Behavioral Flashcards
4 Rationality Axioms
What is the “Sell in May and go away” strategy, and what behavioral bias does it reflect?
Empirical anomaly: Markets show seasonally weak performance from May to October, stronger from November to February.
Strategy Rule:
Sell on the first trading day of May.
Buy either:
On the 6th trading day before end of October, or
On the 1st trading day of October (yields better results).
Reflects calendar/time-based behavioral bias (irrational seasonal investing behavior)
What is the Availability Bias in behavioral finance?
A cognitive bias where people judge the likelihood or frequency of an event based on how easily examples come to mind.
Leads to overestimating the importance of recent, vivid, or emotionally charged information.
Can result in irrational investment decisions, such as:
Overreacting to recent market crashes.
Overvaluing stocks in the news (e.g., tech IPOs after a media hype).
Investors may ignore statistical evidence or long-term trends.
What is Framing in behavioral finance, and how does it relate to information selection bias?
Framing refers to how the presentation or context of information influences decision-making, even if the underlying facts remain unchanged.
Information selection bias occurs when individuals focus on certain data while ignoring others, often unconsciously, due to how the information is framed.
Investors may interpret the same financial outcome differently based on how it is worded or framed:
Gain frame: “This portfolio has a 70% chance of profit” → perceived positively.
Loss frame: “This portfolio has a 30% chance of loss” → perceived negatively.
Leads to irrational choices, like:
Overweighting positively framed news, underweighting risks.
Avoiding decisions framed in terms of potential losses, even when optimal.
What is Conservatism Bias in behavioral finance, and how does it relate to information selection bias?
Conservatism bias occurs when individuals underreact to new information, placing too much weight on prior beliefs.
In the context of information selection bias, people discount or downplay new evidence that conflicts with existing views.
This bias leads to slow adjustment of expectations, even when the new data is significant.
Common in investing when:
Analysts stick to outdated forecasts despite strong earnings surprises.
Investors delay portfolio rebalancing after a market regime shift.
Results in inertia, missed opportunities, and persistent mispricing.
What is the core idea of prospect theory?
People do not evaluate outcomes based on final wealth states (as in Neoclassical theory) but rather on gains and losses relative to a reference point.
In other words: people are more sensitive to changes in wealth than to absolute levels of wealth.
What are the key components of prospect theory?
A. Reference Dependence
People make decisions based on gains or losses relative to a reference point, not total wealth.
B. Loss Aversion
Losses hurt more than equivalent gains feel good.
Empirically, the pain of losing €100 is about twice as strong as the pleasure of gaining €100.
C. Diminishing Sensitivity
The value function is concave for gains (risk averse) and convex for losses (risk seeking).
Implication: The difference in value between €100 and €200 is perceived less intensely than between €0 and €100.
D. Probability Weighting
People overweight small probabilities and underweight large ones.
E.g., a lottery ticket is overvalued because the tiny chance of winning is perceived as more significant than it statistically is.
This leads to:
Risk-seeking behavior in gains when probabilities are low (lottery tickets),
Risk-averse behavior in losses when probabilities are high (insurance).
How does the prospect theory value function looks like?
Imagine an S-shaped curve, centered at the reference point (0):
Left of 0: Steep and convex (losses).
Right of 0: Flatter and concave (gains).
The curve is steeper for losses, illustrating loss aversion.
What are the behavioral implications of prospect theory?
Neoclassical vs Prospective
What is the Disposition Effect?
The tendency of investors to sell winning assets too early and hold losing assets too long.
Which behavioral theory explains the Disposition Effect?
Prospect Theory (by Kahneman & Tversky, 1979).
How does the Prospect Theory value function behave for gains and losses?
Concave for gains → risk-averse
Convex for losses → risk-seeking
Steeper in the loss domain → loss aversion
Portfolio Optimization: Efficient Frontier vs. Utility-Based Frontiers
Efficient frontier (gray) assumes purely rational mean-variance tradeoffs.
Expected Utility (green) is shaped by investor-specific utility functions—reflecting diminishing marginal returns and risk sensitivity.
Expected Value (blue) drops at higher volatility, showing behavioral aversion to high volatility, despite higher returns.
Identifying Risk Preferences (Part 1): Survey-Based Quantification
Q1. -2.50% Performance worse than -2.5% is a “total disaster”.
Q2. -0.83% This is the maximum tolerable loss. Anything worse causes discomfort.
Q3. +0.83% A realistic, satisfactory return.
Q4. +5.00% A near-perfect outcome. Total satisfaction level.
Loss aversion and risk aversion?
Loss aversion: The utility loss incurred from losses is higher than the utility gain from profits
of the same amount i.e. the higher the loss aversion, the higher is the gain which would be
necessary to compensate losses, so that the investor prefers a loss reduction from -100 to 0
to an increase in profit from 0 to 100.
Risk aversion: an investor is risk averse if he/she prefers a certain cash flow over an uncertain
cash flow with the same expected value. The risk aversion is no comparison of profits and
losses as it happens in the Prospect Theory, but only a comparison of certain and uncertain
cash flows.
Which investment (bonds or shares) would Mike prefer if he had a one year investment?
Assume beta=2
Explanation:
o Short horizon: both utilities negative, but bonds slightly less negative
o Long horizon: bonds negative utility, shares positive
o the investor is more strongly affected by losses at a shorter investment horizon
than at a longer investment horizon (see value function)
o Reason: strong loss aversion -> losses have to be compensated by relatively high
gains. In long horizon only shares are able to generate positive utility for investor
(only shares can overcompensate losses). Bonds give equal probability for losses
and profits -> as losses weigh heavier than profits in the eyes of the investor, bonds
have no positive utility and are worse than shares.
What is the “Law of Small Numbers”?
The cognitive bias where people mistakenly believe that small sample sizes must reflect the properties of the overall population (i.e., expecting “representativeness” too quickly).
Example
After flipping a coin 3 times and getting heads each time, someone believes tails is “due”—even though each flip is independent.
What is Ambiguity Aversion?
The tendency to prefer known risks over unknown risks, even if the expected outcomes are similar.
Example
People prefer betting on a jar with 50 red/50 black balls over one with an unknown red/black mix—even if the odds may be the same.
What is the Volatility Puzzle?
The empirical observation that assets with high volatility often yield lower risk-adjusted returns than low-volatility assets—contradicting traditional finance theory.
Example
Low-volatility stocks often outperform high-volatility stocks over time, despite being less risky—contradicting the CAPM prediction that higher risk should be rewarded with higher returns.
What is the Equity Premium Puzzle?
The observed fact that historical returns on stocks are much higher than can be explained by standard economic models, given reasonable levels of risk aversion.
Example
U.S. equities have historically outperformed government bonds by 5–7% annually, which standard models can’t justify without assuming unrealistically high risk aversion.
What is Myopic Loss Aversion?
The tendency of investors to:
Strongly dislike short-term losses (loss aversion), and
Evaluate their portfolios too frequently (myopia)
This leads them to shy away from risky assets like stocks, even if they offer higher long-term returns.
How does Myopic Loss Aversion explain the Equity Premium Puzzle?
Investors avoid equities because they check their portfolios often and are emotionally impacted by short-term losses. To hold stocks, they demand a large premium to compensate for this discomfort—explaining the unusually high historical equity returns.
What is Mental Accounting?
A behavioral bias where people treat money differently depending on its source, intended use, or mental “category,” rather than considering it as part of a single, fungible pool.
Someone receives a $500 tax refund and splurges on a vacation, even though they have credit card debt—because they view the refund as “extra” money.
