Behavioral Finance Flashcards
6 Emotional Biases
Loss aversion, overconfidentce, self-contraol, status quo, endowment, regreat aversion
LOSSER
Loss-Aversion bias
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
Loss Aversion Bias - disposition effect
Holding (not selling_ investments that have expereinces loses (loser) too long; and the sell (not holding) investments that have experienced gains (winners) too quickly-
Myoptic loss aversion
inappropriate short term focus
Overconfidence bias & consequences
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
Self attribution bias
Take credit for success and assign blame to others
Self Control Bias
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
Status Quo Bias
Doing nothing instead of making a change, maitaining existing positions
Endowment biases
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
Regret Aversion
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
Cognitive Error types; Belief perseverance biases & processing errors
‘Belief perseverance’ - conservatism, confirmation, representativeness, illusion of control, and hindsight
‘Processing errors’ - anchoring and adjustment, mental accounting, framing, availability
Conservatism Bias
Maintain prior views or forecasts by inadequately incorporating new information. Underreachtion to new information, overweight base rates nad underweight new information
Confirmation Bias
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
Representativeness Bias
Classification of new information based on past experiences and classifications
Illusion of Control Bias
Believing one can control or influence outcomes. Leads to excessive trading and inadequate diversifiction
Hindsight bias
Selective persecption and retention aspects -people may prevent themselves from learning from the past
Anchoring and adjustment bias
Set anchors when estimating probabilties and tend to adjust anchors insufficiently - new information is not properly adjusted for
Mental accounting
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
Framing Bias
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
Availability bias
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
Behavioral finance - BFM! & BFMA
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
Bayes formula
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
Rational economic man (REM)
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
Challenges to REM - bounded rationality
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
Prospect Theory
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
Efficent market hypthesis
markes fully accurately and instantaneously incorporate all available info into mkt prices
Challenges to Efficient market hypthesis -
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
Behaviorally modified asset allocation guidelines
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
