Behavior Finance 7-9 Flashcards
traditional finance
investors are rational, risk averse, self-interest utility maximizers
unlimited knowledge
neoclassical economics
market is efficient (EMH)
Bayer’s conditional probability
Utility theory
REM (rational economic man) use indifference.curve analysis
Behavior finance irrational/suboptimal
BPT Behavioral portfolio theory: 1. constructed in layers 2. concentrated in the low and high risk asset. Median-risk asset tend to be ignored.
Mean variance considers correlation between assets and would be more likely to diversify across asset types.
psychological grounded
BFMI Micro: individual
emotional bias
BFMA Macro: market
efficiencies of markets
Bounded rationality - limitation on ability to process info
Prospect theory - loss averse, reference dependence to determine g/l leading to possible cognitive error
Satisfice
capacity limitation of knowledge
friedman - savage double inflection utility functon
很贫穷和很有钱会risk averse
在中间 risk seeking
sentiment risk
Risk averse
rational
concave
prefer certainty
pay to avoid
Risk seeking
convex
risk seeking
certainty equivalent : max(pay to participate)
max(accept to not participate)
pay to undertake
Perspective analysis (effort to use behavior finance) Prospect theory ( how g/l are evaluated)
based on SEU subjective expected utility
Bounded rational is adequate, satisfied 满意
6 editing to simplify evolution of choices
codification combination segregation cancellation simplification detection of dominance
weakform
technical cannot generate excess return
semi-strong
fundamentally cannot generate excess return
strong-form
no one can earn excess return
3 market anomalies
fundamental - P/E dividend yld
violation of both semi-strong and strong form efficiency
technical - violation of all 3 forms efficiencies
ST moving avg of price move above LT moving avg - buy signal
stock move below a support level - sell
stock move above a support level - buy
Calendar anomaly - small cap have abnormally high return in Jan last day of each month and first 4 days of each month
behavior portfolio construction
consumption and saving
Behavior portfolio theory (layer) focus on portfolio construction
Behavior asset pricing model postulates a sentiment premium should be included in asset pricing
adaptive market hypothesis (AMH) principal of evolution, success is defined as survival, markets change overtime, arbitrage opportunity get priced into the market. assumes successful market participants apply heuristics until they no longer work and then adjust them accordingly.
cognitive error 5
HIRCC hindsight illusion of control representativeness conservatism confirmation
Processing bias 4
FMAA Framing Mental accounting Anchoring Availability
Emotional Bias 6
LOSSER Loss aversion overconfident self-control status quo endowment regret-aversion
Conservatism
underweight new info
is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information
Confirmation
selective bias
Seeking data to support beliefs, discounting contradictory facts
ignore and undervalue what contradict their belief
a cognitive error, is a belief perseverance bias. Individuals who exhibit this bias look for confirmation of their belief and ignore any information which contradicts their belief.
representativeness bias
IPS
classifying info base on past experience
overweight most recent information
base rate neglect
- too little consideration given to the initial classification being correct
sample size neglect
-inferring too much from a small new sample of information
illusion of control
CAPM, mean variace framework
tend to believe they can control or influence outcomes
lead to excess trading
Hindsight bias
may see past events as having been p predictable and reasonable to expect
Anchoring
overweight initial default number
stick to their original estimates/analysis
hold onto
Mental Accounting
goal based
invest in layers
treat one sum of money differently from another equal-sized sum of money
layer/goals
framing
provide a full range of relevant info
decision based on how case is presented
focus future and let go realized loss
availability bias
start the allocation process within global market portfolio
Individuals exhibiting this bias will assess the likelihood of an outcome based on how easily they can recall the information.
a cognitive error, is an information-processing bias.
- may limit their investment opportunity set
- may choose an investment without doing a thorough analysis of the stock, may fail to diversify, and
- may not achieve an appropriate asset allocation.
overcome this bias by developing an appropriate investment policy strategy, with a focus on appropriate goals (short- and long-term), and having a disciplined approach to investment decision making.
loss aversion bias
disposition effect
goal based
prospect theory, loss averse
in which people tend to strongly prefer avoiding losses as oppose to achieving gain
investor behave as the evaluation of g/l based on reference point
disposition effect
holding the investment that have experienced losses too long, and selling investment that have experience gains too quickly
- limiting upside profit
- trade excessively and hold risker portfolio
Myopic loss aversion (近视的）special application of loss aversion
explain for equity premium that describes an anomalously higher historical real returns of stocks over gov’t bond
combines time-horizon-based framing, mental accounting and loss-aversion bias
more concerned with ST losses than LT results/gains
over emphasis ST G/L and weight losses more heavily than gains
resulting a higher equity risk premium
overconfidence
self-attribution bias
people demonstrate unwarranted faith in their intuitive reasoning, judgements, cognitive abilities.
attribute success
overestimated knowledge levels, ability and access to information
underestimate risk and overestimate exp(r)
trade excessively
hold poorly diversified portfolio
lower return than the market
self control bias
fail to act in pursuit of long-term goal because of lack of self-discipline.
- hyperbolic discount
tendency to prefer small payoffs now compare to large payoffs in the future - save/spend disposable income, spend today rather than save for tomorrow
- st satisfaction conflict lt goal/achievement
status quo bias
do nothing, stay the same
Status quo bias reflects the tendency for forecasts to recent observations and then avoid making changes.
Status quo bias can be mitigated by a disciplined effort to avoid anchoring on the status quo.
need education
endowment bias
emotional attachment
people value an asset more when they hold rights to it than when they do not. Refuse to sell.
regret aversion bias
avoid making decisions made out of fear that the decision will turnout poorly
error of commission - action taken
error of omission -action non-taken
need education
behavior modified asset allocation
the wealthier the client, the more the practitioner should and adopt to the client’s behavioral biases
standard living risk - the likelihood of achieve outliving his/her asset if a function of the level of wealth
cognitive error should be moderated
(easier to correct by education)
emotional biases should be adapted to
Barnewall two-way model
passive
active
BB-K five way model
level of confidence & method of action
ACIG
Adventurer - confident and impetuous 浮躁
unwilling to take advice
Celebrity - anxious and impetuous
seeks and take advice
Individualist - confident and careful
good to work with
Guardian - anxious and careful
seek advice from someone more knowledgable
Pompian behavior model
BITS
PFIA
FROM LOWEST RISK TO HIGH
PP, FF,II,AA Passive preserver emotional friendly follower cognitive independent individualist cognitive active accumulator emotional
Passive preserver
Pompian behavior model
primarily emotional bias
- not financially sophisicated
- low risk tolerance
- not willing to risk own capital
display emotional biases
focus of advice should be on addressing these emotions.
Describing how the investment relationship will help to accomplish goals would seem most appropriate.
naive diversification (framing bias)
1/n divide contribution equally among available funds ignoring the issue of correlation and true diversification.
consequence:
- Maintaining an under-diversified portfolio with assets having high correlations with each other.
- Missing long-term objectives—not achieving the required returns or capital accumulation necessary to meet long-term expenses or goals, and potentially outliving the assets.
Social proof bias
individual are bias to follow the belief of a group
bounded rationality
recognizes that people are not fully rational when making decisions and do not necessarily optimize but rather satisfice when arriving at their decisions
two reason for poor decision by investment committees:
1. decisions reflect the biases of the members.
2. social proof or herding as each member seeks to follow the beliefs of other members
view
actions to take to avoid:
assemble a diverse group of knowlegedgable members
follow an agenda
assure all members share
The gambler’s fallacy
is a cognitive behavioral bias in which an analyst wrongly projects a reversal to a long-term trend.
Misunderstands mean reversion in assuming below average rates must return to above-average rates in a specific time period.
Limitations of classifying investors into the various behavioral investor types include:
- investor can display both emotional biases and cognitive errors, making it difficult to classify the individual according to behavioral biases.
- may display traits of more than one behavioral investor type, making it difficult to place the individual into a single category.
- As investors age, they will most likely go through behavioral changes
- Even though two individuals may fall into the same behavioral investor type, the individuals should not necessarily be treated the same due to their unique circumstances and psychological traits.
- Individuals tend to act irrationally at unpredictable times because they are subject to their own specific psychological traits and personal circumstances. In other words, people don’t all act irrationally (or rationally) at the same time.
deviation from a rational portfolio
for cognitive error
high wealth low SLR
moderate 5-10%
low wealth high SLR
close to rational 0-3%
for emotional bias
high wealth low SLR 10-15%
low wealth high SLR 5-10%
friendly follower FF
primarily cognitive bia
an often overestimate his or her risk tolerance,
may follow “hot” ideas and show availability bias,
follow leads from friends/colleagues, want to be in the latest/popular investment without considering LT goal
low/moderate risk tolerance
overestimate risk tolerance
independent individualist II
primarily cognitive bias
overconfident, self contribution
strong skilled
moderate/high risk tolerance
strong-willed
do own research
active accumulator AA
primarily emotional bias
entrepreneur background, strong skilled
confident, self-control
higher turnover rate, involved in decision making
