Behavior Finanace Flashcards
6.c: Discuss the effect that cognitive limitations and bounded rationality may have on investment decision making.
Combinations of risk seeking and risk aversion may result in a complex double inflection utility function.
Bounded rationality assumes knowledge capacity limits and removes the assumptions of perfect information, fully rational decision making, and consistent utility maximization
Bounded rationality relaxes the assumptions of perfect information and maximizing expected utility. Prospect theory further relaxes the assumption of risk aversion and instead proposes loss aversion.
In the editing phase, economically identical outcomes are grouped and a reference point is established to rank the proposals.
In the second phase, the evaluation phase, investors focus on loss aversion rather than risk aversion.
1) Editing Phase :-1) Codification 2) Combinatin 3) Segregation
4) Cancelation 5) Simplifiction 6) Detection of dominace
2) Evaluation phase -
6.d: Compare traditional and behavioral finance perspectives on portfolio construction and the behavior of capital markets
Challenges to EMH
Fundamental anomalies would relate future stock returns to stock fundamentals, such as PIE or dividend yield. Fundamental anomalies would be violations of both semi-strong and strong-form efficiency
Technical anomalies relate to studies of past stock price and volume. Technical anomalies would be violations of all three forms of efficiency.
Calendar anomalies-It would be a violation of all forms of EMH
Four alternative behavioral models have
been proposed:
(1) consumption and savings, - Investor save initally to fund their retirement. but behavior finance says they do mental accounting
(2) behavioral asset pricing, Traditional finance risk and return. Behavioral finance assumes sentiment premium
(3) behavioral portfolio theory -individuals construct a portfolio by layers. Each layer reflects a different expected
return and risk. BPT further asserts that individuals tend to concentrate their holdings in nearly risk-free or much riskier assets.
(4) the adaptive markets hypothesis -AMH is essentially EMH with bounded rationality, satisficing, and evolution.
The relationship of risk and return should not be stable. The market risk premium changes over time as the competitive environment changes.
Active management can find opportunities to exploit arbitrage and add value.
No strategy should work all the time.
Adaption and innovation are essential to continued success.
Survivors change and adapt.
The Behavioral Finance Perspective
Traditional finance (TF) assumes markets are efficient and prices reflect fundamental value. New information is quickly and properly reflected in market prices.
Four alternative behavioral models have
been proposed: (1) consumption and savings, (2) behavioral asset pricing, (3) behavioral
portfolio theory, and (4) the adaptive markets hypothesis
The consumption and savings approach proposes an alternative behavioral lifecycle model that questions the ability to exercise self control and suggests individuals
instead show mental accounting and framing biases.
Behavioral asset pricing-The behavioral asset pricing model adds a sentiment premium
Behavioral portfolio theory (BPT): Based on empirical evidence and observation,
rather than hold a well-diversified portfolio as prescribed by traditional finance,
Adaptive markets hypothesis (AMH): success in the market is an evolutionary process. Those who do not or cannot adapt do not survive
AMH leads to five conclusions:
The relationship of risk and return should not be stable. The market risk
premium changes over time as the competitive environment changes.
Active management can find opportunities to exploit arbitrage and add value.
No strategy should work all the time.
Adaption and innovation are essential to continued success.
Survivors change and adapt
7.a: Distinguish between cognitive errors and emotional biases.
Cognitive errors are due primarily to faulty reasoning and could arise from a lack of
understanding proper statistical analysis techniques, information processing mistakes,
faulty reasoning, or memory errors.
emotional biases are not related to conscious thought and stem from feelings or impulses or intuition. As such they are more difficult
to overcome and may have to be accommodated.
7.b: Discuss commonly recognized behavioral biases and their
implications for financial decision making.
Cognitive errors can be divided into 5 “belief perseverance” biases that reflect a desire to stick with a previous decision and 4 “processing errors” where the information analysis process is flawed
Conservatism bias -rationally form an initial view but then fail to change that view as new information becomes available.
- Unwilling or slow to update a view and therefore hold an investment too long.
- Hold an investment too long to avoid the mental effort or stress of updating a view.
Confirmation bias- look for new information or distort new information to support an existing view.
- Consider positive but ignore negative information and therefore hold investments too long.
- Set up the decision process or data screens incorrectly to find what they want to see.
**Representativeness bias: **New information is evaluated based on past classification or experience without more thorough analysis.
base-rate neglect - / sample size neglect
**Illusion of control bias: **market participants think they can control or affect outcomes when they cannot.
Hindsight bias is a selective memory of past events, actions, or what was knowable in the past
- Overestimate the rate at which they correctly predicted events which could reinforce an emotional overconfidence bias.
- Become overly critical of the performance of others.
Cognitive Errors: Information-Processing Biases
These are related more to the processing of information and less to the decision making
process.
Anchoring and adjustment bias: Changes are made but in relation to the initial view and therefore the changes are inadequate.
Mental accounting bias : money is treated differently depending on how it is categorized.
- Structuring portfolios in layers to meet different priority goals.
- Failing to lower portfolio risk by adding assets with very low correlation.
- Segregating return into arbitrary categories of income, realized gains and losses, or unrealized gains and losses.
Framing bias : decisions are affected by the way in which the question or data is “framed.”
- Fail to properly assess risk and end up overly risk-averse or risk-seeking.
- Choose suboptimal risk for their portfolio or assets based on the way a presentation is made.
- Become overly concerned with short term price movement and trade too often.
Availability bias starts with putting undue emphasis on the information that is readily available.
Choose a manger based on advertizing or recalling they have heard the name.
Limit investment choices to what they are familiar with resulting in:
• Under diversification.
• Inappropriate asset allocation.
Emotional Biases
Loss-aversion : It arises from feeling more pain from a loss than pleasure from an equal gain
Overconfidence bias occurs when market participants overestimate their own intuitive ability or reasoning.
- Underestimate risk and overestimate return.
- Under diversification.
- Excessive turnover and transaction costs resulting in lower return.
Self-control bias occurs when individuals lack self-discipline and favor immediate gratification over long-term goals
Status quo bias : when comfort with the existing situation leads to an unwillingness to make changes.
- Holding portfolios with inappropriate risk.
- Not considering other, better investment options.
Endowment bias occurs when an asset is felt to be special and more valuable
simply because it is already owned.
- Failing to sell an inappropriate asset resulting in inappropriate asset allocation.
- Holding things you are familiar with because they provide some intangible sense of comfort.
Regret-aversion : participants do nothing out of excess fear that actions could be wrong.
Excess conservatism in the portfolio because it is easy to see that riskier assets
do at times underperform.
Herding behavior is a form of regret-aversion where participants go with the consensus or popular opinion.
