Mr. James (Mr. J) is a single, 58 year old, hard-working, international corporate lawyer (an employee of a large multinational company). He earns a salary of RM600,000 annually. He has residence in both London and New York and generally lives within his annual income net of taxes. He occasionally spends more than his net income, but in other years he saves and invests. His current portfolio is worth approximately RM3,500,000. It reached his value primarily because of some successful high risk oil and technology investments as well as stock options granted by his employer. Mr J has no plans for marriage or children. He had a mild heart attack last year, but he has made a full recovery. His primary financial goal is to retire comfortably at age 65 with a reduced spending level of RM150,000 and to bequeath any assets remaining at his death to his alma mater, Oxford University. Mr. Js financial adviser, Mr Palm Mall, has been working with Mr. J for less than a year. During that time, Mall has proposed a comprehensive financial plan. Despite Malls recommendations, however, Mr. Js asset allocation has remained the same at nearly 80 percent equities, with 40 percent in his employing companys publicly traded stock. Still, Mall has developed a good working relationship with Mr. J. Mall believes that Mr. J is a well-grounded, fairly rational person, but he also believes that Mr. J has some behavioral issues to address. In Malls view, the most important issue is that Mr. J has not taken action yet on the new, more conservative allocation that Mall proposed months ago of 60 percent stocks, 30 percent bonds, and 10 percent cash. Mall worries about the lack of diversification in Mr. Js portfolio. Malls concern us that a severe downward market fluctuation or drop in Mr. Js employing companys stock may cause him to sell assets irrationally, affecting his long-term financial plan. Malls financial plan demonstrates that even with a somewhat less aggressive portfolio, Mr. J could still meet his primary financial objective if he could save just RM25,000 annually. Mall believes that one of the issues is that Mr. J thinks of himself as a very savvy investor because of some risky bets that worked out well for him in the past. Mall suspects that Mr. J hasnt changed his allocation because he thinks Malls allocations recommendation is too conservative. Mall also notices that Mr. J constantly worries about missing out on hot stocks that go up because he was not aggressive enough. Mall decides that the appropriate course of action is to Mr. J to take a behavioral bias diagnostic questionnaire. When Mall gets the answers to the

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questionnaire, he decides to delve further into three biases: regret aversion, overconfidence, and self-control. Mall asks Mr. J further questions on these three biases. Regret-Aversion Diagnostic Test Question 1 Suppose you make an investment in Stock ABC, and over the next six months, ABC appreciates by your target of 15 percent. You contemplate selling but then come across an item in the Financial Times that rehashes the companys recent successes and also sparks new optimism. You wonder whether ABC could climb even higher. Which answer describes your likeliest response given ABCs recent performance and the FT article? Answer: I think Ill hold off and wait to see what happens. Id really kick myself if I sold now and ABC continued to go up. Question 2 Suppose you have decided to invest RM10,000 in one individual company stock, and you have narrowed your choice down to two companies: Blue, Inc., and Red, Inc. Blue is a well-followed, eminently established company whose shareholders include many large pension funds. Red is newer but has performed well; it has not garnered that same kind of public profile as Blue, and it has few well-known investors. According to your calculations, both stocks are expected to have equal risk and return payoffs. Which answer most closely matches your thought process in this situation? Answer: I will most likely invest in Blue because if I invested in Red and my investment failed, I would feel foolish. Few well-known investors backed Red, and I would really regret going against their informed consensus only to discover that I was wrong. Overconfidence Bias Diagnostic Question 1 How easy do you think it was to predict the collapse of the housing market in the United States in 2007-2008? Answer: Somewhat easy Question 2 Assume that from 1926 through 2006, the compound annual return for equities was 10 percent. In any given year, what returns do you expect your equity investments to produce? Answer: Well above 10 percent

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Question 3 How much ability do you believe you have in picking investments that will outperform the market? Answer: A fair amount of ability. Self-Control Bias Diagnostic Question 1 Suppose that you are in need of a new automobile. You have been driving your current car for seven years, and its time for a change. Which of the following approaches are you most likely to take? Answer: When it comes to cars, I like to indulge myself. Id probably splurge on a top-of-the-line model and select most or all available luxury options. Even if I must purchase this car at the expense of saving money, for the long term, I believe that its vital to live in the moment. This car is simply my way of living in the moment. Question 2 How would you characterize your retirement savings patterns? Answer: I hardly ever save for retirement. Spend most of my disposable income, so very little remains available for savings.

Through this process, Mall finds that Mr. J is indeed susceptible to the following emotional biases: Regret-aversion bias (the tendency to avoid making a decision for fear the decision may cause regret later). Overconfidence bias (the tendency to overestimate ones investment savvy). Self-control bias (the tendency to spend today rather than save for tomorrow). As part of the original financial planning process, Mall administered a risk tolerance questionnaire to Mr. J for the purpose of generating a mean variance optimization portfolio recommendations. When Mall generated the optimization recommendation, Mr. Js proposed asset allocation was 60 percent stocks, 30 percent bonds, and 10 percent cash. Malls job is now to answer the following three questions: 1. What effect do Mr. Js biases have on the asset allocation decision? (10 marks) 2. Should Mall moderate or adapt to Mr. Js biases? (10 marks) 3. What is an appropriate behaviorally modified asset allocation for Mr. J? (10 marks)