trades and generally are more concerned with missing an investment trend than with their portfolio’s level of risk.

Psychological Profiling• Individualist Investors • This group has a self-assured approach to investing.• Individualists gain information from a variety of sources

and are not averse to devoting the time needed to reconcile conflicting data from their trusted sources.

• They are also not afraid to exhibit investment independence in taking a course of action.

• Individualist investors place a great deal of faith in hard work and insight, and have confidence that their long-term investment objectives will be achieved.

Psychological Profiling

Summarizing Q & A• What is Traditional Finance?• What is the consequence of traditional assumptions

on individual economic behavior? • What is Behavioral finance?• How individuals are taking decisions based on

behavioral finance? • How the personality typing bridges the difference

between traditional finance and behavioral finance?

Team Assignment

The students are asked to prepare a Personality typing questionnaire based on decision making style and risk

tolerance to identify the four different type of investors.