6. BEHAVIOURAL FINANCE

Question 1

Interest in BF?

Answer 1

Markts often display anomalous behaviours despite investors trying to remain rational

Many standard economic theories rely on assumption of rationality and BF suggests this is not the case

Question 2

What doe BF theories help to explain?

Answer 2

excessive stock price vol
aasset bubbles
herding behaviour
selling winners to early/losses too late
asset prices over/under reacting to new info
investors holding under diversified portfolios
preference for shares of comps in public media

Question 3

Behavioural finance theory
Prospect theory

Answer 3

PT says that losses and gains are valued differently - AKA as loss aversion theory

investors will make decision on perceived gains vs percieved losses (e.g. £50 vs 50% chance of £100 = same value but people will chose £50)

says that standard finance model of rational agents doesnt explain how most people undertake financial decision making

behaviours of investors are outcomes of prospect theory = psychologically more accurate description of decision making in risk based setting

prospect theory investors sell winners too early but do not like to sell shares that are at a loss relative to a reference point

Question 4

2 types of systematic errors made by investors (cognitive illusions)

Answer 4

illusions due to heuristic decision processes

illusions caused by adoption of mental frames or prospect theory

Question 5

What are heurisitcs

Answer 5

Mental shortcuts people use to make decisions in complex or uncertain environments

Bounded rationality = people seek to make decision that is good enough vs the best possible/most optimal decision

Reliance on heuristics increases when stressed (short on time/emotional/complex)

To prevent over reliance - PM could limit to no. of portfolio options presented to client/ensure high qual and properly differentiated

Question 6

Biases in decision making

Answer 6

Anchoring
Status quo bias
Hindsight bias
Herd behaviour
- Availability bias
- Representativeness
Loss aversion
- characteristics
-prospect theory
Overreaction
Regret aversion
Confirmation bias

Question 7

Status quo bias

Answer 7

Tendency to stick with prior choices especially in complex circs
- e.g. sticking with historic AA

complexity often results in delaying choice/refusal to choose
- auto investing in default pension fund

BUT - do you educate out of error, could lead to them drawing false inferences/being overwhelmed
- well designed pension fund arguably better thna someone self investing their pension

Question 8

Loss aversion

Answer 8

Most important driver in human decision making

Investors dont experience losses and gains with the same intensity
- higher degree of emotional intensity with losses vs gain

leads to premature realization of gains and loss avoidance on the downside

Question 9

Reasons for increased levels of loss aversion

Answer 9

Lack of financial capacity to bear loss
- low no. of remaining working years (worse if retirement is cap intensive)
- specific near term financial commitment

Lack of capacity to understand investment losses
- not understanding cap at risk and LT outcome may be unaffected
- more to do with psych than knowledge and may be hard to train out of people

Phych reluctance/unwillingness to bear loss
- some people naturally v risk averse despite having capacity to bear loss

Question 10

Characteristics of loss

Answer 10

Amount - lost in single year (%)

Duration - amount lost in sequential years

Frequency - loss experienced over no. of discrete single years

Relativity - amount lost relative to psychological reference point

Question 11

Prospect theory

Answer 11

Stems from loss aversion = greater pain felt with losses than equivalent gain

When given 2 equal options - investors will place more weight on perceived gains vs perceived losses (70% chance of meeting goal vs 30% change of falling short)
- most investors choose option centred around gains

Investors also risk averse when seeking gains (will settle for reasonable gain) and risk seeking when avoiding losses

Practically - important consequences for marketing and price framing - more effort will go into avoiding losses than making gains
- investors tend to hold on too loses too long and sell winners too soon (sellng soon to lock in a gain and holding on taking additional risk to recover loss)

Question 12

Regret aversion

Answer 12

Desire to avoid feeling pain from poor investment decision
- including pain of responsibility for making decision (not just financial pain)

Encourages holding on to poorly performing shares to avoid crystallizing loss and acknowledging poor decision has been made

Biases new decisions = avoiding investments that have performed poorly in the past

Investors prefer strong consensus judgements (wrong together>wrong alone) - may enforce herd behaviour/FOMO/decision making with ref to peergroup

Question 13

Anchoring

Answer 13

Tendency for indivs to fixate on initial value/anchor as unconscious reference point when making decision
- then not being conscious of more info entering the market
- persists even when investor is aware that value is random
- not making decision based on fundamentals just considering price relative to anchor value

Question 14

Availability bias

Answer 14

Tendency to use info the comes to mind quickly/easily when making decisions

Tend to OW more readily avail info on bias that if came to mind quicker must be more relevant/important

Also OW info presented in format consistent with choice format (e.g. if decision is numerical then prefer info presented numerically)

Practical - manipulating info to more useful form

Question 15

Representativeness

Answer 15

Tendency to see patterns where they dont exist when having to make decisions under conditions of uncertainty w/ inadequate info

tend to draw inferences without considering sample size + extrapolate beliefs from isolated occurrences (e.g. recession in covid vs 2024 = v diff causes)

assume similarity in one aspect will lead to similarity in others

e.g. making inv decisions on basis of value vs growth only vs detailed analysis of company’s distinct features

Question 16

Hindsight bias

Answer 16

Availability bias + representativeness = hindsight bias

Tendency for investors to find an event to have been predictable after the fact (despite little/no evidence that it would happen beforehand)

Links to overconfidence bias - can make investors overly confident in future decisions as they believe they can see into future

e.g. post GFC investors convinced themselves it was obvious returns were going to be disastrous despite 07 strategy forecasters predicting high levels of return

Question 17

Herd behaviour

Answer 17

Tendency for investors to follow eachother due to strong social preferences to conform
- bad decisions perceived as being less incorrect if everyone was wrong together
- can lead to indivs making decisions they wouldnt have ordinarily made
- can result in formation of asset bubbles = self fulfilling prophecy
- dot com bubble - investors eager to take part in trend w/out looking at fundamentals/val metrics. when investors realised comps had little/no revs and were essentially worthless started selling out bursting bubble - Nasdaq down 80% from 2000 peak by 2002

Question 18

Confirmation bias

Answer 18

Tendency for indivs to seek out info that confirms vs contradicts their existing position
- and interpret ambiguous info as supporting their viewpoint

-unhelpful filter of potentially good ideas if they dont conform to prior belief
- failing to see info that challenges belief system and can lead to poor/outdated investment decisions

Question 19

Overreaction

Answer 19

Tendency for investors to overreact to new info - leads to investments being over bought/sold leading to ST price movements

Basis of value investing = take adv of overreaction bias and seeks comps whose share price is depressed on basis of bad news (but still financially sound) with intention of profiting off of price reversals

Question 20

Overconfidence

Answer 20

Tendency to have exaggerated views of own abilities/judgements
Can be linked to anchoring effect - especially when people asked to estimate range of possible values

• can lead to investors overestimating predictive ability
• constructing future forecasts that are too optimistic and UW prob of bad outcomes - can lead to more risk taking and overtrading
• analysts slow to revise previous assessments even where there is evidence it is incorrect

-w/ clients - can be hard to establish true risk profile when there is overconfidence

Question 21

Gambler’s fallacy

Answer 21

Failure to appreciate implications of randomness and probability
- belief that an event (whose occurrences are independent and identically distributed) has occurred more frequently than expected, it is less likely to happen again in the future

• echoes widespread belief of mean reversion (there are observations that support mean reversion but no purely statistic reason why it should occur)
• selling a security that has done well purely on the back of series of positive price movements (not it being expensive fundamentally)

Question 22

Naive diversification

Answer 22

when asked to make several choices at once, people tend to diversify more than when making the same type of decision sequentially
- often investors will choose to spread investments across all options avail to them (e.g. when choosing between 4 pension funds) - no account taken on compatibility of correlation of choices or risk profile etc

Question 23

Mental accounting

Answer 23

Mental accounting refers to the different values a person places on the same amount of money, based on subjective criteria, often with detrimental results -
people frame assets as belong to different, non fungible catergories/accounts

often leads people to make irrational investment decisions and behave in financially counterproductive or detrimental ways, such as funding a low-interest savings account while carrying large credit card balances

e.g. spending discretionary bonus in a way you wouldnt spend regular income

mental accounting suggest marginal propensity to consume from each account is different

To avoid: the mental-accounting bias, individuals should treat money as completely interchangeable no matter where they allocate it—whether to a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments).

Question 24

Cognitive dissonance

Answer 24

Cognitive dissonance is the unpleasant emotion that results from holding two contradictory beliefs, attitudes, or behaviors at the same time

failure to resolve cognitive dissonance can lead to irrational decision-making as a person contradicts their own self in their beliefs or actions.

People will work to resolve on one of the contradicting beliefs such that their decision making is now rational and linear again - greater potential for stress and uncertainty = more powerful post decision rationalization mechanismL

Question 25

Local/Home bias

Answer 25

Tendency to invest/prefer stocks in local companies - not optimal given the benefits of international diversification
- researchers critical of tendency to OW domestic stocks in portfolios

• rationalization of this is that investors may have more info - may result in superior performance tho this is ambiguous especially given high levels of research available for international companies

Question 26

PATH OF LEAST RESISTANCE

Answer 26

Tendency to make decisions based on cognitive biases vs rational analysis of avail info - following path requiring least mental effort or cognitive strain regardless of which choice is most logical

• e.g. auto investing in default pension fund

Question 27

Information trader

Answer 27

According to MPT - this is how to adopt success = become info trader
High qual info = key to profitable investment strategy
suggest people who trade on info are correct in rationally expecting to make profit -
opposite to noise trader

Question 28

Noise trader

Answer 28

Opposite of info trader
Make trading decision without use of fundamental data - relies on trend/sentiment/anomalies/momentum

Question 29

Algorithmic traders

Answer 29

Computer programme uses defined set of instructions to place trades - often based on timing/price/quantity/mathematical model
- has been used to disguise trades of large managers, more efficient execution of large orders by discovering pools of liquidity at certain prices
- large orders broken into set of sub orders and executed over a period of time
- can reduce transaction costs and no human errors

BAD
- less transparency at order book level - allows traders to operate anonymously and stealthily
- can have significant impact on market prices which can impact traders not able to adjust prices and can lead to flash crashed
- relies on historical data to predict future movements - when black swan events occur there can be huge losses for algo traders

Question 30

BF and volume of trading

Answer 30

Standard models of asset markets predict efficient market with rational investors = v little trading
Real life - trading volumes much higher than considered reasonable

Abnormally high levels of trading on stocks with gains and abnormally low on stocks with losses - regret aversion and disposition effect - where profits are capitalized early

Question 31

Disposition effect

Answer 31

Tendency of investors to sell assets that have increased in val and keep assets have dropped in value - related to loss aversion and prospect theory
can be minimized with hedonic framing = way to make gains feel stronger and losses feel less strong

Question 32

BF finance and vol

Answer 32

In rational, efficient world - prices should only change when there is new info - in reality prices change a lot more frequently than thiDs and vol is much higher than expected
stock and bond prices have become increasingly more volatile over time
VIX index = 30 day leading vol index = gauge to the emotional sentiment of US stock market

Question 33

Dividend puzzle

Answer 33

1. Why do firms pay cash dividends?
2. Why do share prices rise when dividends are increased?

In absence of tax considerations - investors should be indifferent to divi or retained earnings as they could create their own by periodically selling stock

Regret aversion = divi allows avoidance of regret aversion as investors dont have to experience regret if they sell stock and price rises subsequently

Mental accounting leads to creation of income and capital gains accounts - paying higher tax on income may not have same impact on investors who attach higher emotional value to gains

Question 34

Equity premium puzzle

Answer 34

equity risk premium - excess return over rfr investor expects by investing in stock market (US between 5-8%)
too large to be explained by risk alone and suggests a v high level of risk aversion and mental accounting

Question 35

Overconfidence bias in clients

Answer 35

• tend to focus on upside > downside of given risk strat
• tend to interpret medium risk and low chance of loss
  = most focus on risk reward trade off and frame carefully/make risk feel real

Question 36

2 types of overconfident advisory clients

Answer 36

• feel they have skills to build own portfolio but too busy
• has full faith that manage they selected will definitely succeed in investment process

both will judge outcomes against much higher standard which may be impossible to meet
IPS is key - ensure goals are realistic and not overambitious. benchmark comparisons also helpful

Question 37

Bounded rationality

Answer 37

Bounded rationality is the idea that rationality is limited when individuals make decisions, and under these limitations, rational individuals will select a decision that is satisfactory rather than optimal.

Question 38

Loss aversion timeframes

Answer 38

Enduring loss thought to be more important than identical one off loss
three year tipping point found to be common - where investors may stop investing after a run of bad performance

Question 39

Investment lifestyling

Answer 39

Lifestyling means giving up some potential gains in order to more robustly protect against loss - particularly as client nears retirement/fixed liability

Important as often once people make decisions they tend to leave them unchanged

Question 40

The Endowment Effect

Answer 40

refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value.

often triggered when the item has emotional or symbolic significance to individual

to combat - manager can trim down and diversify large pool over time rather than suggesting selling entire investment immediately

Question 41

Behavioral portfolio theory

Answer 41

BPT suggests investors have varied aims and goals - so creates a portfolio that creates a broad range of goals
resembles pyramid structure with layers defined by separate goals

BASE = goal of safety - wealth protection is primary goal. lowest risk
risk then increases up BPT pyramid - top later = wealth maximization
specified £ allocated to each mental account and investments made according to level of safety

diversification achieved not via AA but by investor goal diversification
portfolios will not be efficient from an MPT pov but claimed investors will get higher utility from the risks they take

Question 42

Present bias

Answer 42

Tendency to give stronger weight to payoffs that are closer to present time

Implies higher discount rate for now vs future

Tendency to discount future in favour of present

overvalue more immediate rewards or benefits at the expense of future rewards or benefit

can lead people to make irrational decisions that favor short-term gains - often @ expense of LT wellbeing

can take form of hyperbolic discounting = where investors discount value of future rewards far more steeply as they get closer to the present

Question 43

How to avoid present bias in investments

Answer 43

Debias people from retiring early and drawing from pension with messaging = pension pot growing at max rate
most people retire before state pension age but have not planned to retire early

Adopt LT investment strat that requires disciplined, consistent investment over time

Question 44

Inertia

Answer 44

Tendency of indivs to maintain current course of action - even when faced with new info/changes in environment

Tendency to stick with default option

Question 45

base rate fallacy/neglect

Answer 45

Tendency to give more weight to event specific info than we should

and ignoring highly relevant generic or base rate info

Misjudge probability of event by ignoring important background info

Misguided by presentiveness heuristic - drawing similarities and ignoring sample size