Behavioral Finance

Question 1

6 Emotional Biases

Answer 1

Loss aversion, overconfidentce, self-contraol, status quo, endowment, regreat aversion

LOSSER

Question 2

Loss-Aversion bias

Answer 2

Strong preference for avoiding loss as opposed to achieving gains.

• limits upside potential
• hold risker portfolio than acceptable from risk/return perspective
• Excessive trading from selling winners

Question 3

Loss Aversion Bias - disposition effect

Answer 3

Holding (not selling_ investments that have expereinces loses (loser) too long; and the sell (not holding) investments that have experienced gains (winners) too quickly-

Question 4

Myoptic loss aversion

Answer 4

inappropriate short term focus

Question 5

Overconfidence bias & consequences

Answer 5

Unwarranted faith in own reasoning, judgement, and/or cognitive abilites (aka illusion of knowledge

• underestimate risk and overest. exp. returs
• hold poor diversified portfolios
• trade excessively
• lower returns than market

Question 6

Self attribution bias

Answer 6

Take credit for success and assign blame to others

Question 7

Self Control Bias

Answer 7

Fail to pursue long term goals due to lack of self-discipline

• save insufficient for future
• accept to much risk for returns (to make up for inadequate savings
• Allocation inbalance

Question 8

Status Quo Bias

Answer 8

Doing nothing instead of making a change, maitaining existing positions

Question 9

Endowment biases

Answer 9

Valuing an asset more when you have rights to it than when you dont - violates willing buyer/seller theory

• Maintain inapproarpiate allocations
• Hold classes of ‘familiar assets’ staying away fro the less experienced classes

Question 10

Regret Aversion

Answer 10

Avoid making decisions that will result in action out of fear that the decision will turn out poorly, avoid pain of regreat - hold a position too long

• error of commision: regret from action taken
• error of ommission: regreat from action not taken
• Conseq: herding behavior, too conservative

Question 11

Cognitive Error types; Belief perseverance biases & processing errors

Answer 11

‘Belief perseverance’ - conservatism, confirmation, representativeness, illusion of control, and hindsight
‘Processing errors’ - anchoring and adjustment, mental accounting, framing, availability

Question 12

Conservatism Bias

Answer 12

Maintain prior views or forecasts by inadequately incorporating new information. Underreachtion to new information, overweight base rates nad underweight new information

Question 13

Confirmation Bias

Answer 13

People tend to look for and notice what confirms their beliefs, and to ignore or undervalue what contradicts

• Consider only position infomraiton
• Ignore info that refutes beliefs
• Under diversify
• Disproportionate employer stock investment

Question 14

Representativeness Bias

Answer 14

Classification of new information based on past experiences and classifications

Question 15

Illusion of Control Bias

Answer 15

Believing one can control or influence outcomes. Leads to excessive trading and inadequate diversifiction

Question 16

Hindsight bias

Answer 16

Selective persecption and retention aspects -people may prevent themselves from learning from the past

Question 17

Anchoring and adjustment bias

Answer 17

Set anchors when estimating probabilties and tend to adjust anchors insufficiently - new information is not properly adjusted for

Question 18

Mental accounting

Answer 18

Treatment of one sum of money different then another - put into buckets/accounts.

• neglect of opportunities to reduce risk by combining assets with low correlation
• irrationally distinguish between returns from income and capital appreciation

Question 19

Framing Bias

Answer 19

Person answers a question differently based on the way in wihchi t is asked/framed
-misidentify risk tolerances, choose suboptimal investmenrs, focus on short term fluctuations resulting in excessive trading

Question 20

Availability bias

Answer 20

People take heuristics (rule of thumb or mental shortcuts) approach to estimating the probability of ourcomes based on how easily they come to mind

• lmit investment opps
• fail to diversity and app. asset allocation

Question 21

Behavioral finance - BFM! & BFMA

Answer 21

FI(Micro), FA(Macro)
Micro- examines behaviors or biases that distinquish individal investors from rational assumed in classical economic theory
-Macro - market anomolie that distinquish markets from the efficents markets of tradiional finance

Question 22

Bayes formula

Answer 22

Expects people to update old beliefs in a certain manner given new information -but people have cognitive limitations not accounted for in expected utility theory

Question 23

Rational economic man (REM)

Answer 23

Try to obtain highest possible economic well being or utility given budget contraints and available info, choices based on own well being and not others
-perfect rationality,self interest and information are governing principles

Question 24

Challenges to REM - bounded rationality

Answer 24

Bounded Rationality - people have informational, intellectual and computational limitations - people gather some but not all info and use heuristics to make a satisfactory decision, not necessarily optimal
-satisfice - satisfy and suffice: finding accpetable soltuion by setting constraints

Question 25

Prospect Theory

Answer 25

Alt, to expected utility theory
-people are risk averse with mod to high prob of gains or low prob losses, and risk seeking with low prob of gains or high prob of losses

Question 26

Efficent market hypthesis

Answer 26

markes fully accurately and instantaneously incorporate all available info into mkt prices

Question 27

Challenges to Efficient market hypthesis -

Answer 27

Market anamolies - evidence of market efficency
-Fundamental anamolies -value and growht investing
-Technical : moving averages, when short moves above or below long moving average, trading range break - when price pentrates resistence level
calendar - january effect

Question 28

Behaviorally modified asset allocation guidelines

Answer 28

Decision to moderate or adapt on two levels

• Wealth: adapt to wealthier and moderate to less wealthy (;high standard of living, low wealth)
• Behavioral bias: moderate cognitive errors and adapt to emotional