Behavioral Finance Flashcards
Which theory assume risk aversion?
Utility theory
Bounded Rationality
Bounded rationality assumes knowledge capacity limits and removes the assumption of perfect information, fully rational decision making, and consistent utility maximization. Individuals instead practice satisfice. Outcomes that offer sufficient satisfaction, but not optimal utility, are sufficient.
Which theory assumes loss aversion?
Prospect theory
Explain how decisions are made in prospect theory.
Choices are made in two phases. The editing phase and the evaluation phase. The goal of the editing phase is to simplify the number of choices that must be made before making the final evaluation and decision. In the second phase, the evaluation phase, investors focus on loss aversion rather than risk aversion.
Explain the editing phase of prospect theory.
In the editing phase, proposals are framed or edited using simple heuristics (decision rules) to make a preliminary analysis prior to the second evaluation phase. Economically identical outcomes are grouped and a reference point is established to rank the proposals. The reference point frames the proposal as a gain or loss and affects the subsequent evaluation or decision step.
Explain the evaluation phase of prospect theory.
In the evaluation phase, investors focus on loss aversion rather than risk aversion. The implication is that investors are more concerned with changes in wealth than they are with the resulting level of wealth, per se. Additionally, investors are assumed to place a greater value in changes on a loss than on a gain of the same amount. Investors tend to fear losses and can become risk seeking (assume riskier positions) in an attempt to avoid them.
Detail the steps of the editing phase.
The precise sequence and number of steps. The first three steps may apply to individual proposals.
- Codification
- Combination
- Segregation
The next three steps may apply when comparing two or more proposals.
- Cancellation
- Simplification
- Detection of dominance.
What happens during the Codification stage?
During the codification stage a reference point is selected and the proposal is coded as a gain or loss of value and is assigned a probability.
What happens during the Combination stage?
Combination simplifies the outcomes by combing those with identical values.
What happens during the Segregation stage?
The expected return is separated into a risk-free and risky component of return.
What happens during the Cancellation stage?
Cancellation removes any outcomes common to two proposals.
What happens during the Simplification stage?
Simplification applies to very small differences in probabilities or to highly unlikely outcomes.
What happens during the Detection of Dominance stage?
Any proposal that is clearly dominated by another proposal would be discarded.
What is the isolation effect, how does it develop, and why is it called an anomaly?
Editing choices can sometimes lead to the preference anomaly known as the isolation effect, where investors focus on one factor or outcome while consciously eliminating or subconsciously ignoring others. It is referred to as an anomaly because the sequence of the editing can lead to different decision.
What are the three versions of the efficient market hypothesis (EMH)?
- Weak-form efficient
- Semi-strong form
- Strong-form efficieny
Describe a weak-form efficient market and its consequences.
Current prices incorporate all past price and volume data. If true, managers cannot consistently generate excess returns using technical analysis.
Describe a semi-strong efficient market and its consequences.
Current prices incorporate all public information, including past price and volume data. The moment valuable information is released, it is fully and accurately reflected in asset prices. If true, managers cannot consistently generate excess returns using technical or fundamental analysis.
Describe a strong-form efficient market and its consequences.
Current prices reflect all privileged nonpublic (i.e. inside) information as well as all public information, including past price and volume data. If true, managers cannot consistently generate excess returns using public information, nonpublic information, or technical analysis.
Explain “no free lunch”.
It is difficult if not impossible to consistently outperform the market on a risk-adjusted basis.
What is the “price is right”.
Stock prices correctly reflects intrinsic value.
Give evidence to support the weak-form EMH.
Historical studies show virtually zero serial correlation with past stock prices. If past prices showed strong serial correlation, then past prices could be used to predict subsequent changes. Stock price changes appear random.
What are the two area of test for the semi-strong EMH and explain their results?
Event studies and studies on manager’s ability to generate excess returns.
Event study - Stock split announcement studies showed stock prices rise abnormally for up to two years before the split and compete an upward adjustment coincident with the split announcement, thus supporting semi-strong EMH and not strong EMH.
Excess return study - Studies of MF managers show the majority have negative alphas before and after management fees.
What are the challenges to EMH and explain their results?
Fundamental anomalies -
Numerous studies have shown that value stocks with lower P/E, P/B, and P/S, higher E/P, and B/P, and dividend yield outperform growth stocks.
Studies show abnormal positive returns for small-cap stocks.
However other studies suggest the abnormal return is not evidence of excess return but of higher risk. Fama and French extended CAPM by adding market cap and B/P as priced risk. Analysis using these revised risk premiums suggest the apparent excess returns are just a failure to properly adjust (upward) for risk.
Technical anomalies -
When short-term moving average of price moves above (below) a longer-term moving average, it signals a buy (sell).
when a stock price rises above a resistance level, it signals a buy.
Calendar anomalies - January effect: Stocks have abnormally high returns in January, in the last day of each month, and in the first four days of each month.
Transaction cost, the need for high leverage, and liquidity reasons can remove most of the benefits of these anomalies.
What are the four alternative behavioral models.
- Consumption and savings
- Behavioral asset pricing
- Behavioral portfolio theory
- Adaptive markets hypothesis (AMH)
What is the Consumption and savings model?
Traditional finance assumes investors are able to save and invest in the earlier stages of life to fund later retirement. This requires investors to show self control by delaying short-term spending gratification to meet long-term goals. The consumption and savings approach proposes an alternative behavioral life-cycle model. Investors mentally account and frame wealth as current income, assets currently owned, and present value of future income. Traditional finance assumes that all forms of wealth are interchangeable. Behavioral finance presumes that individuals are less likely to spend from current assets and expected income, and more likely to spend current income. This makes them subject to framing bias. If a bonus is viewed as current income, they’re more likely to spend it. If it is viewed as future income, they are more likely to save it.
What is the Behavioral asset pricing model?
The behavioral asset pricing model adds a sentiment premium to the discount rate; the required return on an asset is the risk-free rate, plus a fundamental risk premium, plus a sentiment premium.
What is the Behavioral portfolio theory (BPT)?
In Behavioral portfolio theory (BPT), individuals construct a portfolio by layers. Each layer reflects a different expected return and risk. Allocation of funds to and investment of each layer depends on the importance of each goal to the investor. BPT further asserts that individuals tend to concentrate their holdings in nearly risk-free and much riskier assets.
What is the Adaptive markets hypothesis (AMH)?
The Adaptive markets hypothesis (AMH) assumes successful market participants apply heuristics until they no longer work and then adjust them accordingly. AMH assumes that success in the market is an evolutionary process. Those who do not or cannot adapt do not survive.
How do cognitive errors develop?
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.
Should cognitive errors be mitigated or accommodated?
Mitigated through better training or information.
How do emotional biases develop?
Emotional biases stem from feelings, impulses, or intuition.
Should emotional biases be mitigated or accommodated?
Emotional biases are difficult to overcome and may have to be accommodated.
What are the two categories that cognitive error are divided into?
- Belief perseverance
2. Processing errors
List the belief perseverance biases
- Conservatism bias
- Confirmation bias
- Representativeness bias
- Illusion of control bias
- Hindsight bias
List the processing error biases
- Anchoring and adjustment bias
- Mental accounting bias
- Framing bias
- Availability bias
