Archive / Investment Adviser (Level 2) / Behavioural Finance in Practice
nism-series-xb-overconfidence-dilution-risk-management[ INVESTMENT ADVISER (LEVEL 2) ]
A client who turned a small bet on a single stock into a 5X return in three months begins attributing the entire gain to her own skill and wants to significantly increase her allocation to that stock. Per the NISM workbook's discussion of overconfidence and dilution in risk management, what is the central risk the Adviser must guard against here?
[ A ]The client overestimates her own skill relative to luck, since most people rate their own ability well above the 50th percentile, an arithmetical impossibility in aggregate, and may modify her existing asset allocation based on a single, possibly non-repeatable, outcome[ CORRECT ]
[ B ]Home Country Bias
[ C ]Retail Therapy
[ D ]Status Quo Bias
Takeaway
Option A is correct.
Derivation
The NISM workbook notes that 'individuals consider themselves as better than they really are,' with most survey respondents ranking their own performance in the 60th-75th percentile, an aggregate impossibility, and that in investing 'this manifests itself in terms of attributing skill to their bets that have come off,' which 'can lead to overconfidence.' It warns the client 'may be tempted to over-invest in an asset class or security and modify the existing asset allocation,' and that the Adviser's role is to 'stand between the client and her big mistake.' This differs from Home Country Bias, Retail Therapy, and Status Quo Bias, which are separate behaviours covered in the same chapter.
Why the others fail
B — Home Country Bias
This is a preference for only domestically listed securities, which has no connection to attributing a single successful trade to skill.
C — Retail Therapy
This is shopping to relieve emotional stress, which does not involve reallocating a portfolio after an investment success.
D — Status Quo Bias
This is a tendency to avoid making any changes to an existing portfolio at all, which is the opposite of the client's urge here to actively increase her exposure.