Sample Questions:
1. Over 1,000 subscribers to Morningstar.com completed an online survey that
included the following three questions:
A. How would you rate the return on the stock of your employing firm over the last
five years versus the return of the overall stock market?
B. What is your best estimate of the future return on the stock of your employing
firm over the next five years versus the return of the overall stock market?
C. In your opinion, is the stock of your employing firm more or less likely than the
overall stock market to lose half of its value over the next five years?
The responses show that the answers to questions A and B are highly and positively
correlated. The responses to question C indicate that 83.6% of the respondents
believed that their employing firm’s stock price had an equal or less chance of
losing half of its value compared to the overall market. What psychological biases do these responses suggest? Suggested answer:
The responses to questions A and B demonstrate that investors fall victim to
representativeness bias by extrapolating past performance into the future.
Employees whose employing firm outperformed the market in the past are
predicting it to do so again in the future. Firms that under performed in the stock
market are predicted to continue under performing by their employees. The belief
by employees that their employer’s stock is safer than a diversified portfolio is
consistent with overconfidence. Such overconfidence in their employer is probably
caused by familiarity bias. Employees appear to believe that which is familiar to
them (their company’s stock) is better and less risky than that with which they are
less familiar (other stocks). However, a large amount of firm-specific risk is
diversified away in a carefully selected portfolio like the S&P 500, making the
investment of retirement funds in a widely diversified portfolio far less risky than a
similar investment in a single stock. Only 16.4% of the respondents in the
Morningstar.com survey seem to have realized this. Representativeness bias and
familiarity bias can influence employees to invest heavily in their employer when
that stock has exhibited high historical returns. This can be a disastrous mistake, as
witnessed in the case of Enron, WorldCom, Tyco and other spectacular corporate blowups.
2. Suppose an investor made a spectacular gain on BioSpecifics Technologies Corp.
(BSTC) and subsequently invested the proceeds in a highly speculative
biotechnology startup. What psychological bias might have caused this bet?
Suggested answer: The house money effect (gambler’s fallacy) 3. CASE STUDY
Victoria Jourdan, CFA, works for an investment firm that manages private client
accounts. Both Jourdan and the Inger family reside in a politically stable country
whose currency trades at a fixed exchange rate of 1:1 with the Euro. Real GDP
growth and inflation both average about 3 percent annually, resulting in nominal
annual growth of approximately 6 percent. The country in which the Ingers reside
maintains a flat tax of 25 percent on all personal income and a net capital gains tax
(based on the sale of price-appreciated assets) of 15 percent, with no distinction
between short- and long-term holding periods. Also incorporated into the tax code is
a wealth transfer tax. Any asset transfer between two parties, whether as a gift or
family inheritance, is taxed at the flat rate of 50 percent. The country maintains a
national pension plan, but that plan’s long-term viability has been called into
question because of an unfavorable demographic trend toward older, retirement-
age recipients. Public debate has grown about how to assure the financial security
of future retirees, and among this debate’s chief outcomes has been the creation of
self-contributory, tax-advantaged investment accounts for individuals. Taxpayers
may annually contribute up to €5,000 of after-tax income to a Retirement Saving
Account (RSA), which they then control. RSA investment returns are exempt from
taxation, and participants may begin making tax-free withdrawals of any amount at age 62. The Inger Family
Jourdan has been asked to manage the Inger family account, which is a new
relationship for her firm. Jourdan observes that the Inger family has no stated
investment policy or guidelines, and she arranges for a meeting with Peter and
Hilda Inger, who have been married for 37 years, plus their two children, Christa
and Hans, aged 25 and 30, respectively. Peter, Hilda, and Hans accept the
invitation, but Christa, who currently resides a considerable distance away from her parents, cannot attend.
Peter Inger, 59, is a successful entrepreneur who founded a boat manufacturing
business, IngerMarine, when he was 23 years old. He has worked compulsively to
build the company into a producer of luxury pleasure boats sold worldwide, but he is
now considering a business succession plan and retirement. Peter is eager to
“monetize” his equity stake in IngerMarine and believes he will be able to sell his
company within the next three months. He is already evaluating three separate bids
that indicate probable proceeds, net of taxes on gains, of approximately €55 million
to the Inger family in total. The four Inger family members are the sole IngerMarine
shareholders, and any sale proceeds will accrue to the four family members in
proportion to their percentage ownership in IngerMarine. Peter believes that
everyone in his family is financially secure and wishes to preserve that security; he
recognizes the family’s need for a coherent investment plan. Hilda Inger, 57, comes
from a wealthy family. Since her marriage to Peter, she has been a housewife and
mother to Christa and Hans. Hilda is the beneficiary of a trust established by her
family. Throughout her lifetime, the trust will distribute to her an inflation-indexed
annual payment (currently €75,000), which is taxed as personal income. At her
death, payments will stop, and the trust’s remaining assets will be transferred to a
local charity. Both Hans and Christa are unmarried. Hans currently works as a senior
vice president at IngerMarine and specializes in boat design. Peter has tried to
involve Christa in the family business but she has resisted, instead achieving
moderate recognition and financial success as an artist. Christa has a 5-year-old
son, Jürgen, whom she has chosen to raise alone. The meeting with Peter, Hilda, and
Hans and several telephone discussions with Christa result in the following financial
and personal details for the Inger family.
A distinguishing characteristic of private asset management is the wide range of
personal concerns and preferences that influence the decision-making process Step 1:
Peter Personality: Peter is a perfectionist and likes to maintain control. Now that
he has attained financial success, he seems intent on preserving his wealth. He has
consistently been averse to risk, leverage, and change, both in his company and in
his personal life. IngerMarine has followed policies of low debt and slow growth,
focusing on earnings stability. Like many of his countrymen, Peter holds a portion of
his liquid assets in gold bullion. He believes that gold provides a viable hedge
against catastrophic economic surprises and plans to maintain his current holding
(€500,000) for the foreseeable future. By his own admission, Peter has been slow to
adopt a succession plan—he has always believed that he was the best person to run
IngerMarine. Although he now wants to sell IngerMarine and retire, in the past he
resisted various purchase offers for the company.
Goals: Peter wants to maintain the standard of living that he and Hilda currently
enjoy. In fact, he is actively investigating real estate for a second home, and he
desires that the new home “make a statement.” Hilda hopes the home will
ultimately be featured in a magazine and anticipates that it will cost approximately
€7 million. Peter also wants to get to know his grandson better. Since Jürgen’s birth,
Peter has been estranged from his daughter and he wants to restore the
relationship. He would like to provide financial support for Jürgen’s health- and
education-related expenses, and he plans to begin a gifting program for Jürgen next
year; the gifts will be €15,000 per year, increasing with inflation. Finally, Peter also
has a strong desire to ensure his family’s financial security and feels he will have
accumulated enough wealth through the sale of IngerMarine to realize this goal. He
does not, however, have a formal estate plan for transferring assets to his children and grandchildren. Step 2: Psychological Profiling
A determinant of individual investing that has generally received less focus than
other, more objective influences is the psychological process by which an individual
establishes his or her investment preferences. C Step 3:
Construct an IPS (Investment policy Statement) presents the investor’s financial objectives, the degree of risk
In the case of Peter and Hilda, it appears that their current needs are being met by
Peter’s salary of €500,000. If IngerMarine is sold, they may require a return that
replaces Peter’s salary (a critical objective) and desire a return that will
accommodate their major acquisitions and still leave their children financially
secure (important but less critical objectives).
Peter and Hilda Ingers’ investment objectives are primarily short to intermediate term in nature:
• Support for current lifestyle
• Construction of second home
• Support for Jürgen’s education
Longer term, Peter and Hilda wish to preserve the financial security that their family
currently enjoys. Preserving purchasing power is apparently more important to them than creating further wealth.
Peter’s risk-taking has clearly centered on the business risk of IngerMarine. He has
retained ownership of the company for many years, demonstrating tolerance for
business risks that he may feel he controls. In other areas, including company debt
policy and expansion plans, Peter has shown less willingness to take risk. His
personal debt policy and low volatility investment portfolio also indicate a
conservative approach to finances.